17 September 2010

Global Strategy
Alternative view
www.sgresearch.com

Popular Delusions
A structural shift is set to imbalance grain markets and increase global instability

The 1973 spike in world oil prices is usually attributed to OPEC’s spectacularly successful
Dylan Grice
(44) 20 7762 5872 embargo. But commodity markets face disruptions all the time and the effects are short lived.
dylan.grice@sgcib.com
Why did the 1973 oil markets disruption lead to permanently higher real prices? The OPEC
embargo was merely the trigger. The cause was a structural shift which saw a rapid surge in
the import needs of oil’s biggest consumer, the US, as its oil production peaked in 1970.
Today, the grain market’s biggest consumer - China - is undergoing a similar shift.
th
 On the 6 October 1973 – the holy Jewish holiday of Yom Kippur that year - the fourth
and most intense Arab-Israeli war started. Egyptian jets launched surprise attacks on Israeli
command posts on the eastern side of the Suez and the Sinai, while Syrian planes
simultaneously attacked from the north. It would be the most serious Arab-Israeli conflict
ever, threatening at one stage to spill over into a full-blown nuclear conflagration between
the Soviet Union and the US.

 Fortunately, a cease-fire was brokered before it came to that. But by then the
industrialised economies were in disarray suffering simultaneous recession and inflation.
Indeed, this spectacular use of the “oil weapon” which Kissinger said “altered irrevocably
the world as it had grown up in the post war period” would be the most lasting effect. The
psychological effects of the “OPEC shock” continue to linger in the public’s mind today.

 But the “oil weapon” might not have been as potent as has generally been assumed.
Indeed, it failed miserably when used during the six day Arab-Israeli conflict of 1967. Then
the US had so much spare capacity the embargo simply brought the Arab nations to the
edge of financial ruin. The reason it worked so spectacularly in 1973 was that the US spare
capacity was now gone. Indeed, US oil production had already entered into permanent
Global Strategy Team
Albert Edwards decline and its import dependency was surging (chart below, grey line).
(44) 20 7762 5890
albert.edwards@sgcib.com  So the spike in oil prices may have been triggered by OPEC’s embargo, but the violence
Dylan Grice of the move and the continued volatility was caused by a permanent structural shift. A
(44) 20 7762 5872 similar shift seems to be playing out in grain markets today.
dylan.grice@sgcib.com

The 1970s spike in oil prices was made possible by surging US oil dependency
50 Stable US oil Sudden increase in Arabian light crude 60%
dependency US oil dependency
45
US oil dependency (net
40 imports as % of consumption) 50%

35

30 40%

25 1967 OPEC embargo

during the six day war
20 has no effect on oil 30%
prices
15

10 1973 OPEC embargo 20%

works like a dream ...
5 (and oil prices never return
to pre-embargo levels)
0 10%
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990

Source: SG Cross Asset Research

Macro Commodities Forex Rates Equity Credit Derivatives

Please see important disclaimer and disclosures at the end of the document
 Popular Delusions

Real commodity prices should decline over time as technological advancement lowers the
supply costs without affecting the basic utility of the commodity. A bushel of wheat today is
pretty much the same as a bushel of wheat five thousand years ago, except that it costs a
fraction of the labour to produce. Temporary bottlenecks shouldn’t change this long-term
downward trajectory, and should cause only temporary price increases until new supply can
be brought to market.

A famous example of a temporary shock was that suffered by agriculture markets in 1972 after
a catastrophic Soviet harvest forced Brezhnev to secretly tap world markets in an operation
which became known as the “Great Grain Robbery.” The Soviet Union was one the largest
consumers of grain in the world and its sudden, forced and mercifully short-lived plunge into
the world grain markets as a large buyer caused prices to nearly triple (see chart below).

What a temporary shock looks like – the CRB food index after the Great Grain Robbery
450
CRB food i ndex spi kes
400
a fte r poor Sovi et Nomi nal food prices
350 harvest
Re a l Food prices
300
250
200
150 ... but real pri ce decl i ne
resumes as shock di ssi pates
100
50
0
01/09/68
01/07/70
01/05/72
01/03/74
01/01/76
01/11/77
01/09/79
01/07/81
01/05/83
01/03/85
01/01/87
01/11/88
01/09/90
01/07/92
01/05/94
01/03/96
01/01/98
01/11/99
01/09/01
01/07/03
01/05/05
01/03/07
01/01/09
Source: SG Cross Asset Research

But the shock was largely temporary, as poor harvests tend to be. There was an aftershock in
1977 as the Soviets endured another poor harvest but the bull market in agricultural produce
was over. Prices remained in a tight range for the next few decades and failed to keep pace
with inflation.

The shock to energy markets was more serious. It was driven by the permanent peaking of US
oil production in 1970 which pushed the US dependency ratio (imports as a % of
consumption) from 20% to 40% in barely three years. The permanent nature of that shift is
reflected in the permanent rise in real oil prices: the subsequent oil glut of the 1980s crashed
the market and ruined many leveraged players, but even in the depths of the global
commodity bear market in the aftermath of the Asian crisis in 1997, real prices were 70%
higher than they had been before the OPEC shock of 1973 (see sequence of charts below).

This implies an interesting hypothesis: the 1970s bull market in energy wasn’t caused by the
OPEC embargo but by the strain of the market’s largest consumer suddenly and permanently
increasing its dependency on the oil available for export. The implication is that had OPEC not
embargoed oil during the Yom Kippur war, real oil prices would eventually have risen anyway
because underlying conditions required it.

2 17 September 2010
 Popular Delusions

US oil production permanently peaked in the 1970s

4,500

4,000

3,500

3,000

2,500 US Oi l production (000 ba rrels)

pe a ks i n 1970
2,000

1,500

1,000

2009P
1949
1952
1955
1958
1961
1964
1967
1970
1973
1976
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
Source: IEA

… leading to a rapid doubling of US import dependency …

70%
US de pendency on
US net oil imports as a % of consumption

60% worl d oil surges

50%

40%

30%

20%

10%

0%
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
Source: IEA 2008

… and pushing real oil prices to a new long-term equilibrium

120

100 De pths of Asian

Real Arabian Light Prices (2009 $)

Pre -e mbargo cri s is s ees re al oil

pri ce was pri ce trough at $17
80
$10 p/ba rre l

60

40

20

0
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008

Source: BP Statistical Review

17 September 2010 3
 Popular Delusions

The hypothesis might be more than just interesting though. It might even be relevant! Today,
the largest consumer in the grain markets – China - is seeing its dependency on world export
markets surge in a similar way to that seen in the oil market in the 1970s.

Is China to today’s grain market what America was to the world’s energy markets?

Chinese net grain imports as a % of cons. 20%

15% Chi nese dependency on world

gra i n markets is s urging
10%

5%

0%

-5%
1960/1961
1962/1963
1964/1965
1966/1967
1968/1969
1970/1971
1972/1973
1974/1975
1976/1977
1978/1979
1980/1981
1982/1983
1984/1985
1986/1987
1988/1989
1990/1991
1992/1993
1994/1995
1996/1997
1998/1999
2000/2001
2002/2003
2004/2005
2006/2007
2008/2009
2010/2011
Source: USDA

Why might this shift be permanent? With 7% of the world’s land and water but 22% of the
world’s mouths to feed, China’s fight to retain grain self-sufficiency was always going to be a
losing battle unless the economy was devoted entirely to agriculture. Of course, prior to
Deng’s 1978 reforms that’s exactly what China was. But the logic of industrialization in such a
land and water constrained country implies scare water and land be effectively imported via
grain and livestock, while abundant labour be exported through manufactured products. And
while China has excelled at the latter, it has understandably resisted the former.

But how long can it defy the arithmetic of natural resource endowments? The dismantling of
the agrarian economy in favour of an industrial model has seen scarce land built upon. Roads,
car parks, factories and shopping malls increasingly take the place of farms. Industrialization
also implies richer households eat more protein and, paradoxically, meat-rich diets require
much more grain than vegetarian ones (apparently around seven times more). None of this
would be a problem if China was capable of increasing its agricultural productivity as
spectacularly as it is increasing its living standards. But so far at least, it isn’t coming close.
According to the USDA Chinese land productivity continues to decline.

China’s land productivity growth is falling

10
Log of Chinese ouput per hectare

Source: USDA

4 17 September 2010
 Popular Delusions

The strain first started to show in the collapse in Chinese inventories in the early 2000s. Now,
as China tries to rebuild them it is showing up in China’s surging import dependency. It seems
reasonable to think that it will soon be showing up in price.

Chinese agricultural inventory (month’s worth of consumption)

Grain inventory (months sup[ply) 12

10

Source: SG Cross Asset Research

“Hunger eats civilization” says Marjane Saatrapi, author of the beautiful book Persepolis. Food
inflation has a dark history. It has been said that the 70s food crisis contributed to the Iranian
revolution. We know the Russian Revolution started with starving workers protesting high
bread prices. The Parisian riots of 1789 following the devastated crop of 1788 snowballed into
the French Revolution and the revolutionary fervour which swept Europe in 1848 followed a
sequence of bad harvests.

If BHP Billiton’s bid for Potash Corp succeeds, the Australian miner could own a third of the
world’s potash supply in ten years’ time. This week, a magazine interview in which
Sinochem’s Han Gensheng said that Potash Corp was too pricey was pulled from Chinese
news sites hours later. The site which had carried the comments now denies the interview
ever took place. The Chinese appear to be getting twitchy on the security of their future grain
supplies. Who can blame them? The following names might be worth looking at.

Company Name Country Mkt Cap ($m) Book Val p/sh* est. Intrinsic Value Last close** IVP
Chaoda Modern Agriculture Ltd. Hong Kong 2,661 6.28 13.1 6.6 1.98
Marine Harvest ASA Norway 2,226 3.19 6.1 5.0 1.20
Bunge Ltd. United States 8,146 70.80 56.0 56.7 0.99
Archer Daniels Midland Co. United States 20,949 23.01 28.2 32.5 0.87
Yara International ASA Norway 9,704 99.38 224.4 269.4 0.83
Agrium Inc. Canada 11,432 30.77 60.8 74.4 0.82
K+S AG Germany 10,569 10.93 34.4 42.4 0.81
Nufarm Ltd. Australia 756 6.07 3.2 4.1 0.79
Incitec Pivot Ltd. Australia 5,475 2.10 2.8 3.6 0.77
Golden Agri-Resources Ltd. Singapore 4,051 0.63 0.4 0.6 0.67
Taiwan Fertilizer Co. Ltd. Taiwan 2,291 51.17 57.6 99.0 0.58
Syngenta AG Switzerland 23,756 79.39 126.3 251.5 0.50
Monsanto Co. United States 31,603 18.86 27.0 57.5 0.47

Source: SG Cross Asset Research, FactSet. * Latest actual data. ** Closing prices as of 15 September. *** Our analyst rates K+S a Buy with a price target of €50. For a more complete

explanation of intrinsic value see Dylan’s ‘Bargain hunting with Ben: in search of mispriced intrinsic value’, 2 December 2009.

17 September 2010 5
 Popular Delusions

IMPORTANT DISCLOSURES
BP SG is acting as one of the Mandated Lead Arrangers and Bookrunner for a loan granted to BP.
K&S SG acted as joint bookrunner in the K+S' senior bond issue (5% 24/09/14 EUR).
K&S SG acted as Mandated Lead Arranger and Bookrunner of the credit facility granted to K+S to finance the acquisition of Morton Salt.
Nufarm SG acted as advisor to Sumitomo in the acquisition of Nufarm Ltd.

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6 17 September 2010