Commodities 08/2010

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Investment ResearchGeneral Market Conditions

Global wheat prices have rallied since early July, as estimates of Russian production have

been revised down on the back of an extended period of drought. We have assessed the

fundamental situation in the grains market after the August WASDE report from the US

Department of Agriculture (USDA) and conclude that the recent rally is overdone and

specifically that a new global food crisis is not imminent. Still, the recent price surge

could put upward pressure on inflation in the near term and highlight structural challenges

facing the agricultural sector.

August WASDE report mildly bullish

The August WASDE report saw a larger-than-expected downward revision to global

wheat stocks: the USDA now projects 2010-11 ending stocks at 174.8 million tonnes

(July report: 187.1, survey: 178.8). The global wheat stocks-to-use ratio was revised

down from 28.0% to 26.3%. For corn and soybeans, 2011 stock estimates were also

taken down and stocks-to-use are now forecast at 16.7% and 25.8%, respectively.

Overall, the report was mildly bullish for the grains sector but still paints a picture of a

well-supplied market. We look for Matif milling wheat prices to retreat to EUR175 per

ton before year-end, as the recent rally looks overdone. We see current levels as attractive

for locking in wheat prices from a producer point of view.

Russian drought leads rally in wheat

European (Matif) milling wheat prices have risen from EUR140 per tonne to above

EUR220 in less than two months - levels not seen since the summer of 2008. However, in

the past few days, wheat prices have peaked and dropped to now trade just around

EUR210, with prices up a little on the WASDE report.

Wheat price rally on Black-Sea production shortfall

Source: EcoWin, Danske Markets.

12 August 2010

CommoditiesWheat scare unwarranted as stocks remain huge

Key points

Global wheat prices have ralliedon weather-related supply

concerns. We view the recent

price surge as overdone,

however, as the global wheat

market remains well-supplied.

The risk of a new global food

crisis is small in our view.

Things to look out for include:further trade restrictions,

contagion to other soft

commodities and speculative

flows.

On the whole, we look for Matifprices to retreat to EUR175 per

ton before year end and see

current levels as attractive for

producers to lock in wheat prices.

Senior Analyst

Christin Tuxen

+45 4513 7867

[email protected]

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2 | 12 August 2010www.danskeresearch.com

Commodities

The panic rise was more or less solely caused by a supply shock. Wheat has risen on fears

that Black-Sea production would be severely harmed by a prolonged period of very dry

weather. Russia accounts for 9% of global production and 14% of exports but also output

from other major exporters in the region such as Ukraine and Kazakhstan may be at risk

from an ongoing drought. In an attempt to contain domestic price rises, Russia last week

announced an export ban to take effect from 15 August until year-end. Crucially, ongoing

wildfires may not only destruct this seasons crop but could potentially hinder next

seasons plantings of winter wheat. Ukraine officials this week said that the country is

contemplating export quotas for grains.

Further adding to likely production shortfalls is the fact that Canadian wheat was hit hard

by heavy rains earlier in the year and Pakistani crop is now threatened by flooding.

Combined with the fact that record harvests in recent years have led farmers to plant less

wheat, wheat stocks look set to decline significantly this year. This has spurred fears of a

global food crisis similar to the one that hit the global economy in 2007/08 when rising

food prices led consumer prices to surge and inflation-targeting central banks to hike

interest rates despite a significant slowdown in economic activity.

Current situation is very different from 2007/08 crisis

In our view, the situation in the global grains market is very different from the one in

2007/08 and provided no hoarding or new trade barriers are introduced, we look for

markets to calm down in the near term and for the inflationary impact to be limited.

Longer term, the surge in wheat does however highlight a range of structural problems in

the agricultural sector.

First of all, global stocks of wheat are ample at present. Measured in terms of the stocks-

to-use ratio, the market is well supplied with stocks available to honour almost 30% of

yearly consumption; in the US the corresponding figure is above 80%. This is rather

different from the situation in the summer of 2008 when US stocks-to-use ratio was

running at a mere 10%. At above 26% the wheat market is still at a very comfortable

level.

Second, we should not forget that a supply reaction can happen fast in the grains market:

when farmers observe higher prices they usually increase plantings of the grain in

question for the next season. This is indeed what has been seen in recent years after bumper harvests led to booming inventories. The planting season is about to start in

Australia and Argentina, which makes for a quick reaction to Black-Sea crop damage.

Third, prices of other grains and soft commodities have followed wheat up only to a very

limited extent (barley is the exception though). This highlights that the recent panic is so

Wheat production by region

Source: USDA, Danske Markets.

Wheat market fairly loose... ... but getting a little tighter this year

Source: USDA, Danske Markets. Source: USDA, Danske Markets.

Plantings decline on record harvests

Source: USDA, Danske Markets.

9%

20%

17%

12%

9%

33%

Production

United States EU-27 China India Russia Other

0

50000

100000

150000

200000

250000

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

Wheat, world stocks (1000 ton)

0.21

0.24

0.27

0.3

0.33 World, stocks-to-use (%)

0

20

40

60

80

2008/09 2009/10

Est.

2010/11

Proj.

US area planted (mn acres)

US area harvested

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far mainly contained to wheat. Notwithstanding, it cannot be ruled out that higher prices

on wheat could crowd out plantings of other crops such as soybeans and corn. Stocks of

these grains are also at decent levels but in particular the soybeans market is somewhat

tight and could thus be vulnerable to production shortfalls arising from planting

substitution.

Fourth, the demand side should provide only limited support to prices. Crucially, we are

currently in a different stage of the business cycle than was the case in 2008 when

capacity utilisation was high and underlying inflationary pressure significant as a result.

Also, with focus shifting to second-generation biofuels, which use biomass etc. rather

than grains as input, demand from the energy sector - and thus spill-over between food

and energy sectors - should be limited.

Finally, whereas the 2007/08 rally was likely to have been partly caused by a rise in

speculative positions, this does not seem to have been the case to the same extent this

time round. Leading up to the price spike speculators were on average net short wheat but

an extensive short-covering rally has reversed the situation such that non-commercials are

now net long. During the recent rally the ratio of non-commercial positions to total open

interest has in fact declined. This suggests that speculative flows into the sector have in

fact been reduced.

Overall, it is important to note that the current shock is rather different from the 2007/08

one which arose from a demand shock: global grains stocks were low, the global

economy was booming, regulatory changes spurred demand for grains for biofuel

production and financial interest in commodities was accelerating.

Agflation scenario unlikely in the near term but longer-termoutlook highly uncertain

The UN Food and Agricultural Organisation has made an attempt to calm the markets,

saying that global inventories are indeed sufficient to compensate for the production. This

week the OECD joined the UN in playing down the impact of the Russian drought. We

largely agree with the view that there is little reason to panic as things are now, but the

short and the longer term implications of the wheat crisis are likely to differ.

Near term: little sign of contagion but both physical and financial risks in

place

We look for wheat prices to continue the downward correction seen in recent days and to

retreat to EUR175 per tonne before year-end as the market wakes up to reality whichremains elevated global wheat stocks. During the course of 2011, wheat prices could rise

a little from this newfound level as global demand ticks higher alongside close-to-trend

economic growth (and sustained population growth). This assumes no further trade

restrictions and a normal planting reaction to this years production shortfall. Notably,

US and European farmers stand to benefit from the price increases as their crops have

developed neatly while Black-Sea producers face a tough time.

Having said that, risks that the recent rally could spur further price rises along the grains

physical supply/demand chain remain. Wheat, corn and rice are fairly close substitutes in

consumption as well as production and thus while the price rises so far are mainly

restricted to wheat, spill-over cannot be ruled out. This could make the price rises more

broad-based and fuel inflation to a larger degree. Notwithstanding, there is little tightness

in neither wheat, coarse grains (incl. corn) or rice.

Short covering in wheat


Little tightness across grain types

Source: USDA, Danske Markets. Note:coarse

grains

refer to other grains than wheat and rice(includes corn and barley).

0%

5%

10%

15%

20%

25%

30%

35%

TotalGrains

Wheat CoarseGrains

Rice,milled

Stocks-to-use, %

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Also, speculation remains a joker and was at least partly blamed for the 2007/08 spike.

However, investor interest in commodities has been muted in this recovery phase despite

loads of liquidity. Part of the reason for the limited flows into commodities as an asset

class is the contango structure that prevails in most futures markets, not least in grains:

when putting their money in commodity futures investors thus incur a negative roll yield

due to the downward-sloping curve which must then be made up for by an even larger

upward move in price levels.

Milling wheat: Danske forecast vs. fwd


Longer term: structural challenges looming

Although the near-term impact of the wheat surge may be limited, it does turn into focus

a range of potential problems in the agricultural sector.

First, the experience of the past two months underline that volatility in agricultural

markets has risen. This is partly a consequence of the market becoming more finely

balanced in terms of supply and demand due to underinvestment combined with rising

use of grains from first-generation biofuels and emerging-markets demand. On top of this,

comes the rising impact of financial markets due to the focus of commodities as a

separate asset class, potentially useful in portfolio diversification. Heightened volatility

policymakers may turn their eyes on financial trading in commodities and eventually lead

to more widespread regulation of a market which remains highly politically sensitive.

Second, wheat is potentially facing another supply issue from spreading of wheat rust

aka ug99- which is a fungal infection attacking the stem of the plant, seeEconomist: Rust

in the bread basket. The disease has recently been spreading in southern Africa and but

may however travel far via the wind and could have devastating consequences if it

reaches some of the worlds major producers.

Finally, the recent incidents of drought and flooding also highlight the potential threats to

the agricultural sector arising from extreme weather events likely related to a changing

climate. Indeed, 2010 is on track to become the warmest on record according to the UK

Met Office. This poses both threats and opportunities to farmers but will most likely

require a re-structuring of the sector in coming decades.

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DisclosureThis research report has been prepared by Danske Research, which is part of Danske Markets, a division of

Danske Bank. Danske Bank is under supervision by the Danish Financial Supervisory Authority. The author of

this report is Christin Tuxen, Senior Analyst.

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quality research based on research objectivity and independence. These procedures are documented in the Danske

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as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be

obtained from the authors upon request.

Risk warning

Major risks connected with recommendations or opinions in this research report, including as sensitivity analysis

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Commodities 08/2010

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