Investment Research — General Market Conditions

12 August 2010

Commodities
Wheat scare unwarranted as stocks remain huge
Global wheat prices have rallied since early July, as estimates of Russian production have
Key points
been revised down on the back of an extended period of drought. We have assessed the
fundamental situation in the grains market after the August WASDE report from the US  Global wheat prices have rallied
Department of Agriculture (USDA) and conclude that the recent rally is overdone and on weather-related supply
specifically that a new global food crisis is not imminent. Still, the recent price surge concerns. We view the recent
could put upward pressure on inflation in the near term and highlight structural challenges price surge as overdone,
facing the agricultural sector. however, as the global wheat
market remains well-supplied.
The risk of a new global food
August WASDE report mildly bullish crisis is small in our view.
The August WASDE report saw a larger-than-expected downward revision to global
 Things to look out for include:
wheat stocks: the USDA now projects 2010-11 ending stocks at 174.8 million tonnes
further trade restrictions,
(July report: 187.1, survey: 178.8). The global wheat stocks-to-use ratio was revised
contagion to other soft
down from 28.0% to 26.3%. For corn and soybeans, 2011 stock estimates were also
commodities and speculative
taken down and stocks-to-use are now forecast at 16.7% and 25.8%, respectively.
flows.
Overall, the report was mildly bullish for the grains sector but still paints a picture of a
well-supplied market. We look for Matif milling wheat prices to retreat to EUR175 per  On the whole, we look for Matif
ton before year-end, as the recent rally looks overdone. We see current levels as attractive prices to retreat to EUR175 per
for locking in wheat prices from a producer point of view. ton before year end and see
current levels as attractive for
producers to lock in wheat prices.
Russian drought leads rally in wheat
European (Matif) milling wheat prices have risen from EUR140 per tonne to above
EUR220 in less than two months - levels not seen since the summer of 2008. However, in
the past few days, wheat prices have peaked and dropped to now trade just around
EUR210, with prices up a little on the WASDE report.

Wheat price rally on Black-Sea production shortfall

Senior Analyst
Christin Tuxen
+45 4513 7867
tux@danskebank.dk
Source: EcoWin, Danske Markets.

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Commodities

The panic rise was more or less solely caused by a supply shock. Wheat has risen on fears
Wheat production by region
that Black-Sea production would be severely harmed by a prolonged period of very dry
weather. Russia accounts for 9% of global production and 14% of exports but also output Production
United States EU-27 China India Russia Other
from other major exporters in the region such as Ukraine and Kazakhstan may be at risk
9%
from an ongoing drought. In an attempt to contain domestic price rises, Russia last week
announced an export ban to take effect from 15 August until year-end. Crucially, ongoing 33%
20%
wildfires may not only destruct this season’s crop but could potentially hinder next
season’s plantings of winter wheat. Ukraine officials this week said that the country is
contemplating export quotas for grains. 9% 17%

12%
Further adding to likely production shortfalls is the fact that Canadian wheat was hit hard
by heavy rains earlier in the year and Pakistani crop is now threatened by flooding.
Combined with the fact that record harvests in recent years have led farmers to plant less Source: USDA, Danske Markets.

wheat, wheat stocks look set to decline significantly this year. This has spurred fears of a
global food crisis similar to the one that hit the global economy in 2007/08 when rising
food prices led consumer prices to surge and inflation-targeting central banks to hike
interest rates despite a significant slowdown in economic activity.

Current situation is very different from 2007/08 crisis

In our view, the situation in the global grains market is very different from the one in
2007/08 and provided no hoarding or new trade barriers are introduced, we look for
markets to calm down in the near term and for the inflationary impact to be limited.
Longer term, the surge in wheat does however highlight a range of structural problems in
the agricultural sector.

Wheat market fairly loose... ... but getting a little tighter this year

250000 Wheat, world stocks (1000 ton) 0.33 World, stocks-to-use (%)

200000 0.3

150000 0.27

100000 0.24

50000 0.21

0
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
2010

Source: USDA, Danske Markets. Source: USDA, Danske Markets.

First of all, global stocks of wheat are ample at present. Measured in terms of the stocks-
to-use ratio, the market is well supplied with stocks available to honour almost 30% of Plantings decline on record harvests
yearly consumption; in the US the corresponding figure is above 80%. This is rather 80 US area planted (mn acres)
different from the situation in the summer of 2008 when US stocks-to-use ratio was US area harvested
running at a mere 10%. At above 26% the wheat market is still at a very comfortable 60
level.
40
Second, we should not forget that a supply reaction can happen fast in the grains market:
20
when farmers observe higher prices they usually increase plantings of the grain in
question for the next season. This is indeed what has been seen in recent years after 0
bumper harvests led to booming inventories. The planting season is about to start in 2008/09 2009/10 2010/11
Est. Proj.
Australia and Argentina, which makes for a quick reaction to Black-Sea crop damage.

Third, prices of other grains and soft commodities have followed wheat up only to a very Source: USDA, Danske Markets.

limited extent (barley is the exception though). This highlights that the recent panic is so

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Commodities

far mainly contained to wheat. Notwithstanding, it cannot be ruled out that higher prices
on wheat could crowd out plantings of other crops such as soybeans and corn. Stocks of
these grains are also at decent levels but in particular the soybeans market is somewhat
tight and could thus be vulnerable to production shortfalls arising from planting
substitution.

Fourth, the demand side should provide only limited support to prices. Crucially, we are
currently in a different stage of the business cycle than was the case in 2008 when
capacity utilisation was high and underlying inflationary pressure significant as a result.
Also, with focus shifting to second-generation biofuels, which use biomass etc. rather
than grains as input, demand from the energy sector - and thus spill-over between food
and energy sectors - should be limited.

Finally, whereas the 2007/08 rally was likely to have been partly caused by a rise in
speculative positions, this does not seem to have been the case to the same extent this Short covering in wheat
time round. Leading up to the price spike speculators were on average net short wheat but
an extensive short-covering rally has reversed the situation such that non-commercials are
now net long. During the recent rally the ratio of non-commercial positions to total open
interest has in fact declined. This suggests that speculative flows into the sector have in
fact been reduced.

Overall, it is important to note that the current shock is rather different from the 2007/08
one which arose from a demand shock: global grains stocks were low, the global
economy was booming, regulatory changes spurred demand for grains for biofuel
production and financial interest in commodities was accelerating.
Source: EcoWin, Danske Markets.

“Agflation” scenario unlikely in the near term but longer-term

outlook highly uncertain
The UN Food and Agricultural Organisation has made an attempt to calm the markets,
saying that global inventories are indeed sufficient to compensate for the production. This
week the OECD joined the UN in playing down the impact of the Russian drought. We
largely agree with the view that there is little reason to panic as things are now, but the
short and the longer term implications of the wheat crisis are likely to differ.

Near term: little sign of contagion but both physical and financial risks in
place
We look for wheat prices to continue the downward correction seen in recent days and to
Little tightness across grain types
retreat to EUR175 per tonne before year-end as the market wakes up to reality which
remains elevated global wheat stocks. During the course of 2011, wheat prices could rise 35% Stocks-to-use, %
a little from this newfound level as global demand ticks higher alongside close-to-trend 30%
economic growth (and sustained population growth). This assumes no further trade 25%
restrictions and a “normal” planting reaction to this year’s production shortfall. Notably, 20%
15%
US and European farmers stand to benefit from the price increases as their crops have
10%
developed neatly while Black-Sea producers face a tough time.
5%
Having said that, risks that the recent rally could spur further price rises along the grains 0%
physical supply/demand chain remain. Wheat, corn and rice are fairly close substitutes in Total Wheat Coarse Rice,
Grains Grains milled
consumption as well as production and thus while the price rises so far are mainly
restricted to wheat, spill-over cannot be ruled out. This could make the price rises more Source: USDA, Danske Markets. Note: “coarse
grains” refer to other grains than wheat and rice
broad-based and fuel inflation to a larger degree. Notwithstanding, there is little tightness
(includes corn and barley).
in neither wheat, coarse grains (incl. corn) or rice.

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Commodities

Also, speculation remains a joker and was at least partly blamed for the 2007/08 spike.
However, investor interest in commodities has been muted in this recovery phase despite
loads of liquidity. Part of the reason for the limited flows into commodities as an asset
class is the contango structure that prevails in most futures markets, not least in grains:
when putting their money in commodity futures investors thus incur a negative roll yield
due to the downward-sloping curve which must then be made up for by an even larger
upward move in price levels.

Milling wheat: Danske forecast vs. fwd

Source: EcoWin, Danske Markets.

Longer term: structural challenges looming

Although the near-term impact of the wheat surge may be limited, it does turn into focus
a range of potential problems in the agricultural sector.

First, the experience of the past two months underline that volatility in agricultural
markets has risen. This is partly a consequence of the market becoming more finely
balanced in terms of supply and demand due to underinvestment combined with rising
use of grains from first-generation biofuels and emerging-markets demand. On top of this,
comes the rising impact of financial markets due to the focus of commodities as a
separate asset class, potentially useful in portfolio diversification. Heightened volatility
policymakers may turn their eyes on financial trading in commodities and eventually lead
to more widespread regulation of a market which remains highly politically sensitive.

Second, wheat is potentially facing another supply issue from spreading of wheat rust –
aka ug99- which is a fungal infection attacking the stem of the plant, see Economist: Rust
in the bread basket. The disease has recently been spreading in southern Africa and but
may however travel far via the wind and could have devastating consequences if it
reaches some of the world’s major producers.

Finally, the recent incidents of drought and flooding also highlight the potential threats to
the agricultural sector arising from extreme weather events likely related to a changing
climate. Indeed, 2010 is on track to become the warmest on record according to the UK
Met Office. This poses both threats and opportunities to farmers but will most likely
require a re-structuring of the sector in coming decades.

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Commodities

Disclosure
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Danske Bank. Danske Bank is under supervision by the Danish Financial Supervisory Authority. The author of
this report is Christin Tuxen, Senior Analyst.

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