Why Bubble Prices In Beef, Poultry And Pork Will Collapse, And How To Profit

• I expect protein prices to fall by about 50% over the next year or two
•  The corn ethanol mandate, the God particle of the food economy, is in jeopardy
• Corn prices collapsed immediately after changes to the ethanol mandate in Sept. 2013
• After hitting all-time highs, pork has been cut in half & beef prices are rolling over
• Poultry prices will inevitably follow the pork much lower
• Beneficiaries include restaurants, protein processors, grocers and the CONSUMER
• Protein producers such as  (TSN), Sanderson Farms (SAFM) and Pilgrim’s Pride (PPC) will suffer lower margins

Before understanding how and when the protein bubble will burst, we have to understand how it was formed in the first place. Let’s review it briefly before I explain why I think prices are heading a lot lower.

Over the last 10 years, protein prices have surged, followed the price of corn as it marched to all time record highs. I predicted this outcome in my May 2012 paper, “Popping the Corn Bubble.” I blamed the corn ethanol mandate as established in the Energy Policy Act of 2005 and the Energy Independence and Security Act of 2007 for setting off a general surge in agriculture commodity prices that would drag soybeans, wheat, hay and cotton, as well as protein prices with it.
Corn supply is cut by 40%

As you look closely at the chart below, understand that corn prices had been stable for the last 50 years at about $2.30 per bushel.

Droughts come and go, as do recessions. Policies such as the corn ethanol mandate are far more disruptive because they can last for decades. The chart below is revealing.

By 2007, the Renewable Food Standard’s corn ethanol mandate was suddenly diverting 40% of the corn crop away from the food supply. This set in motion a number of responses. First, farmers planted 24 million new acres of corn to meet the exploding demand. This diverted production away from soybeans, wheat, hay and cotton, the prices of which marched to all time highs. It also led to a historically large corn crop in 2014. Meanwhile, protein producers began economizing on the use of corn. Cattle farmers culled their herds, sending them to slaughter early. This drove cattle populations to 60-year lows, which led to a surge in beef prices.

As you can see on the chart, when reality forced EPA chief Gina McCarthy to propose a cut to the mandate – *boom* – the price of corn was cut in half. Now, barring a return to the old mandate, protein prices are bound to follow. I will explain why I am becoming more confident in this prediction.

On January 26th, Senator Diane Feinstein –not exactly a right-winger – proposed the Corn Ethanol Mandate Elimination Act of 2015. It’s co-sponsored by Jeff Flake of Arizona and Pat Toomey of Pennsylvania. The bill is currently before the Environment and Public Works Committee chaired by energy bull and climate skeptic Senator Jim Inhofe. My guess is that it will be approved in committee. It is important that a prominent Democrat such as Feinstein is behind this bill because it confirms my expectations that Democrats will increasingly move to the center on energy policy. This migration to the center will have tremendous investor ramifications and is already affecting commodity prices from oil to agriculture in my opinion.
Let’s discuss each of the proteins: beef, poultry and pork.

Where’s the beef?

Since corn gluten feed comprises 80% of a cattle farmer’s cost of goods, the producer response was immediate. Cattle farmers culled their herds. As a result, the supply of beef decreased in the market, causing beef prices to rise to all-time highs (see chart below).

Adding to the volatile story of beef production, cattle farmers in Texas and California have faced extreme droughts. This act of Mother Nature complicates the cattle raising process and increases cost of production, both of which add to the inflation of the bubble in beef prices. But as I’ve said before, droughts come and go; policies are less flexible.

Cattle populations are starting to pick up for the first time since 2009 as record high beef prices send cattle farmers into a production frenzy. Because it takes a full year to grow a harvestable heifer, the supply response should be slower than with other proteins. Nonetheless, I believe cattle herds will increase more than the current 2015 consensus estimate of a 1% to 2% increase. I think the increase is going to be 3X that amount. The chart above shows that beef prices peeked in November of 2014 and are starting to roll over. I expect prices to return to their long-term mean price level, which is at least 50% lower than current prices.

Ironically, because it only takes 3 months to produce a harvestable clucker, poultry prices have not yet rolled over. Though corn prices have a similarly disruptive affect on production costs in the poultry industry, there’s something else going on that has penalized production.

Major players in the chicken production industry have faced anomalistic challenges in the form of genetic fertility problems within the chicken flock. This genetic disorder prevents roosters from reproducing if they have been overfed. This is a temporary problem as producers rebuild their feedstock populations. Poultry prices will eventually follow the food chain lower.

Pork

Pork prices have rolled over aggressively and should continue to fall. It takes just 6 months to produce a harvestable pig so supplies have responded quicker than beef supplies.

As with the other proteins, the rise in corn prices placed upward pressure on the cost of production within the swine industry, pushing prices to all-time highs even before the porcine epidemic diarrhea virus further penalized producers. (See chart).
The porcine epidemic diarrhea virus resulted in the death of over 7 million piglets or about 7 – 10% of the total population. It primarily resulted in the death of younger swine, due to their weaker immune systems relative to their older counterparts. In any case, the reduction of supply in the market once again resulted in the high swine prices. I expect all the protein charts to look just like the one on pork below.

Conclusion

Each of the poultry, pork and cattle markets suffered from rising corn prices but each had its own parallel drama that also affected prices. Recently, bipartisan legislation was proposed to end the ethanol mandate altogether. This will take corn prices even lower, returning them to their long-term historic averages. Along with corn prices themselves, the price of poultry, swine and beef will fall as well.

Further ensuring the reduction of commodity food prices, the drama in each of the production processes will soon end. The effects of the drought are subsiding (accept in California), helping bring beef prices lower. The fertility problem in roosters has been fixed, and the farmers are in the process of rebuilding the entire breeding flock, which will eliminate the bad gene. The porcine virus has been cured, and the production of swine is returning to normal levels.

As a result, the prices of poultry, pork, and cattle will follow corn prices back to their long-term averages; but they will do so at a rate that hinges upon the distinct issues that each industry faced.

Recently, news of a “unexpected” 9% increase in chicken populations started the ball rolling driving the stocks of poultry producers lower. This week, Tyson Foods (TSN) fell nearly 5%,  Sanderson Farms (SAFM) fell 6.5%, and Pilgrim’s Pride (PPC) got creamed by 13%.

If you take a long look at the charts above, you’ll see that the long-term mean price levels for poultry, pork and beef are far below present levels. Despite the little correction in the poultry stocks, there’s a lot more downside left if my prediction is correct.On the other hand, restaurants will benefit substantially from lower costs. Across the board, restaurants have been raising menu prices commensurate to the rise in their commodity food costs – about 25% industry wide. As protein and other food prices fall, restaurants will surely maintain the price increases and enjoy the first margin relief they’ve had in years. Some of this is baked into the stocks as a group because they aren’t cheap. But, because sell-side analysts are not in the business of making bold calls on commodities, I believe street estimates for the restaurant group are far too low. Therefore, I would expect some earning’s outperformance for the group, especially those with plenty of protein on the menu like Darden (DRI),  (Blumin’ Brands (BLMN) and Texas Roadhouse (TXRH).