SocGen Popular Delusions 2010-09-17

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17 September 2010Global StrategyAlternative view

www.sgresearch.com

Popular DelusionsA structural shift is set to imbalance grain markets and increase global instability

Dylan Grice(44) 20 7762 [email protected]

Global Strategy TeamAlbert Edwards(44) 20 7762 [email protected]

Dylan Grice(44) 20 7762 [email protected]

The 1973 spike in world oil prices is usually attributed to OPECs spectacularly successfulembargo. But commodity markets face disruptions all the time and the effects are short lived.Why did the 1973 oil markets disruption lead to permanently higher real prices? The OPECembargo was merely the trigger. The cause was a structural shift which saw a rapid surge inthe import needs of oils biggest consumer, the US, as its oil production peaked in 1970.Today, the grain markets biggest consumer - China - is undergoing a similar shift. On the 26th October1973 the holy Jewish holiday of Yom Kippur that year - the fourthand most intense Arab-Israeli war started. Egyptian jets launched surprise attacks on Israeli

command posts on the eastern side of the Suez and the Sinai, while Syrian planes

simultaneously attacked from the north. It would be the most serious Arab-Israeli conflict

ever, threatening at one stage to spill over into a full-blown nuclear conflagration between

the Soviet Union and the US.

Fortunately, a cease-fire was brokered before it came to that. But by then theindustrialised economies were in disarray suffering simultaneous recession and inflation.

Indeed, this spectacular use of the oil weapon which Kissinger said altered irrevocably

the world as it had grown up in the post war period would be the most lasting effect. The

psychological effects of the OPEC shockcontinue to linger in the publics mind today.

But the oil weapon might not have been as potent as has generally been assumed.Indeed, it failedmiserablywhen used during the six day Arab-Israeli conflict of 1967. Then

the US had so much spare capacity the embargo simply brought the Arab nations to the

edge of financial ruin. The reason it worked so spectacularly in 1973 was that the US spare

capacity was now gone. Indeed, US oil production had already entered into permanent

decline and its import dependency was surging (chart below, grey line).

So the spike in oil prices may have been triggered by OPECs embargo, but the violenceof the move and the continued volatility was caused by a permanent structural shift. A

similar shift seems to be playing out in grain markets today.

The 1970s spike in oil prices was made possible by surging US oil dependency

10%

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60%

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Arabian light crude

US oil de pendency (net

imports as % of consumption)

Stable US oil

dependency

1967 OPEC e mbargo

during the six day war

has no effecton oil

prices

1973 OPEC embargo

works like a dream ...(and oi l pri ces never return

to pre-embargo levels)

Sudden increase in

US oil dependency

Source: SG Cross Asset Research


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Real commodity prices should decline over time as technological advancement lowers the

supply costs without affecting the basic utility of the commodity. A bushel of wheat today is

pretty much the same as a bushel of wheat five thousand years ago, except that it costs a

fraction of the labour to produce. Temporary bottlenecks shouldnt change this long-term

downward trajectory, and should cause only temporary price increases until new supply can

be brought to market.

A famous example of a temporary shock was that suffered by agriculture markets in 1972 after

a catastrophic Soviet harvest forced Brezhnev to secretly tap world markets in an operation

which became known as the Great Grain Robbery. The Soviet Union was one the largest

consumers of grain in the world and its sudden, forced and mercifully short-lived plunge into

the world grain markets as a large buyer caused prices to nearly triple (see chart below).

What a temporary shock looks like the CRB food index after the Great Grain Robbery

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Nomi nal food prices

Rea l Food prices

CRB food index spikes

after poor Soviet

harvest

... but real price decli ne

resumes as shock dissi pates


But the shock was largely temporary, as poor harvests tend to be. There was an aftershock in

1977 as the Soviets endured another poor harvest but the bull market in agricultural produce

was over. Prices remained in a tight range for the next few decades and failed to keep pace

with inflation.

The shock to energy markets was more serious. It was driven by thepermanentpeaking of US

oil production in 1970 which pushed the US dependency ratio (imports as a % ofconsumption) from 20% to 40% in barely three years. The permanent nature of that shift is

reflected in the permanent rise in real oil prices: the subsequent oil glut of the 1980s crashed

the market and ruined many leveraged players, but even in the depths of the global

commodity bear market in the aftermath of the Asian crisis in 1997, real prices were 70%

higher than they had been before the OPEC shock of 1973 (see sequence of charts below).

This implies an interesting hypothesis: the 1970s bull market in energy wasnt caused by the

OPEC embargo but by the strain of the markets largest consumer suddenly and permanently

increasing its dependency on the oil available for export. The implication is that had OPECnot

embargoedoil during the Yom Kippur war, real oil prices would eventually have risen anyway

because underlying conditions required it.


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US oil production permanently peaked in the 1970s

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

1949

1952

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1958

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1967

1970

1973

1976

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1982

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1991

1994

1997

2000

2003

2006

2

009P

US Oi l production (000 ba rrels)

pea ks in 1970

Source: IEA

leading to a rapid doubling of US import dependency

0%

10%

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60%

70%

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2006

2008

USnetoilimportsasa%

ofconsumption US de pendency on

world oil surges

Source: IEA

and pushing real oil prices to a new long-term equilibrium

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120

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1970

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2008

RealArabianLightPrices(2009$)

Pre-embargo

price was

$10 p/barrel

Depths of Asian

cris is sees real oil

price trough at $17

Source: BP Statistical Review


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The hypothesis might be more than just interesting though. It might even be relevant! Today,

the largest consumer in the grain markets China - is seeing its dependency on world export

markets surge in a similar way to that seen in the oil market in the 1970s.

Is China to todays grain market what America was to the worlds energy markets?

-5%

0%

5%

10%

15%

20%

1960/1961

1962/1963

1964/1965

1966/1967

1968/1969

1970/1971

1972/1973

1974/1975

1976/1977

1978/1979

1980/1981

1982/1983

1984/1985

1986/1987

1988/1989

1990/1991

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1994/1995

1996/1997

1998/1999

2000/2001

2002/2003

2004/2005

2006/2007

2008/2009

2010/2011

Chinesenetgrainimportsasa%ofcons.

Chin ese dependency on world

grai n markets is surging

Source: USDA

Why might this shift be permanent? With 7% of the worlds land and water but 22% of the

worlds mouths to feed, Chinas fight to retain grain self-sufficiency was always going to be a

losing battle unless the economy was devoted entirely to agriculture. Of course, prior to

Dengs 1978 reforms thats exactly what China was. But the logic of industrialization in such a

land and water constrained country implies scare water and land be effectively imported via

grain and livestock, while abundant labour be exported through manufactured products. And

while China has excelled at the latter, it has understandably resisted the former.

But how long can it defy the arithmetic of natural resource endowments? The dismantling of

the agrarian economy in favour of an industrial model has seen scarce land built upon. Roads,

car parks, factories and shopping malls increasingly take the place of farms. Industrialization

also implies richer households eat more protein and, paradoxically, meat-rich diets require

much more grain than vegetarian ones (apparently around seven times more). None of this

would be a problem if China was capable of increasing its agricultural productivity as

spectacularly as it is increasing its living standards. But so far at least, it isnt coming close.

According to the USDA Chinese land productivity continues to decline.

Chinas land productivity growth is falling

1

10

LogofChineseouputperhectare

Source: USDA


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The strain first started to show in the collapse in Chinese inventories in the early 2000s. Now,

as China tries to rebuild them it is showing up in Chinas surging import dependency. It seems

reasonable to think that it will soon be showing up in price.

Chinese agricultural inventory (months worth of consumption)

0

2

4

6

8

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12

Gra

ininventory(monthssup[ply)


Hunger eats civilizationsays Marjane Saatrapi, author of the beautiful book Persepolis. Food

inflation has a dark history. It has been said that the 70s food crisis contributed to the Iranian

revolution. We know the Russian Revolution started with starving workers protesting high

bread prices. The Parisian riots of 1789 following the devastated crop of 1788 snowballed into

the French Revolution and the revolutionary fervour which swept Europe in 1848 followed asequence of bad harvests.

If BHP Billitons bid for Potash Corp succeeds, the Australian miner could own a third of the

worlds potash supply in ten years time. This week, a magazine interview in which

Sinochems Han Gensheng said that Potash Corp was too pricey was pulled from Chinese

news sites hours later. The site which had carried the comments now denies the interview

ever took place. The Chinese appear to be getting twitchy on the security of their future grain

supplies. Who can blame them? The following names might be worth looking at.

Company Name Country Mkt Cap ($m) Book Val p/sh* est. Intrinsic Value Last close** IVPChaoda Modern Agriculture Ltd. Hong Kong 2,661 6.28 13.1 6.6 1.98

Marine Harvest ASA Norway 2,226 3.19 6.1 5.0 1.20

Bunge Ltd. United States 8,146 70.80 56.0 56.7 0.99

Archer Daniels Midland Co. United States 20,949 23.01 28.2 32.5 0.87

Yara International ASA Norway 9,704 99.38 224.4 269.4 0.83

Agrium Inc. Canada 11,432 30.77 60.8 74.4 0.8

K+S AG Germany 10,569 10.93 34.4 42.4 0.81

Nufarm Ltd. Australia 756 6.07 3.2 4.1 0.79

Incitec Pivot Ltd. Australia 5,475 2.10 2.8 3.6 0.77

Golden Agri-Resources Ltd. Singapore 4,051 0.63 0.4 0.6 0.67

Taiwan Fertilizer Co. Ltd. Taiwan 2,291 51.17 57.6 99.0 0.58

Syngenta AG Switzerland 23,756 79.39 126.3 251.5 0.50

Monsanto Co. United States 31,603 18.86 27.0 57.5 0.47

Source: SG Cross Asset Research, FactSet. * Latest actual data. ** Closing prices as of 15 September. *** Our analyst rates K+S a Buy with a price target o f 50. For a more complete

explanation of intrinsic value see Dylans Bargain hunting with Ben: in search of mispriced intrinsic value, 2 December 2009.
http://www.sgresearch.com/p/en/3/0/20434/39F2185F9BB6B425C1257680003E325C.html?sid=d5fc5b263536a88f2d5688c4f960bbf3http://www.sgresearch.com/p/en/3/0/20434/39F2185F9BB6B425C1257680003E325C.html?sid=d5fc5b263536a88f2d5688c4f960bbf3http://www.sgresearch.com/p/en/3/0/20434/39F2185F9BB6B425C1257680003E325C.html?sid=d5fc5b263536a88f2d5688c4f960bbf3http://www.sgresearch.com/p/en/3/0/20434/39F2185F9BB6B425C1257680003E325C.html?sid=d5fc5b263536a88f2d5688c4f960bbf3


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IMPORTANT DISCLOSURESBP SG is acting as one of the Mandated Lead Arrangers and Bookrunner for a loan granted to BP.

K&S SG acted as joint bookrunner in the K+S' senior bond issue (5% 24/09/14 EUR).K&S SG acted as Mandated Lead Arranger and Bookrunner of the credit facility granted to K+S to finance the acquisition of Morton Salt.Nufarm SG acted as advisor to Sumitomo in the acquisition of Nufarm Ltd.

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SocGen Popular Delusions 2010-09-17

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