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Wheat Prices Go Against the Grain

Howard Simons

This is the end, bear market trend
This is the end, my only trend
The end of our bearish plans
The end of everything that stands
The end

I speak, of course, of wheat, not stocks -- yet. A former colleague in the commodity business used to refer to the dirt-wheat spread: Farmers bought dirt and sold wheat.

This is not a very flattering way of looking at one of the oldest and most useful businesses in the world. Think about your own diet and how few days you do not eat wheat in at least one form. The whole thing can make you misty-eyed thinking about those food pyramids, the four food groups and other elementary-school folderol.

So if wheat is so popular and so useful, why has its price been depressed for so long now? More important, now that we seem to be having a grain rally that lasts for more than two days -- sounds a little like stocks over the past year, doesn't it? -- what should we look for as traders and investors?

All Wheat Is Not Created Equal

In two weeks, I will be making my annual "mid-Kansas in mid-July" trip to lecture at the International Grains Program at Kansas State University. In the hallway is a veritable museum of the different types of wheat involved in global commerce. Let's concern ourselves with those types traded on U.S. commodities exchanges:

Of these, the Chicago contract is the most heavily traded, even though most bread is made from the Kansas City hard red winter wheat. White wheat is used in noodles, durum in harder pastas like spaghetti, and soft red wheat is used in products such as rolls. The different growing areas, crop cycles and final uses of the various wheat markets produce some very actively traded spreads, none of which will be discussed here today.

One of the differentiating characteristics of all these different wheat varieties is protein content; the more protein, the harder the wheat, and the more valued it is for feeding applications and specialty processing. What makes wheat unique among grains is a protein called gluten that allows wheat flour to stick together in a dough: No gluten, no bread, at least as we know it.

The Wheat Bear Market Ends Wheat prices' long slide ended in early 2001

Source: Bloomberg

Shake and Bake

As is the case for so many agricultural products, a free market in wheat simply does not exist. Wheat is subsidized heavily nearly everywhere, and that leads to overproduction and the sort of long-term and persistent price downtrend that took place between 1996 and the start of 2001. The recent farm bill will perpetuate the problem of keeping marginal producers in business, especially if the current move higher restores farm incomes somewhat.

The weaker dollar will increase the relative attractiveness of U.S. wheat in export markets, and if that fails, there are always the inane subsidies of the Export Enhancement Program and Public Law 480, an Eisenhower-era food giveaway program designed to fight communism by shipping free food to favored nations and, in the process, bankrupting the local farmers who couldn't possibly compete with this largesse. Can food exports stop terrorism? In the dreams of farm-state politicians, you betcha, and get ready to hear that argument sometime in the near future.

Rootin' for Gluten

Gluten is produced as an additive to many baked goods by various agribusiness firms, many of which like Cargill and Koch Industries are privately held. Archer Daniels Midland(ADM), known best for soy processing and playing ethanol subsidies like a Stradivarius, and Bunge(BG) are two of the larger publicly-traded players in the wheat market.

But to get a more focused wheat play, we need to turn to a small stock like Midwest Grain Products(MWGP), which produces premium wheat starch and ethanol along with gluten. The stock has a total return of 26% over the past year -- 17.1% in 2002 alone -- and none of its executives or auditors have had to pose for mug shots. If there's anything the bean counters should be able to count, it's beans and other grains.

Higher Wheat Makes MWGP Sweet It has done well when wheat prices are high

Source: Bloomberg

What makes Midwest's shares appealing is their ability to capture the gains from higher wheat prices with low volatility. While Midwest has gained in price over the past year, ADM has fallen 14.8% and Bunge 12.4%. These latter two companies are affected more by the higher feedstock costs for their processing operations.

Moving Forward

In terms of other wheat plays, it's best to take a page from another commodity: in a gold rush, for example, sell picks and shovels. Likewise, in a period of rising farm subsidies and higher grain prices, sell tractors. The agricultural supply business -- fertilizers, seeds, chemicals and equipment -- will do a much better job of capturing the money flow than will anyone moving the grain. For example, Deere(DE) has gained 11.9% so far in 2002. We'll take a look at this whole class of suppliers soon.

In the meantime, remember that the long-term price trend for farm commodities is lower, and significantly so. Just as forays into gold should be sold too soon, so should investments in the agricultural sector. After all, it's a tough way to make a living -- the joke runs that an Iowa corn farmer won the state lottery. As the news cameras were rolling, a reporter asked what he planned to do with the windfall. He replied, "I don't know. I guess I'll just keep farming until the money runs out."