Tuesday, March 18, 2014 - Food and Oil

Food and Oil

by Sinclair Noe

DOW + 88 = 16,336
SPX + 13 = 1872
NAS + 53 = 4333
10 YR YLD - .02 = 2.68%
OIL + 1.62 = 99.70
GOLD – 12.00 = 1356.50
SILV - .38 = 20.92

Let’s start with some economic news. The National Association of Home Builders housing market index increased to 47 in March, up from 46 in February. A reading below 50 means more builders view conditions as poor rather than good. Fewer homes are being started in early 2014 than at the end of 2013. Housing starts came in just slightly below economists’ expectations of 910,000 at 907,000.

Separately, a quarterly survey by the Business Roundtable found US chief executive officers somewhat more positive about the economy, including plans for hiring and capital spending over the next six months; they expect gross domestic product to advance 2.4% this year. The forecast is a slight upgrade from an expectation of 2.2% in the previous survey but still less than robust.

The Consumer Price Index, or CPI, increased a seasonally adjusted 0.1% in February, matching the increase in January. According to the Labor Department report, the increase was mainly due to higher prices for food. Energy prices decreased 0.5%. Over the last 12 months, the CPI is up 1.1%. Costs for meats, poultry, fish, dairy and eggs drove the gains. Most notably, beef and veal prices surged.

Prices for beef saw their biggest monthly change in February since November 2003; that was when fears of mad-cow disease abroad led to a spike of export demand for US beef. When the disease was later confirmed in domestic cattle, prices shot down.

So, with food, and specifically meat prices moving higher, the next logical step is that dairy prices are moving higher; up 0.7% from January to February. The price that consumers paid for a gallon of milk was more than $3.56 in February, up more than 10 cents since September. The good news is that the full impact of higher prices hasn’t hit your wallet, yet. For example, the price of a block of cheese on the wholesale market is up 35%, but this price hike hasn’t been passed on to shoppers. The bad news is that those higher wholesale food prices will slowly but surely result in higher retail prices.

Federal forecasters estimate retail food prices will rise as much as 3.5% this year, the biggest annual increase in three years. The reason is simple - drought. We’ve tried to warn you this was coming and it is. California and Texas have seen tight cattle supplies after years of drought. Prices also are higher for fruits, vegetables, sugar and beverages.

In futures markets, hogs are up 42% on disease concerns and cocoa has climbed 12% on rising demand, particularly from emerging markets; coffee prices have soared so far this year more than 70% because of a drought in Brazil.

The price increases pose a challenge for food makers, restaurants, and retailers, which must decide how much of the costs they can pass along. During previous inflationary periods, food makers switched to less-expensive ingredients or reduced package sizes to maintain their profit margins. Retailers and restaurants usually raise prices as a last resort.

In 2008, a spike in food prices caused riots from Haiti to sub-Saharan Africa and South Asia. In 2011, rising food prices were a factor behind the Arab Spring protests in North Africa and the Middle East that ultimately toppled governments in Tunisia and Egypt. We probably are not looking at severe shortages this year, but a lot depends on the weather. If conditions get worse; if the drought gets worse; if the corn and soybean crops in the Midwest get hit by inclement weather; if they do, then we could see significant food price increases.

California farmers say a number of products could be affected later this year, including broccoli, sweet corn and melons from growing regions in Fresno to Huron, where farmers will likely cut acreage due to water shortages. Spring and fall lettuce production in the San Joaquin Valley also could drop by 25% to 30% this year, although growers could try to make up some of that by extending the planting season in the desert and in the Salinas Valley.

Supplies of other items may be supplemented from other growing regions, but at a higher cost. For example, buyers may have to rely more heavily on Florida and Mexico for corn, and there may be more melons coming from Mexico and even offshore. California supplies nearly 90% of the nation's strawberries; growers typically plant a second crop in the summer for fall production; if we don’t see more rain, we won’t see a second planting. It’s not like somebody can step in and fill that void.

For the moment, fair weather accompanying the drought has caused vegetable crops to come to market ahead of schedule, creating an overlap from the deserts and the San Joaquin Valley, creating a temporary oversupply of some veggies. Enjoy it while you can, better yet, can it while you enjoy it.

Stocks are rallying in the wake of the latest developments in the Ukraine region. Gains were broad, with all 10 primary sectors of the Standard & Poor’s 500-stock index higher. Groups tied to the pace of economic growth, including materials, were among the day’s biggest advancers.  After five days of nervous anticipation that held stocks lower last week, stocks so far this week have gone straight up, even with Russian troops massed along the eastern border of Ukraine. In an address to the Russian Parliament, Putin said Russia did not want Ukraine to be divided further, and that he did not want to seize more of the country.

According to Reuters, Crimea may nationalize oil and gas assets within its borders belonging to Ukraine, and sell them off to Russia. The ongoing political standoff in Crimea has already halted Ukraine’s oil and gas ambitions. Ukraine came close to inking a deal with a consortium of international oil companies that would have led to an initial $735 million investment to drill two offshore wells. The consortium led by ExxonMobil, with stakes held by Shell, Romania’s OMV Petrom, and Ukraine’s Nadra Ukrainy, had been particularly interested in a nat gas field in the Black Sea, which holds an estimated 200 to 250 billion cubic meters of natural gas.

If it can get the field up and running, Exxon hopes to eventually produce 5 billion cubic meters per year. Exxon’s consortium outbid Russian oil company Lukoil for the rights to the block. Exxon’s plans for Black Sea nat gas may not have a future if Russia simply takes Ukraine’s assets. The speaker of Crimea’s parliament said that its oilfields should be under the care of Moscow. After Sunday’s referendum, those reserves appear to have shifted to Russian control.

Exxon likely doesn’t see much upside in getting into a tiff with Russia over the Black Sea, especially since it hadn’t even agreed on a production sharing agreement with Kiev yet. But Exxon has billions of dollars of investments in the Russia Arctic in a co-venture with Rosneft, its largest non-US project. If the situation escalates, Rosneft might possibly be targeted with sanctions.

It’s not easy diagnosing the insanity being spouted by the media regarding Russia’s invasion of Crimea, and I don’t claim to have the answers, but it appears to be closely tied to oil interests. It certainly looks like Russia will take Crimea, won’t pay a big price for it, and there’s not a thing anyone can do about it. And the best explanation is oil. Russia is now the world’s #1 oil exporting nation, topping Saudi Arabia by more than a million barrels a day. Russia has an estimated 80 billion barrels in reserves and everybody wants some.

Wall Street has figured out that they can’t allow jingoism to affect their bets. Analysts from Goldman Sachs Group, Bank of America, and Morgan Stanley have said Europe probably won’t back sanctions that limit flows of Russia’s oil and gas. European members of the Paris-based International Energy Agency imported 32% of their raw crude oil, fuels and gas-based chemical feedstocks from Russia in 2012.

Even if Angela Merkel isn’t bluffing when she says Germany is willing to suffer in the cold and dark to punish Russia, she’d have a hard time getting the less disciplined countries of the EU to participate in her stoic resistance. And even if Merkel and the EU can herd cats and present a unified front, Russia will simply sell oil out the back door. Yes, Russia now has a back door. Last year, Russia completed East Siberian-Pacific Ocean pipeline, and that connects Russian oil to China and East Asia.

This weekend on the CNN, Senator John McCain said, “Russia is a gas station masquerading as a country. It’s kleptocracy, it’s corruption, it’s a nation that is really only dependent upon oil and gas for their economy.” Yea, O.K., so what?  You could say the same thing about Saudi Arabia, that beacon of democracy and a fine American ally.

Let’s keep it simple; you probably drove a car today; the food you eat today was transported by truck; everything in this country runs on oil. It certainly isn’t the best source of energy but it is the dominant source of energy. And for a long time now, we have run our foreign policy on the idea of securing oil to keep the economic engine running. We have sent troops into harm’s way to keep the oil flowing. We have sacrificed untold bounty and blood at the altar.

You might think we would be smart enough to step back and reconsider this strategy. It might make sense to concentrate our energy and our brainpower and our capital toward developing alternatives to the insanity.

I can tell you that very soon you will be hearing about groundbreaking alternatives in energy that have the potential to break this old cycle. Energy stories that sound impossible, but just remember, something is only impossible until it is done.