Dimitri Kryukov of Verno Investment Management -
The summer heat wave in central Russia that saw temperatures soar over 40Â°C, appears to be over. But the long-term economic impact of the drought remains unclear.
As temperatures subside, the key questions that remain are the degree of damage caused by the drought and whether increases in the price of grain and related products are speculative and short term in nature or justified in the longer term. At this time, slightly more than 20% of grain-sown land is known to have been damaged. While food producers are reportedly complaining about a dramatic increase in the cost of grain, state officials claim that such price action is totally unreasonable since there is no shortage. The Federal Anti-Monopoly Service (FAS) has initiated several investigations into pricing levels. Our analysis is as follows.
Estimates of the opening reserve balance for the 2010 harvest year (which started July 1) range from 17m to 24m tonnes of grain, approximately half of which (9.5m tonnes) is owned by the State Grain Interventions Fund. To date, 54% of the total crop has been harvested, resulting in 40.1m tonnes of grain collected. This is a yield of 2.1 tonnes per hectare, a nearly 25% decline on year. The 2010 forecast has been drifting downwards week after week, but now appears to have settled at 60m-65m tonnes of grain (70m tonnes is the optimistic scenario) compared with 97m tonnes harvested last year. To cope with potential shortages, Prime Minister Vladimir Putin imposed a grain exports ban effective from August 15 until the end of the year. Exports prior to enforcement of the ban were 34m tonnes. Consequently, the 2010 domestic grain supply (opening balance + crop exports) will be somewhere in the range of 73m-91m tonnes of grain - an extremely wide band. The final figures will not be available until the fall.
Internal grain consumption was 76m tonnes in 2009, including 41m tonnes of wheat. 2010 grain consumption is expected to be 73m tonnes, including 45m tonnes of wheat. Under the conservative scenario, the domestic supply/demand grain balance, imports aside, is very tight, making the food producers nervous. However, grain market participants believe that there will likely be a surplus of roughly 5m tonnes of grain. The potential shortages are creating additional challenges as, for example, the purchasing price for raw milk has reportedly risen to RUB14/litre from the previous level of RUB11/litre, a 27% increase, on stockbreeder speculation that a shortage of fodder grains will negatively impact livestock.
In our view, a wheat price of RUB5,000-7,000 /tonne appears to be justified given that the unit cost of the marginal supplier has increased dramatically due to crop damage. If it turns out, however, that the marginal supplier has only experienced minor losses, high-cost suppliers will be eliminated from the market and the surge in the wheat price will prove to be speculative and unjustified. The Institute for Agricultural Market Conditions (IKAR) price estimate for the 2010 wheat crop is RUB5,500-6,500/tonne. As a basis for comparison, last year's price of approximately RUB4,000/tonne, was pushed down to 3,500/tonne in spring of 2010 based on high crop expectations. When the export ban was announced, wheat prices stood at RUB6,500-7,000/tonne.
Additionally, the agricultural producers' debt burden, lack of funds to finance sowing, and expected decline of yields on land that was damaged by drought and fires can also affect prices. In many areas, the soil is in poor condition and producers will not have enough time to sow winter wheat, which yields 1.5x more than summer wheat. This could result in an approximate 20% decline in the countrywide grain yield in 2011, making it unlikely that the 2011 harvest will materially exceed that of 2010. To mitigate this, the government has approved a RUB35bn support package consisting of RUB25bn of three-year loans and RUB10bn of subsidies. Banks, primarily Sberbank and Rosselkhozbank, will have to extend RUB127bn of agriculture loans, approximately 14% of total agricultural loans, which in turn make up 5.2% of Russia's total bank loans.
Another question that arises is whether imports will ease the situation and put downward pressure on domestic prices. Neighbouring Kazakhstan is expecting a good 2010 harvest and could possibly deliver wheat priced at around $200/tonne, (RUB6,000/tonne). While Ukraine, like Russia, faced abnormal weather conditions that exclude the possibility of a good harvest, the FOB price in the port of Odessa is $265/tonne, or approximately $300/tonne including transportation to Russia. On a separate note, the State Grain Interventions Fund will be released at some point. Speculations is that are food-quality wheat prices are set to be RUB5,300-5,500/tonne. This information, however, is as yet unconfirmed.
In conclusion, we highlight the following. First, the inflationary effect cannot be avoided, but its degree will only become clear after the harvest. VTB analysts have calculated that products sensitive to grain prices, such as bread, pasta, dairy products and meat, account for about 16% of the CPI basket. Meat products alone make up almost 10% of the CPI basket. Assuming that the price of grain is up 50% on year and accounts for about 25% of the shelf price of affected products, we arrive at a potential blended price increase of 12.5%, and believe that the additional inflationary impact will be about 2 percentage points (pps) to be distributed over 2010 and 2011. Second, there is likely to be an impact on GDP, which is so far assessed as a decrease of 0.5-1.0 pps from 2010 growth. Third, we expect agricultural and food producer stocks to enter a period of increased volatility due to the fact that some agricultural producers (such as Black Earth Farming) have experienced more pronounced damage than others (such as Razgulay). Companies have not yet disclosed exact figures, however, providing grounds for speculation. Food producers also have uncertainty over input costs going forward. The only sector that could potentially benefit is the retail sector. Historically, retailers have been able to utilize higher inflation by exerting some influence on their suppliers and increasing their mark-ups.
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