Overestimation

Besides the lax dress code and preoccupation with how much rain our neighbor got, one of the defining features of farmers is our willingness to live in a constant haze of uncertainty.  Nearly every day we are faced with some decision requiring us to consider how some set of events is going to play out, and then plan accordingly…or not.

Whether we like it or not, along with government cheese and the food pyramid, most of the information we use to market our produce is provided by the USDA.  Despite their reliance on centralized bureaucracy and antiquated methods, the USDA does a much better job of forecasting than most farmers would like to admit, and I dare say a consistently better job than probably any private forecaster you and I can afford.  However, that’s not to say they don’t step in it every once in awhile.  They really pulled a doozy in May when they forecast we’d have a 15 billion bushel corn crop, with nearly 2.5 billion bushels to spare.

At the time their forecast was released, we all should have known that it was a bunch of rubbish.  The cornbelt was still dealing with cold, snow, flooding, etc., when we should have been drag racing corn planters across mellow fields.  The corn market bottomed within just a couple of days after the MAY WASDE, then futures rallied $1.20 over the next ~30 days, and CASH prices have rallied even further as we endured the worst start to the corn growing season in modern history.  Within barely more than a month, most farmers have gone from having too much corn and wishing for higher prices, to having high prices but hoping they grow some corn!  We’ve simply traded one set of uncertain circumstances for another, and now we have to figure out a new way forward.

Nearly all farmers I talk with are exceptionally bulled up at the moment.  During the run-up we bought a tremendous amount of old-crop corn between $3.70 and $4.00, then a large slug of new-crop corn once we passed $4.00, but as prices have steadied recently the pace of sales has also steadied.  I think it’s reasonable and correct for producers to pace themselves at this point because we are truly dealing with an unprecedented situation.  However, let’s not make the same mistake as USDA, and overestimate the potentials for further price increases.

A few weeks ago, a friend of mine had to sort of take me out to the woodshed on Twitter because some poorly-worded comments of mine seemed to suggest we could ignore the demand destruction that is undoubtedly accompanying this price rally.  While I wasn’t too concerned about demand destruction in that instant, I do believe he was on the right track.  Producers need to be aware of the true potential of the global grain system to accommodate an extreme shortfall without considerably higher prices from here.  In the next few paragraphs and charts I will try to use some historical comparisons to gain some perspective on how demand and supply may evolve over the coming months.

There’s so many unknowable unknowns right now, but we have to start somewhere, so I am taking my new “Point-In-Time” historical WASDE database out for a test drive.  Over a multi-month time horizon, the market adjusts prices to reflect expectations for the amount of extra corn, or the carryout.  If the carryout slips below 10% of annual consumption, prices will get perky, and if expectations for carryout fall below 5%, prices will go vertical until enough consumption is curtailed to ensure there will be a carryout.  Between the May and June WASDE reports, USDA began the process of adjusting expectations with the largest June production cut ever since S&D estimates have been published.

The 10 years with the largest overall production cuts can be put into two groups: half of the years saw production declines between 4 and 10% between the initial and final estimates, while the other half of years ranged between 15 and 33% declines, with most of them between 25 and 32% declines.  Based on what we know so far, I believe we should be expecting at least a 25% decline in production.  A 25% drop in production would be >3.75 billion bushels, or far more than our entire carryout, so how does that tend to play out?  As it turns out, the market does a fairly efficient job of ensuring we end up with at least just enough.  If you look at what happened in those 10 years, stocks/use ratios tended to decline, sometimes quite dramatically, but in all cases ended at >5%.

Obviously there had to be adjustments to absorb such major production setbacks with so limited disruption to the final supply/demand balance, so where did it come from?  As you’d expect, consumption usually took a whack, but typically less than a 10% cut.  The outlier year was the 2012 crop where expected consumption dropped by nearly 20%, with all of that appearing in the estimates by the August report.  Another factor I feel folks might be overlooking is the degree to which beginning stocks can increase between May and harvest, as old-crop gets rationed due to anticipatory price increases.  The 2011 and 2012 crop years showed the largest impacts of rationing on increased carry-in (i.e. reduced old-crop consumption) and decreased consumption, which I believe is the result of a much larger portion of the crop now going to ethanol, which has added more elasticity to corn demand.

So the question is, this year, just how much production loss can be absorbed without breaking “normal” supply and demand tradeoffs?  In order to try and answer that question, I built a “model” of the supply and demand balance sheet for this year whereby other supply and consumption factors are estimated as a function production.  Two of the three biggest factors to consider are Feed & Residual consumption and exports.  As it turns out, there is a pretty strong quantitative relationship between the annual change in corn production and the annual change in feed and residual consumption, as shown in the next chart:

The relationship between exports and production is less obvious than for feed and residual, but in recent years there does appear to be a correlation whereby dramatic increases or decreases in production are met with corresponding adjustments to exports.  Given the relative abundance of corn and other feed grains available among other export origins, we should not be surprised if we see a drop in exports at least on par with the line shown here:

Among the remaining supply and demand factors I considered, I don’t see a quantitative correlation as a function of production that can be used, but the patterns of change from historical monthly WASDE estimates provides some basis for guesstimation.  Beginning with the JUNE WASDE estimate, and then reducing crop size toward a “worst case scenario”, I made the following assumptions:

• Ethanol production would decrease 5.5% to 5.2 Bbu
• Beginning Stocks would increase by 9.5% to 2.5 Bbu: As discussed above, this will be the result of old-crop hoarding, and the US getting priced out of old-crop exports
• Imports could increase by ~20 Mbu: Seems like this could be even larger as we’re already hearing about South American cargoes being bought into the Eastern seaboard

When I brought all of these together, along with Feed & Residual and Export demand scaling based on production, I came up with the following matrix:

While I have to emphasize that the matrix is based entirely on “noisy correlations” and wild-assed guesstimates, I am quite surprised how large of a production drop could be absorbed without creating an unprecedented shortage.  I am not trying to predict what’s going to happen, but I want to have a better idea of what the outcomes might be as we get a better sense of total production.  From here, we can use the price vs stocks/use data from monthly WASDE reports to gain some perspective on the likely price implications: