Hedging your monthly food bill

Posted on August 29th, 2012

It should be no surprise, that the drought going on in the Midwest will have an impact on the cost of food over the next few months. However, we believe it will go on much longer than that. Here's an idea how your portfolio can offset some of that.

With China releasing some of their corn reserves and the talk of temporary suspension of the bio-fuels mandate or the RFS (Renewable Fuels Standard), the market is hoping to put the breaks on the surging price of corn.  However, this classic supply and demand story of the Midwest’s drought won’t see an end in this calendar year.

Expect corn prices to stay elevated through 2013; maybe not as high as they are now, but elevated from the norm of the past 3-4 years.  Those that have dipped into reserves or moved away from the grain start to come back to it in advance of the 2012 summer will drive this will come back in as buyers to backfill what they released.

Farmers know this and based on this, our expectation is that agriculture stocks like Mosaic (MOS), Monsanto (MON), and Potash (POT) will benefit from this. We also suspect investments in equipment and irrigation should also result helping out Deere (DE) and Valmont (VMI).

Monsanto (MON) probably has the best potential as their drought resistant corn seed puts them in a prime spot to take advantage of the weather challenges. Its not out of the question for the crop insurance providers to start to influence farmers to use such products in order to reduce their risks.

Experts are predicting the impact will work its way into livestock costs, so while perhaps you’re not see it today, beef will start to rise in prices as ranchers will have to cut back due to feed costs.

But why do this trade now? The reason is the opposite side of the trade looks just as juicy, and that is a recent development. Our thesis leads us to a bearish stance on companies that rely on the price of corn like Kellogg (K) and General Mills (GIS) as their costs are sure to stay elevated. Right now, due to Isaac’s path these stock have had a pop on a potential lower costs, but this should be short lived and we believe they are overvalued.

If you’ve got an appetite to put on a pairs trade we like going bullish on MON and bearish on GIS.

As always, we’ll want to stay hedged, so using spreads will keep the cost of protection down as well as effectively using cash. Pick your strikes as you see fit, but we’re looking for a 5% more for each symbol in opposites directions.

This trade will benefit if MON goes up by more than K and will really pay off if K drops and MON rises. However, if both stocks tank, it will still have a neutral impact on the total position. Again, it works best when MON does better relative to K. The trade fails if K outperforms MON.


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