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Energy, Food and Inflation

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We are entering the important growing time for corn and soybeans. This is a time where weather is critical and any "hot and dry" patterns could cripple the crop.

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The Journal of Commerce industrial price index is moving higher. This index, called the JOC-ECI measures inflation. One year ago it was 129 and today it is 139, or 7.8% higher. This contrasts with the slow-to-no growth the Department of Labor and Commerce has been reporting and certainly jives more with what we are experiencing every day as consumers when we fill up our car or go grocery shopping.

Retail gasoline prices are up a record 43% in the past four months and concerns about supply have accelerated due to continued refinery glitches and a slow turnaround from regular seasonal maintenance. One way to view this is to look at the relationship between current gasoline stocks and the four week average of gasoline consumption. Currently the days-to-cover ratio sits on 21 days which is two days below the seasonal average and the tightest inventory situation since 1956. Translated, this should keep a strong bid under the market.

Food prices at the producer level are also rising and are running at an 8% year-to-year trend. Farm prices are quickly moving into the producer level and the 15% pace over the last three months is inflationary and will work its way more forcefully into retail prices. Collectively gas, food and drugs are up 11% on an annual rate.

The grain markets have been rallying since May 2006. At that time I wrote a piece comparing the agricultural sector to the metals. I looked at where the markets were relative to their lows at the beginning of the commodity bull market. Copper, for instance was up 588% while wheat was up 52%, soybeans +42% and corn +30%. Surely, it seemed with the talk of alternative energy in the form of ethanol (corn) and biodiesel (soybean oil) plus a low stocks-to-useage ratio, it was time to load up the cart in this sector. Since then, corn prices more than doubled, soybeans rallied +44% and wheat reached a high of $5.57 bushel, which was up 54%. While these are substantial gains I do not believe it is over.

We are entering the important growing time for corn and soybeans. This is a time where weather is critical and any "hot and dry" patterns could cripple the crop. We already have market imbalances in corn and wheat where the inventory-to-consumption ratios have fallen to multi-decade lows. Even before the ethanol craze this ratio for corn was falling and now world consumption has been outstripping world production even with a record harvest last year in the U.S. The last time the ratios were this low was in the 1970's when world population was smaller and we were not dealing with the voracious appetites from China and India.

I expect fundamentals to tighten and should we experience any weather problems, such as La Nina, it would only serve to exacerbate the situation and it could lead to a more severe hurricane season and cause havoc in the energy world.

In addition to owning futures or options on the agricultural sector, there are other ways to speculate on higher prices. Higher grain prices encourage production so companies that make farm machinery will do well as should fertilizer companies. Farmland and water resources should do well in this environment, but I would stay away from the long side of ethanol as production margins will be squeezed as corn prices go higher. Food companies that are heavily dependent on wheat, corn or soybeans and beer companies that use barley will also have their margins, suffer so these should be avoided.

Perhaps Chicago's Fed Michael Moskow has it right when he recently said, "inflation is a larger risk than an economic slowdown." Not only is the JOC-ECI index telling us this, the bond market action is not acting as if interest rates will be cut anytime soon.
Positions in corn, wheat, soybeans, soybean oil, nat gas futures, crude oil futures, CPO, ADM, MON, DE

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