After feeding at the trough of cheap commodities during 2009, restaurant operators are facing an increasingly difficult cost environment as food prices head higher. Of all commodity cost inputs, corn speaks to this fact most lucidly.
Since the most recent low in prices (6/29, $3.25/bushel), corn prices have move sharply higher. There are several reasons for the move; some are more transient than others. Corn prices provide a highly accurate reflection of the cost environment facing restaurant companies since the commodity is used in soft drinks (high fructose corn syrup), bread, as feed for livestock and in the production of ethanol. There is no restaurant company that I’m aware of that is immune to a sustained move higher in corn prices; it’s really a question of how exposed each company is.
The United States produces more than twice as much corn as its closest corn producing competitor, China, according to USDA data. Any factors impacting corn production on the United States have a strong impact on the direction of prices and, therefore, restaurant company margins.
Regulatory risk is the most pertinent factor in domestic corn markets today. In 2007, with the passing of the Energy Independence and Security Act, the U.S. government adopted an active role in the price of the grain. The Renewable Fuel Standard (RFS) portion of the EISA pertains to bio-diesel and ethanol. The RFS mandates that “applicable volumes of renewable fuel” must be produced with the majority of that renewable fuel to be ethanol to be blended in with gasoline. The result has been gasoline E10: 10% ethanol mixed with 90% gasoline.
As you can see in the chart below, as passage of this legislation became more certain, corn responded appropriately by gaining sharply over the next few months. Recent agitation on the part of the Environmental Protection Agency to increase the ethanol blend to E15 (15% of the blend) has added further support to corn prices. In conversation with our Energy sector head, Lou Gagliardi, he has made it clear that he expects this momentum to continue and for lobbyists in D.C. to seek higher and higher levels of ethanol in gasoline. A recent study, touted by the EPA, “confirming” the safety of E15 for older vehicles (as well as new models) was just released late last week and is available on the Renewable Fuels Association website.
Recent USDA reports have highlighted some interesting supply and demand dynamics in the corn market. Firstly, the USDA revised its 2010/2011 U.S. corn yield forecast lower to 162.5 bushels per acre in the September World Agricultural Supply and Demand Estimates from 165 bushels per acre prior. The higher 2009/10 use of corn for ethanol was incorporated in to this forecast. Another pertinent factor is the excessive rain in corn-growing regions earlier in the summer coupled with high temperatures in August. Weather has impacted grains heavily this summer with China and Russia experiencing shocks to their grain supply chains. Irregular weather patterns can cause significant price fluctuations in corn – especially if top corn supplying countries are affected: The United States, China, Brazil, Mexico, Argentina, and India are currently the top six. Investors seem to believe that national corn balances will tighten further, as is suggested by the chart below of net long contracts for corn. If anything, the high level of net long speculative positions could impede further gains in corn prices if a significant portion of the positions are unwound.
Of course, since corn prices are denominated in dollars, it is important to consider the impact of foreign exchange on spot prices. Our view on the U.S. dollar continues to be bearish in light of sharp down moves in recent weeks in response to rhetoric from Capitol Hill. As long as the dollar continues to decline, it will continue to be bullish for corn price and negative for restaurant margins.
Howard Penney
Managing Director
