Konstantin Fastovets of Renaissance Capital -

-- We believe food prices are high because commodities across the board are used as a hedge against inflation. February food-balance forecasts by the US Department of Agriculture (USDA) indicate that grain and oilseed stock/use ratios are far from catastrophic (oilseed and grain stocks are above those seen two and three years ago, respectively). Examining global indices shows that a broad commodities basket outperformed a broad equity basket in 2010 by more than 700 basis points, which we see as a clear sign of overbuying (a broad equities portfolio implies greater risk than a broad commodities portfolio).

-- Important events for the sector as a whole include the cancellation of export VAT on grain and oilseeds in Ukraine's 2011 tax code, the drop in general risk perception associated with Ukraine (CDS spread narrowing), and draft laws aimed at liberalising the land market and monopolising agricultural exports.

Food prices in 2011

By December, the United Nations' Food and Agriculture Organisation's (FAO) global food price index had risen to its highest recorded level, having advanced more than 30% since July. Vegetable oil, cereal, and sugar prices demonstrated the most dramatic increases - up 55%, 39%, and 19% on year, respectively, by the end of 2010.

Although in our view some price growth, such as in the case of sugar, is based on fundamental shortages, food scarcity may not be the principal driving factor behind the 2010 price rally. We think one possible explanation for high food prices may be that investors are using commodities as a hedge against inflation.

Moving into 2011, we see three major factors governing food prices: 1) support from continued use of commodities as an inflation hedge; 2) pressure from an increase in supplies for scarce commodities (sugar) with the start of the new season (second half of 2011); and 3) price shifts, due to links between commodities (ie. wheat prices driving poultry prices).

Hedging inflation with food

Examining the fundamentals of global grain and oilseed markets suggests that, while 2010 has been marked by a shortage, scarcity does not fully explain why prices have risen by over 55% since July. According to the USDA's World Agricultural Supply and Demand Estimates (WASDE) report, published earlier in February, the 2010/11 marketing year is characterised by a global stock/use ratio of 0.192 for both grain and oilseed, which is far from catastrophic. In fact, oilseed and grain stocks are above those seen two and three years ago, respectively.

A review of commodity performance in general over 2010 shows that prices of other relatively liquid commodities, such as gold, copper and coal, seem to have grown as much as, if not more than, wheat prices. Furthermore, the return on a broad commodity index over the past year has been over 7 percentage points higher than the return on a broad equity index - which is highly unusual, considering that the latter implies greater risk. Altogether, we believe this indicates that investors may be overbuying commodities, and are perhaps using them as a hedge against inflation and unpredictability.

Looking through 2011, we think two opposing forces will govern global crop (and food) price dynamics: 1) price support from continued use of liquid commodities (wheat, corn, soybean) as inflation hedges; and (2) price pressure from increased supplies provided by the new harvest in the second half of 2011. We believe the 2011 global harvest should be better than last year's, due to the low likelihood of catastrophic weather conditions occurring for a second consecutive year (at the very least, Russia and Ukraine should perform much better).

Ukrainian grains: Quota effects in sight

The Ukrainian government has introduced grain export quotas of 4.2m tonnes in total until the end of March 2011. We estimate Ukraine will be able to export roughly 8.2m tonnes of grain by March 31, which, considering the 40m tonnes harvest, leaves an estimated 6-7m tonnes in excess of consumption inside the country.

Since the quotas were originally introduced in October, we have been waiting for internal Ukrainian prices to start decreasing relative to the outside world. Most relatively large farmers, however, seem to have been storing their grain, expecting the government to cancel quotas, or to at least refrain from prolonging them, effectively halting the oversupply from flooding the market. At the end of November, however, Ukrainian prices seem to have finally started lagging world dynamics. The average spread between Ukraine class 3 wheat and USDA no. 2 soft red wheat increased from 10-15% in March-May (a similar figure for September-October) to 20-25% in mid-November. If quotas are extended further into 2011, we think this may widen the spread even further, and lower effective grain prices for Ukrainian farmers. We note here that this will not necessarily have a negative effect on traders (ie. Kernel), which are able to compensate lower export volumes with higher margins (they buy relatively cheaply inside the country).

We also note that, according to the new Tax Code passed by the government at the end of 2010 (effective January 1), there will be no VAT refunds on grain and oilseed exports. The effect of this policy will probably be transferred completely onto farmers, and will likely widen the price spread between Ukraine and the rest of the world by 5-7%, on our estimates (effectively the VAT previously refunded by the government will be compensated by lower crop prices, set by traders).

Sugar: A case of short supply

While inflation hedging may also be a driver for sugar, we think price movements in this commodity currently largely reflect fundamental factors. Over 2010, sugar prices gained more than 19%, reaching a new 31-year high of $0.33/lb in December. As noted in our last report on Astarta, we believe the sugar deficit seen over the past two years has been caused by poor centrifugal sugar output from India (in part due to decreased cane planning areas, and in part due to conflict between sugar producers and cane farmers), which has not been compensated by an increase in sugar output from Brazil. We think the high sugar price should now make it profitable for Brazil to produce a larger proportion of sugar from its cane harvest (the new harvest will start in May and go through to November), which should expand supply and cause deflation going forward into 2011.

Since the Ukrainian sugar market is detached from global exchanges with a 50% income tariff, we think most of the local price pressure will come from the new production season, which will start in September 2011 (this year, Ukraine produced an estimated 1.54m tonnes, which is some 20% below estimated consumption).

Assuming the same planting areas in 2011 as in 2010, we believe the country should be able to produce at least 2.1m tonnes of sugar (roughly 100,000 tonnes in excess of domestic consumption), effectively ending the deficit. We also note here that, according to our calculations, when the spread between local sugar prices and raw cane sugar reaches roughly $250/tonne or above, it will become profitable for Ukrainian sugar producers to import cane for processing, putting additional pressure on local prices.

Ukrainian harvests in 2010 and 2011

According to preliminary data from Ukraine's Ministry of Agriculture, the 2010 harvest yielded 39.2m tonnes (net) of grain, which is 15% below the 2009 total and 2-4% below our August forecast. News flow from agriculture consulting agencies and mass media suggests the sunflower seed harvest remained relatively constant yewar on year (important for Kernel), while soybean output increased 61% and rapeseed output declined 22%. As discussed in the previous section, prices for both grains and oilseeds have increased approximately 40% on year.

While the sugar beet harvest increased 36% year on year in 2010, preliminary industry data suggest sugar output only increased 21%, to 1.54m tonnes, due to a lower content of sugar in beet (the 2010 sugar output falls approximately 20-30% below consumption).

Winter kill a possibility

The 2011 winter sowing campaign in Ukraine is finally complete, totalling 9.2m ha of planting, down 8% from 2010. We have two principal concerns in relation to possible winter kill this season (that is, when sown crops have not hardened sufficiently to withstand severe winter conditions): 1) the sowing campaign has run very late - in some regions of Ukraine farmers were planting through December; and 2) mid February has been characterised by very cold weather (10-15 C below freezing), with inadequate snow coverage. Overall, we are not fully comfortable with the agriculture ministry's 45m tonne grain harvest forecast for 2011.