There’s little debate that the rising production and price of corn has helped stoke the increased sales of farm equipment during the past decade. For example, analysts have demonstrated a strong positive correlation between the price of corn and the valuation of Deere & Co.’s stock prices. This has also been the case for pretty much all manufacturers of ag machinery since the mid-2000s.
There’s also little argument that much of corn’s momentum during this period has been the result of the rapid rise in the use of corn for ethanol production. But concerns have emerged recently about the declining demand for ethanol and its impact on farm equipment sales moving forward.
In an in-depth look at the ag equipment market, Adam Fleck, analyst for Morningstar, explores the concern that the demand for U.S. corn has permanently leveled off for a variety of reasons, including a stagnant use of the crop as a feedstock in the production of ethanol.
Rapid Growth Slowing
Tracing the usage of corn from the early 1990s, Fleck points out that from 1992 through 2002, domestic corn usage grew at a 1.5% compound annual growth rate; this metric ticked up to a 3.2% yearly rate over the next 10 years. “However, the vast majority of this growth stemmed from the onset of corn-based ethanol production in 2003-04; we calculate underlying demand excluding this source grew at a 0.7% annual growth rate from 1992 to 2002 but actually ticked down to 0.5% each year from 2003 to 2013.”
But, Fleck says the momentum that ethanol provided for corn usage could be slowing.
“Ethanol production is also set to provide more limited demand growth for corn. The Energy Information Administration estimates that roughly 99% of corn-based ethanol consumption stems from E10 — ethanol blended into gasoline at a 10% rate. Although the Environmental Protection Agency has approved the use of E15, car manufacturers are reluctant to support engine warranties with such fuel blending, given the potential that the input could cause undue wear and tear,” says Fleck.
“Similarly, E85 — a replacement fuel for traditional gasoline — has not enjoyed rapid adoption because of concerns about fuel economy and limited distribution infrastructure.
“Without a substantial shift in policy among producers and automotive original equipment manufacturers, it seems unlikely that ethanol demand growth over the next 10 years will match that of the past decade.”
Recently, opposition to increasing the use of ethanol has grown stiffer from several sides, including oil producers and small engine makers. Fleck says, the push-back could go even further as some in government and the oil industry are calling for a full repeal of the act. He adds that the EPA recently said it has flexibility to adjust Renewable Fuels Standard-mandated minimums.
“While we don’t expect such a drastic move in our base case, the lack of government-required ethanol blending would most likely materially drive down corn-based biofuel production,” Fleck says. “We’d expect some ethanol production to remain in this case, given the fuel’s use as an oxygenator (as a replacement for MTBE) in gasoline, but this minimum level is likely to be well below current production rates.”
In its latest baseline 10-year forecast, USDA pegs ethanol use — including dried distillers grains — at about 5.4 billion bushels of corn, compared with 4.7 billion estimated for 2012-13. “The resulting CAGR is just 1.5%, well below the 17% annual rate in the prior decade, suggesting future corn demand growth will be much closer to underlying food and livestock feed usage.”
Fleck also points out that beyond ethanol, the changing pattern of crop exports will also play a significant role in future U.S. corn demand. “Expanded acreage in Brazil and Argentina has probably permanently shifted the worldwide landscape,” he says, noting the rapid rise of both corn and soybean production in South America.
Longer Term Outlook
While Fleck notes that these and other dynamics will continue to impact the farm equipment business, he doesn’t find a near-term downturn particularly concerning.
He says, “While we remain concerned about the resulting farm equipment sales environment, we don’t believe the potential headwinds will damp Deere’s narrow economic moat rating or AGCO’s positive moat trend. We believe the long-term potential for farm equipment manufacturers remains positive, given climbing farming marginal costs (boosting minimum crop prices compared with historical levels) and emerging-market mechanization advancements.”