By Michael Swanson Ph.D., Chief Agricultural Economist
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The rapid and significant drop in feed costs at the end of 2013 sets the protein market up for an opportunity to see feeding margins recover from recent historic lows. After pushing retail protein prices to new extended record highs, how long will the industry have before the inevitable supply expansion threatens its margin recovery? Unlike previous drought-induced cycles, this cycle will be extended and driven by export opportunities and regulatory barriers. The re-expansion cycle should run two to three years before the protein industries manage to short-circuit their profitability with over-supply.
The protein business revolves around biologically transforming feed into food. The biological "crush" of corn and soybean meals into beef, pork, poultry, and dairy has come through one of the most financially challenging period in years. The rapid run-up in corn prices started in October 2006. From 2007 to October 2013, corn prices increased by 122% compared to the previous five year average. In comparison, cattle prices rose by 23% and hog prices by 27% percent in the same time period. Given the outsized importance of feed in the cost structure, all the feeding industries suffered major compressions in the ratio of revenue to feed costs. This difficulty forced protein producers to adapt or to exit, and it forced consumers to accept much higher retail protein prices. These adaptions and higher consumer prices allowed the protein industries to avoid similar declines in total profitability.
Protein prices at the retail level are always difficult to measure. Individual cuts or components have unique marketing and seasonal issues which makes focusing on an identifiable cut or components problematic for measurement purposes. The Bureau of Labor Statistics (BLS) maintains an established and weighted index for each of the major proteins and dairy. In the late 1990s and early 2000s, proteins and dairy indices were priced well below the "all items" index from the BLS. The cheapest protein was beef, but it broke out of its low price status with the "mad cow disease" scare of 2004. Since 2010, beef has become the highest priced of the proteins relative to the overall index. Dairy went through a couple of self-induced price cycles in the 2000s with a notable spike in 2007 and a crash in 2009, and it has only recently approached its 2007 highs at the retail level. Poultry has finally broken out of its status as a consumer bargain, with current retail prices exceeding the overall index. This is the first time since the start of the 1998 data series that poultry prices will have risen faster than overall inflation for a sustained period of time. The only protein "bargain" that now remains can be found in the pork sector.
Meat and dairy prices in the U.S. are not set in a vacuum. Global consumer demand continues to influence prices in the U.S. market. In 2000, only broilers had a significant exposure to the global demand market with net exports accounting for 15% of production. All three of the other major protein industries were essentially neutral in terms of net exports. In 2013, net exports will account for approximately 20% of pork and poultry production, and dairy products have jumped to 11%. Only beef remains relatively neutral in terms of net exports, but beef has maintained a strong net export on a value basis. The U.S. has consistently exported higher-value cuts relative to imports of lower-value cuts for grinding. Faster growth in the global market has been vital to allowing the protein industries to absorb the much higher cost of feeding over the last seven years. This structural development shows no sign of slowing down or reversing. But current trade policies and exchange rates do not guarantee U.S. protein producers a smooth ride.
Between much higher domestic consumer prices and expansion into the faster growing global market, protein producers weathered the feed cost cycle better than anticipated. Using profitability measurements from the Risk Management Association (RMA), industry profitability did not decline nearly as much as would be expected based on the compression of revenue to feed ratios. 2009 saw the bottom of the cycle in terms of industry profitability. As the industries were able to force higher prices through to the consumer and restaurant segments and recapture export share on a weaker dollar, median industry profitability recovered relatively quickly. The 2012 drought brought another spike in corn and feed costs, but also allowed the industry to continue to advance consumer and food service pricing yet again. Overall the protein production industry saw a notable decline in profitability in the recently released April 2012 to March 2013 RMA data. While all the industries stayed profitable as measured by the median profitability over assets, a major compression was seen in profits. However, unlike 2009, profits did not become negative.
The recent collapse in corn prices from $6.79 per bushel in July 2013 to $4.49 in October 2013 will help feeding margins. This decline and the associated drop in other feed components will reduce the feed cost per hundredweight in California dairies by $3 to $4. As always, improved margins will incent dairymen and all other protein producers to expand production. In the short term (the next 2-3 quarters), most of the production gains will come from cheaper feed rations and production, and the supply increase will not be sufficient to force down increased prices for U.S. consumers and restaurants. It appears that the global markets could absorb most or all of the increased production without too much difficulty as the U.S. dollar will remain relatively weak. However, increased profitability will bring a structural expansion in all the segments over the next 2 to 3 years. This structural expansion takes longer to bring into production due to permitting and construction. Once this more significant expansion comes online, it is likely that domestic buyers will have more leverage to push back on pricing, and the profitability cycle will inevitably cycle back down - not on feed costs, but over expansion of supply.
Michael Swanson is a senior agricultural economist and consultant for Wells Fargo, the largest commercial agricultural lender in the United States. His responsibilities include analyzing the impact of energy on agriculture and forecasting for key agricultural commodities such as wheat, soybeans, corn, and cotton, and livestock sectors, such as cattle, dairy, and hogs. Additionally, he helps develop credit and risk strategies for Wells Fargo's customers and performs macroeconomic and international analysis on agricultural production and agribusiness.
Michael received undergraduate degrees in economics and business administration from the University of St. Thomas in St. Paul, Minn., and both his master's and doctorate degrees in agricultural and applied economics from the University of Minnesota.
Wells Fargo Agricultural Industries presents this analysis as a complimentary service to its employees and customers. It cannot guarantee the accuracy of all the sources of data. And, commodity prices are extremely volatile based on unforeseeable changes. These estimates will change with all new market changes.