Itaú BBA - Lower Prices Consistent With Macro Fundamentals

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Lower Prices Consistent With Macro Fundamentals

June 5, 2013

A favorable supply outlook led to downward revisions in agricultural commodity prices.

•    Prices rose in May, driven by low grain inventories and concerns with planting delays in the U.S.

•    Macro fundamentals remain consistent with lower commodity prices.

•   Agriculture: Favorable supply outlook (corn, soybeans, sugar and coffee) led to downward revisions in our year-end forecasts. Wheat close to equilibrium. Global equilibrium in sugar and coffee depends on Brazil.

Commodity prices rose on average 0.3% in May (according to the Itaú Commodity Index, or ICI), led by higher grain prices. Low inventory levels and concerns related to planting delays in the U.S. drove price increases in futures contracts for delivery before the next crop in the Northern Hemisphere, pushing the Agricultural ICI up by 1.0%. Meanwhile, sub-indexes for metals and energy slid 1.2% and 0.5% from their April averages, respectively. The lower average still reflects the sharp decline seen in mid-April, which was partly offset by a slight rebound in May.

A favorable supply outlook led to downward revisions in agricultural commodity prices. Favorable weather conditions in Europe and China, and a larger crop in the U.S. than the previous one, point to surpluses in the global balance for corn and soybeans. Fundamentals for coffee and sugar also suggest surpluses. Hence, we are revising downward our year-end forecast for the Agricultural ICI sub-index. We now forecast a drop of 6.3% year over year in 2013 (vs. a 3.3% decline in our previous forecast). This report features detailed sections for corn, soybeans, wheat, coffee and sugar.

Macro fundamentals are consistent with lower commodity prices: i) growth forecasts for China and other emerging economies are still being revised downward; ii) the U.S. dollar keeps strengthening against a broad basket of currencies; and iii) inflation expectations keep declining. All these factors are consistent with price declines for the commodities which are most affected by macroeconomic factors, and they support the downward adjustment in estimates for base metals in our last report (Metal Prices to Stay at Low Levels, May 2013).

We are revising downward our year-end forecast for iron-ore prices and maintaining below-consensus forecasts for other base metals. We cut our forecast for iron-ore prices to USD 115.0/ton from USD 125.0/ton due to the outlook for lower demand growth (slower economic growth in China and other emerging economies). Forecasts for other metals remain at the same levels, as they already incorporated the deterioration in macro fundamentals. 

Economic growth in the U.S. led to smaller discounts in WTI to Brent crude; Brent crude prices recovered slowly, in line with our scenario. Higher-than-expected growth in the U.S. is behind a smaller WTI-to-Brent discount than in the past. Looking ahead, oil output in the U.S. will likely rebound, renewing a widening discount pressure. However, the outlook for faster economic growth in the U.S. will, we believe, prevent the discount from returning to the levels seen in 2012 (average USD 17.5/bbl). Meanwhile, prices for Brent crude are recovering slowly, in line with our scenario. Our forecast remains at USD 110.0/bbl by year-end, as operational refining capacity resumes (increasing demand for crude) and conflicts in several producing countries cause output declines.

Corn and soybeans: outlook for surpluses in the next crop year

Average prices (first due date) advanced in May, with corn rising to USD 6.7/bushel from USD 6.5 in April, and soybeans climbing to USD 14.8/bushel from USD 14.1. The increase was driven by low inventories and delayed planting in the U.S.

Corn planting in the U.S. is recovering, but rainfall could hurt the rest of the planting process and lead to a smaller crop. Corn planting in the U.S. advanced at a rapid pace in mid-May, largely offsetting the delay seen at the beginning of the month, while soybean planting is close to its seasonal pattern. However, the outlook for above-average rainfall during June will likely spoil the rest of the planting process. Hence, the planted area should be smaller than initial expectations.

Supply from South America is expected to be larger than last years. The pace of soybean shipments from Brazil accelerated in May to 8.0 million metric tons, a record high. The pace may be sustained in June and July, paving the way for ports to export the second corn harvest. Once again, the winter corn harvest is apt to be larger than the summer one. With planting delays in the U.S., this harvest could once again be used to meet external demand that is higher than seen before 2012. This outlook for South America reduces — but does not eliminate — the upward pressure on short-term contracts.

Despite the price increase, the futures market is pricing in a sharp decline in contracts for delivery after the U.S. harvest. Futures contracts for delivery after the harvest in the U.S. are trading at around USD 5.7/bushel for corn and USD 13.1/bushel for soybeans, reflecting expectations of surpluses in the next crop year, with larger production in the Northern Hemisphere.

The first official estimates point to a large corn surplus. The U.S. Department of Agriculture released its first estimates for the balance between supply and demand in the 2013-14 crop year. The initial expectation is a surplus amounting to 29.2 million metric tons, leading to higher inventory levels than in the last three years, thanks to a robust increase in the U.S. crop (to 360 million from 272 million tons) and to some gains in other countries in the Northern Hemisphere. The surplus is to materialize even as global demand climbs 13%.

Our scenario also assumes a corn surplus but lower output and demand. We forecast U.S. production at 340 million tons, thus below the first estimate by the USDA. On the other hand, the expansion in global demand is likely to be smaller, about 5% above the average of the past two crop years. The balance leads to the same surplus, with the stocks-to-use ratio rising to 16.5% from 14.5% during the crop-year.

The first official estimates point to another surplus in the soybean global balance. The USDA also published its first estimates for the balance between supply and demand for soybeans in the 2013-14 crop year. The initial expectation suggests a surplus amounting to 12.5 million tons in another year of increasing inventories. The increase in production is estimated at 16 million tons, led by the U.S. (+10 million tons), followed by producers in South America. Given a scenario of higher global output than in the previous period, there would be a surplus even as global demand rises 4.4%.

We forecast a smaller increase in output and the same demand, still leading to a surplus. Our current forecast points to 4 million fewer tons in combined output from the U.S., Brazil and Argentina, but the same level of demand. USDA estimates for carryover stocks in the 2012-13 crop year may be revised downward, as the USDA has not yet acknowledged smaller crops from Brazil and Argentina.

Given the favorable supply outlook, we are revising downward our price forecasts for corn and soybeans to USD 6.0/bushel from USD 6.38 for corn and to USD 13.0/bushel from USD 13.5 for soybeans.

Wheat: close to equilibrium

Prices were stable in May, compatible with the absence of major news about fundamentals for this market. Wheat prices (first due date) remained close to 700 cents/bushel in April and May. Price stability is typically due to the lack of any big news pertaining to fundamentals for the grain.

We are reducing our year-end forecast for wheat price to 730 cents/bushel from 750 due to the downward revision in our forecast for corn. Lower corn prices drive part of the demand for wheat to be substituted for corn.

The outlook is for near-equilibrium in the global balance between supply and demand in the next crop year. The USDA released its first estimates for the global balance in the 2013-14 crop year in its World Agricultural Supply and Demand Estimates (WASDE) report for May. The initial expectation is maintenance of the final stock-to-use ratio at a lower level than in previous harvests. Given the current set of information, we do not see a bias in these estimates.

The WASDE report estimates global output at 701 million tons, marking a strong recovery from the previous harvest (656 million tons). The expectation of yield recovery in Europe is behind about 70% of the expected increase. The U.S. crop is estimated at 56 million tons vs. 62 million tons in the 2012-13 crop. The decline is compatible with the low quality of winter wheat. The preliminary crop forecasts are 13 million tons in Argentina and 5 million tons in Brazil, in a scenario of recovery in yields following crop losses in 2012-13.

Demand is compatible with yield recovery and some substitution of demand in favor of corn. Expected global demand in the 2013-14 crop year, according to WASDE (694 million tons), is 20 million tons higher than demand in the previous year but lower than demand in the 2011-12 crop year (697 million tons). Last year, crop losses in Eastern Europe led to sharp price increases, reducing consumption in emerging nations. That decline, compared with the 2011-12 crop, is partly explained by a switchover in demand for corn in response to the high premium for wheat.

Sugar: global equilibrium depends on Brazil

Sugar prices sustained a downward trend in May, in a move that is consistent with fundamentals for the sector. Prices for raw sugar (first due date) remained on the declining trend seen over the past eight months as sugar traded below USD 0.17/lb. during the second half of the month. The price drop is consistent with i) the outlook for another crop year with inventory accumulation, intensified by the strong pace of the sugarcane harvest in Brazil in the second half of April, and ii) devaluation of the Brazilian real against the U.S. dollar since March. We anticipate prices will remain below USD 0.18/lb (December 2013: USD 0.1765) through the rest of the year.

Price drops in recent years created an incentive for equilibrium in the sector. Since January 2011, prices have fallen over 50%. The drop creates incentives for equilibrium in the sector. On the demand side, it fuels consumption. On the supply side, the decline shrinks profit margins, leading producers to prefer other crops and to invest less in sugarcane plantations.

The reaction to lower prices seems not enough to reverse the surplus in the global balance. Our basic scenario is a decline in global output ex-Brazil amounting to 5 million tons and an increase of 3 million tons in consumption. These adjustments are not enough to prevent the 2013-14 crop year from being another year of inventory accumulation. Equilibrium between supply and demand depends on weather surprises affecting output or on a sharp adjustment in production from Brazil. In the medium term, current prices may possibly be below equilibrium, but uncertainties and slow output may create volatility ahead.

The outlook for Brazil is for a larger sugarcane harvest but favoring ethanol. Unlike last year, relative prices favor the production of ethanol over sugar. Additionally, long periods of rainfall may reduce the expected crop from the Center-South (currently around 595 million tons vs. 532 million in 2012). Thus, sugar production in the nation may be slightly smaller than last year, even with a larger sugarcane crop and possible improvement in total recoverable sugar (ATR).

Harvesting in the Center-South of Brazil depends on favorable weather conditions. Thanks to dry weather in producing regions, the sugarcane harvest advanced at a strong pace between April 15 and May 15. Later, rainfall in the second half of May probably slowed down the harvest. The outlook for coming months is still favorable, but there are risks: long periods of rainfall may delay the harvest and disappoint expectations for the harvest in the Center-South. A smaller harvest in the Center-South would ease the downward adjustment in Brazil’s sugar production and drive international prices upward.

The hydrous ethanol market in Brazil does not ensure the end of the decline in sugar prices. The intensity of Brazil’s shift from sugar production to ethanol depends on the evolution of relative prices for sugar and ethanol (hydrous and anhydrous), physical limitations in mills and the sugar volume that was already contracted. Among these factors, we believe that only the first one will be significant in this crop. If current prices for gasoline at the pump are maintained, prices paid to producers of hydrous ethanol may drop to about USD 0.16/lb. in sugar-equivalent prices. Hence, maintenance of sugar prices close to prices for hydrous ethanol does not ensure the end of the decline in international sugar prices.

Coffee: Brazilian crop and changes in preference cause sharp decline in prices

Steep decline in prices. In May, prices for arabica beans tanked (6%) to as low as USD 127.25/lb. at the InterContinental Exchange (ICE), the lowest since October 2009. In the domestic market, CEPEA prices hit BRL 283.75 per bag, much lower than the value of BRL 340 per bag set by food supply agency CONAB as the average production cost in Brazil. This sharp decline in prices was caused by the expectation of an abundant crop in Brazil. Our forecast for prices by year-end is USD 132/lb.

Record-high production in Brazil and higher inventories. According to CONAB, the estimate for the 2013-14 crop in Brazil, the largest coffee producer in the world, is close to 48.6 million bags. The estimate is 4.4% lower than last year, but it would be the largest crop ever in the country during an off-year in the biennial cycle. Of the total amount, arabica beans would represent 75% of production. In Colombia, the third-largest global producer, the harvest is estimated at 9 million bags by the USDA, up 8.5% from the previous year. If these estimates materialize, abundant production in these countries would more than offset crop losses in Central America and the Caribbean (accounting for 14% of global output) amounting to 2.3 million bags. On the demand side, higher inventories in the U.S. and the European Union indicate further weakness in demand from the biggest consumers in the world, putting more downward pressure on prices.

Changes in preference contribute to the downward price trend for arabica beans. Another factor influencing the drop in arabica prices is higher consumption of robusta beans. Usually, arabica coffee is consumed mainly in developed nations, and prices are higher than for robusta due to its higher quality. However, even though robusta prices fell 5.9% from the previous month, prices have been supported since early last year, leading to a decline in the premium paid for arabica beans (see chart). Such steadiness in prices is related to higher consumption of robusta coffee, particularly in emerging nations. Thus, the substitution of arabica for robusta beans would also contribute to a decline in arabica prices. 

We expect stabilization in coffee prices by year-end. As good results for coffee crops are confirmed in coming months, we may see downward pressure on prices. However, our scenario assumes a recovery in arabica prices by the end of the year. In our view, the outlook for a strong crop is already priced in. Furthermore, if the price drop continues and the discount between arabica and robusta beans gets narrower (because of the better quality of the former), lower relative prices are likely to favor arabica consumption, so that there is no room for a sharper drop in arabica prices.

Artur Manoel Passos

Verena Paiva




** The Itaú Commodity Index is a proprietary index composed of those commodity prices, measured in U.S. dollars and traded in international exchanges, that are relevant to Brazilian consumer inflation. Its sub-indexes are Metals, Energy and Agricultural.

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