Agriculture Update. Global. Food versus feed in the wheat market. Commodities Research. Sharp decline in corn supplies requires more wheat feeding

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1 Agriculture Update Food versus feed in the wheat market Commodities Research Sharp decline in corn supplies requires more wheat feeding We forecast that the US drought will bring corn supplies sharply lower and require feed and ethanol demand destruction. To limit livestock liquidation, we forecast that wheat feeding will be required to supplement corn and DDG use in the US and globally. As a result, our base-case forecast remains that US wheat prices will need to trade back near corn prices by next spring, with our current price forecast embedding a smaller wheat-tocorn premium than currently priced into the CBOT future curves. Damien Courvalin (212) damien.courvalin@gs.com Goldman, Sachs & Co. while lower wheat production could put food supply at risk However, hot and dry weather conditions have also impacted most of the world s largest wheat producing and exporting regions. We forecast lower global wheat production than the USDA and expect that 2012/13 global wheat inventories ex. China and India will decline to their lowest levels since 2007/08, yet remain well above global corn inventories. A further deterioration in weather conditions, potential FSU export restrictions and pent-up import demand create risks that global wheat inventories decline even more than we expect. Such an outcome in the face of inelastic food demand would likely push wheat prices sharply higher and well above corn prices to price wheat out of feed demand. Positioning for EU vs. US wheat price outperformance In short, US wheat is caught between the need for stronger feed use given low US corn production and the potential for stronger exports given low global wheat supplies. As a result, we currently see limited risk-reward in implementing our expectation for further wheat vs. corn convergence, and we recommended closing our short May-13 CBOT wheat vs. corn spread trade last week, for a potential gain. With lower Black Sea exports and EU wheat trading at a discount to US wheat, we believe that European wheat exports will likely pick up in coming months. As a result, we recommend entering a long Mar-13 MATIF vs. short Mar-13 CBOT wheat spread. Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to The Goldman Sachs Group, Inc. Goldman Sachs Economics, Commodities and Strategy Research

2 Hedging and trading recommendations Hedging recommendations Consumers: We forecast higher corn, soybean and wheat prices over the next 3 months given the severity of the current US drought, with our 6-mo price forecast also above the current forward curve. As a result, we recommend consumers lock in current prices as well as layer in upside calls to hedge against the higher prices that we forecast, especially for corn and soybeans. Although up since early July, implied volatility levels remain well below their previous peaks and still represent value especially if weather conditions deteriorate further. Producers: Following the recent rally in corn, soybean and wheat prices, we recommend Southern Hemisphere producers lock in producing margins. Trading recommendations We recommend holding one long Nov-12 CBOT soybean contract against short 0.5 Dec-12 CBOT corn contract as we forecast soybean prices to reverse part of their recent underperformance to corn prices. We also recommend entering a long Mar-13 MATIF vs. short Mar-13 CBOT wheat spread, on our expectation for higher EU wheat exports. Current trading recommendations Current trades First recommended Initial value Current Value Current profit/(loss) 1 Open: Long Mar-13 MATIF Wheat vs. short Mar-13 CBOT Wheat Buy 1 Mar-13 MATIF Wheat, sell 1 Mar-13 CBOT Wheat, hedge half of the EUR/$ exposure on entry August 7, Agriculture Update ($17.47/MT) Long Nov-12 CBOT Soybeans vs. short Dec-12 CBOT Corn Buy 1 Nov-12 CBOT soybean, sell 0.5 Dec-12 CBOT corn June 29, 2012 and July 3, Agriculture Update $0.00/bu $0.44/bu $0.43/bu Long Sep-12 LME Aluminium call options Long Sep-12 LME Aluminium calls with $2,150/t strike June 11, Metal Detector $18.8/t $2.5/t ($16.3/t) Long WTI Crude Oil Buy September 2012 NYMEX WTI Crude Oil February 22, Energy Weekly $107.55/bbl $92.20/bbl ($15.35/bbl) Long Gold Buy December 2012 COMEX Gold October 11, Precious Metals $1,800.5/toz $1,616.2/toz $239.6/toz Rolled from a long Dec-11 COMEX Gold future position on 13-Nov-11 with a potential gain of $423.9/toz Long summer 2013 NYMEX Natural Gas Buy summer 2013 NYMEX natural gas (April-October contracts) April 11, Natural Gas Watch $3.35/mmBtu $3.52/mmBtu $0.17/mmBtu ¹As of close on August 6, Inclusive of all previous rolling profits/losses. Source: Bloomberg, Goldman Sachs ECS Research. Goldman Sachs Economics, Commodities and Strategy Research 2

3 Price actions, volatilities and forecasts Prices and monthly changes 1 Volatilities (%) and monthly changes 2 Historical Prices Price Forecasts 3 Energy units 05 Aug Change Implied 2 Change Realized 2 Change 1Q 11 2Q 11 3Q 11 4Q 11 1Q 12 2Q 12 3m 6m 12m WTI Crude Oil $/bbl Brent Crude Oil $/bbl RBOB Gasoline $/gal NYMEX Heating Oil $/gal NYMEX Nat. Gas $/mmbtu UK NBP Nat. Gas p/th Industrial Metals 4 LME Aluminum $/mt LME Copper $/mt LME Nickel $/mt LME Zinc $/mt Precious Metals COMEX Gold $/troy oz COMEX Silver $/troy oz Agriculture CBOT Wheat Cent/bu CBOT Soybean Cent/bu CBOT Corn Cent/bu NYBOT Cotton Cent/lb 73 n/a n/a NYBOT Coffee Cent/lb 174 n/a n/a NYBOT Cocoa $/mt 2398 n/a 80 n/a NYBOT Sugar Cent/lb CME Live Cattle Cent/lb n/a n/a CME Lean Hog Cent/lb 89.6 n/a n/a Monthly change is difference of close on last business day and close a month ago. 2 Monthly volatility change is difference of average volatility over the past month and that of the prior month (3-mo ATM implied volatility, 1-mo realized volatility). 3 Price forecasts refer to prompt contract price forecasts in 3-, 6-, and 12-months time. 4 Based on LME three month prices. Source: Goldman Sachs ECS Research estimates. Goldman Sachs Economics, Commodities and Strategy Research 3

4 Food versus feed in the wheat market We forecast that the US drought will bring corn supplies sharply lower and require feed and ethanol demand destruction. To limit livestock liquidation, we forecast that wheat feeding will be required to supplement corn and DDG use in the US and globally. As a result, our base-case forecast remains that US wheat prices will need to trade back near corn prices by next spring, with our current price forecast embedding a smaller wheat-tocorn premium than currently priced into the CBOT future curves (see Severe US drought to push corn and soybean prices to new highs, July 23, 2012). Our 3-, 6- and 12-mo wheat forecasts remain $9.80/bu, $8.75/bu and $7.75/bu, and are derived from the price of corn where we believe ethanol demand destruction takes place. However, hot and dry weather conditions have also impacted most of the world s largest wheat producing and exporting regions. We forecast lower global wheat production than the USDA and expect that 2012/13 global wheat inventories ex. China and India will decline to their lowest levels since 2007/08, yet remain well above global corn inventories. A further deterioration in weather conditions, potential FSU export restrictions and pent-up import demand create risks that global wheat inventories decline even more than we expect. Such an outcome in the face of inelastic food demand would likely push wheat prices sharply higher and well above corn prices to price wheat out of feed demand. In short, US wheat is caught between the need for stronger feed use given low US corn production and the potential for stronger exports given low global wheat supplies. As a result, we currently see limited risk-reward currently in implementing our expectation for further wheat vs. corn convergence, and we recommended closing our short May-13 CBOT wheat vs. corn spread trade last week, for a potential gain of $0.50/bu. With lower Black Sea exports and EU wheat trading at a discount to US wheat, we believe that European wheat exports will likely pick up in coming months. As a result, we recommend entering a long Mar-13 MATIF vs. short Mar-13 CBOT wheat spread position. Adverse weather conditions continue to impact global wheat production After a cold spell in February damaged Ukrainian and European wheat crops, hot and dry weather conditions have continued to impact key wheat growing and exporting regions: A drought in the Black Sea region has cut spring wheat yield prospects in northern Kazakhstan and southern and eastern Russia. Forecasts for continued hot weather in Russia in August could further damage the spring wheat crop while forecasts for above-average rains in August in Kazakhstan could help limit production losses. Expected dry weather would impact the Ukraine wheat crop as well, however, with almost all Ukraine wheat of winter type and most of that crop harvested, weather presents limited risks in coming weeks. High temperatures in China could also bring 2012/13 wheat production below its 2011/12 level. For example, a recent USDA attaché report pegged production at 108 MMT, well below the USDA s July WASDE and CNGOIC s forecasts of 118 and 114 MMT, with head blight mentioned as an additional driver to this lower forecast. Dry weather conditions in South and West Australia as well as Argentina are impacting winter wheat development. With these two countries the largest Southern Hemisphere exporters, continued low rainfalls in August / September would be critical. The Indian monsoon is running 20% below normal in July with local authorities expecting a modest improvement to 15% below normal by year end. So far the impact on wheat has been limited as India s North West has been the region most impacted. Goldman Sachs Economics, Commodities and Strategy Research 4

5 However, if rains were to remain low in August and September, this would impact 2013/14 winter wheat planting. The US drought, if it extended into the fall, would also be detrimental to 2013/14 US winter wheat acreage and yield prospects. We are lowering our wheat production forecasts for Russia, Kazakhstan, Australia, Argentina and China, as described in Exhibit 1. These production losses are partially offset by higher US, Canada and EU-27 production, with France s wheat crop larger than previously forecast. Net, assuming the USDA s July WASDE production estimates for other countries, we expect 2012/13 global wheat production of million metric tonnes (MMT), 13.2 MMT below the USDA s July forecast (which the USDA will likely lower in the coming August WASDE) and the just above the 2010/11 production level. In turn, we expect that the 2012/13 exports will decline from MMT currently projected by the USDA to MMT. We expect higher global wheat demand than the USDA on higher wheat feeding given lower corn production in the US and Ukraine. As a result, we forecast that 2012/13 global wheat inventories will decline to MMT from MMT last year and at an only slightly higher level than in 2008/09. Further, global wheat inventories excluding India and China of 93.7 MMT would be the lowest since 2007/08 and only 3 MMT higher than in 2006/07 (Exhibit 2). Exhibit 1: We forecast lower global wheat production, exports and inventories than the USDA in 2012/13 million metric tonnes Production Exports Ending stocks USDA July WASDE GS USDA July WASDE GS USDA July WASDE GS Russia Russia Russia Ukraine Ukraine Ukraine Kazakhstan Kazakhstan Kazakhstan Australia Australia Australia Argentina Argentina Argentina Canada Canada Canada US US US EU EU EU China China n.a. n.a. China India India India Other Other Other World World World Source: USDA, Goldman Sachs ECS Research. Wheat inventories, although sharply lower, remain large relative to corn stocks While under more normal circumstances such a decline in wheat stocks would warrant wheat prices trading at a large premium to corn prices, global wheat inventories excluding India and China remain well above global corn inventories excluding China and India. From 2002/03 to 2008/09, these wheat inventories never exceeded corn inventories by more than 31 MMT, while our forecasts currently point to wheat inventories 34.1 MMT higher than corn inventories (Exhibits 2 and 3). Goldman Sachs Economics, Commodities and Strategy Research 5

6 Exhibit 2: wheat inventories will decline sharply in 2012/13 to their lowest levels since 2008 wheat ending stocks excluding China and India; MMT Exhibit 3: however, 2012/13 global wheat inventories remain well above global corn inventories wheat ending stocks minus global corn ending stocks (excluding China and India); MMT wheat inventories ex. China & India Source: USDA, Goldman Sachs ECS Research estimates. Wheat vs. corn global inventories (ex. China and India) Source: USDA, Goldman Sachs ECS Research estimates. We believe that this larger availability of wheat is key to the price outlook of wheat prices. Specifically, we forecast US corn production at 10,750 mmbu, well below the USDA s 12,970 mmbu forecast, and the lowest since 2006/07. This large shortfall in US corn production, exacerbated by already very low beginning stocks after two consecutive years of deficits, will require significant corn demand destruction, from the export, feed and ethanol sectors. To limit livestock liquidation, we forecast that wheat feeding will be required to supplement corn and DDG use in the US. As a result, our base-case forecast remains that US wheat prices will need to trade back near corn prices by next spring, with our current price forecast embedding a smaller wheat-to-corn premium than currently priced into the CBOT future curves Further, our CBOT wheat-to-corn pricing model suggests that current market prices are already factoring in an even larger increase in US exports than our forecast. Specifically, given our forecast of a 5% US corn stocks-to-use ratio, our model suggests that the current wheat-to-corn price ratio is consistent with a US wheat stocks-to-use ratio of 18%. Assuming all other items from the USDA's US wheat balance table remain unchanged, this level of stocks-to-use would correspond to US wheat exports rising from the 1,200 mmbu currently forecast by the USDA to 1,400 mmbu, a 5.4 million metric ton increase and their highest level since Weather, export policy and import demand create upside risks to wheat prices Nonetheless, we see three growing risks to the wheat outlook: a further deterioration in weather, potential export restrictions, and pent-up import demand from the Middle East. 1. Continued hot and dry weather in the regions listed previously would further exacerbate the decline in 2012/13 wheat production and bring wheat inventories even lower than we currently forecast, with Russia, Argentina and Australia wheat production most at risk in coming weeks. 2. Sharply higher crop prices and growing concerns over food inflation create risks that governments restrict wheat exports. This would be similar to what occurred in 2007/08 Goldman Sachs Economics, Commodities and Strategy Research 6

7 when Argentina, India, Kazakhstan, Ukraine and Russia all restricted exports or in 2010/11 when Ukraine limited exports and Russia outright banned exports. Under our current production forecast, we see this risk as manageable, however further production losses could significantly limit exportable surpluses. We expect a Russian wheat crop of 43 MMT in 2012, compared to 43.2 MMT in 2010 when Russia last imposed an export ban. Our Russian wheat export forecast of 6.3 MMT reflects our view that exports will slow significantly once inventories near 9.5 MMT. We believe that if needed, this would be achieved through export restrictions, such as taxes, rather than an outright export ban as: (1) Russia s overall grain crop is expected at MMT vs. 62 MMT in 2010, (2) the government still has 5 MMT in state intervention stocks, and (3) that the country joined the WTO last month. This would be a similar approach to what Russia did in 2007/08, when it shipped its export surplus before imposing an export tax. The Russian government is expected to discuss grain exports on August 8. We adopt a similar approach for our Ukrainian export forecast, with the government further announcing that no export restriction would be implemented without a two-month notice period. India, which already faces high food inflation, could play a key role in the outlook for wheat supplies in the coming year. The disappointing monsoon could push domestic food prices even higher and lead India to reintroduce the wheat export ban that it lifted only a few months ago. In turn, if the monsoon normalizes, India could continue to export its high wheat inventories, which swelled during its export ban, and help alleviate lower exports in other regions. 3. On the demand side, reports of light forward coverage by major Asian and MENA region importers, potentially due to the sharp rally in wheat prices this spring, suggests that import demand should strengthen in coming months. In particular, while Iran has been proactive in increasing grain imports, Egypt, the world s largest wheat importer, does not seem to have conducted meaningful import tenders since April. While this may be a function of a higher 2012/13 domestic wheat harvest, Egypt will still need to import wheat in coming months and could at that time face lower exportable surpluses or even export restriction from its key suppliers. As a result of these risks, we see the potential for wheat prices to remain above corn prices for longer than we currently forecast. In particular, should all three risks materialize, sharply lower wheat availability in the face of inelastic food demand would likely push wheat prices sharply higher and well above corn prices to price wheat out of feed demand. In effect, US wheat is caught between a need for stronger feed use given the shortfall in US corn production as well as potentially stronger export demand to make up for lower global wheat supplies. As a result, we see limited risk-reward in implementing our expectation for further wheat vs. corn convergence, and we recommended closing our short May-13 CBOT wheat vs. corn spread trade last week, for a potential gain of $0.50/bu (see Agriculture Update, August 2, 2012). Recommending a long European vs. US wheat trade recommendation as US wheat is priced out of the export market for now We expect that Russia and Ukraine wheat exports will likely be front loaded given the potential for export restrictions. However, our forecast for lower FSU supplies also requires stronger EU and US wheat exports than the USDA currently forecasts, with exports picking up further once FSU exports slow down. Goldman Sachs Economics, Commodities and Strategy Research 7

8 With CBOT wheat prices trading at a premium to Back Sea and EU wheat prices despite higher freight costs, we expect this export demand to initially be directed to EU-27 wheat supplies. Weak US wheat export sales so far in the 2012/13 crop year started on June 1 confirm that high CBOT wheat prices have effectively left US wheat off the export market. Further, we expect this lack of export demand to weigh on CBOT wheat timespreads in coming months. Our modeling work suggests that these stronger EU-27 exports will push European wheat prices back to trading at a premium to CBOT wheat prices in coming months. As a result, we view the current large discount of MATIF to CBOT wheat prices as an opportunity to enter a long Mar-13 MATIF wheat vs. short Mar-13 CBOT wheat spread position with an entry level of -$17.5/MT. Our fair value model suggests that this spread could recover to $25.0/MT, as shown in Exhibit 4. With our FX strategists forecasting a EUR/$ exchange rate above the current forward curve (3-, 6- and 12-mo forecast of 1.25, 1.33 and 1.40, respectively) and recommending a long EUR trade, we recommend only hedging half of the currency exposure at this time. Exhibit 4: MATIF wheat prices are well below the level that our export forecasts imply MATIF vs. CBOT wheat spread, actual vs. model ($/MT) Model Actual Forecast Source: USDA, NYSE Euronext, CME, Goldman Sachs ECS Research estimates. Goldman Sachs Economics, Commodities and Strategy Research 8

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