Now is a good time to start penciling in 2023 budgets. Our economist, Matt Erickson, looks at costs, prices and market trends to jump-start your planning.
Rate Hikes and Planning for 2023
- The Federal Reserve announced consecutive 75-basis point increases to the benchmark rate during its June and July meetings. This puts the rate between 2.25% and 2.50% and marks 9, 25-basis point increases for the year. We likely haven’t seen the last of the increases.
- The CME FedWatch Probabilities Chart (left) indicates a 100% probability that the Federal Reserve will raise the benchmark rate at its September meeting by at least 50 basis points. The highest level of confidence (70.5%) signals an additional 75-basis point increase.
- Markets anticipate the Federal Reserve will slow its rate increases after the September meeting. The CME FedWatch Chart indicates a 50-basis point increase at the November meeting. If expectations become reality, the benchmark rate in November would be between 3.50% and 3.75%.
- Market expects the Federal Reserve to keep rates steady between 3.75% and 4.0% starting in December and lasting through at least July 2023. Previous probability charts from the CME Group favored slight reductions in the rate in 2023. Recent comments by Reserve Chairman Jerome Powell have shifted expectations. Markets are now aligned with the Federal Open Market Committee, which projects rate cuts are unlikely before 2024. (If there is an earlier rate cut, the CME FedWatch Tool’s probability chart puts it out to at least July of 2023.)
Why This Matters
The same factors that have been driving rate increases – inflation and a historically tight labor market – continue to weigh on the U.S. economy. July brought some good news when the Consumer Price Index (CPI) dropped to 8.5%, down from its high of 9% in June. Much of the CPI decrease from June to July was due to lower prices for gasoline; U.S. consumers continued to pay more for food and shelter. Meanwhile, the Producer Price Index (PPI) fell below 10% for the first time since November 2021. This indicates prices received for final demand products may be slowing.
While the labor market remains historically tight and continues to put upside pressure on wages, it is showing signs of easing, with the four-week moving average of initial jobless claims leveling off in the latter part of August.
Inflation and labor will be the primary drivers at the Federal Reserve’s September meeting. The Federal Reserve is expected to both raise benchmark rates, possibly by as much as another 75 basis points, and step-up quantitative tightening to a maximum pace of $95 billion ($60 billion in Treasuries and $35 billion in mortgage-backed securities). Quantitative tightening refers to policies that reduce the size of the Federal Reserve’s balance sheet. The monthly cap for quantitative easing has been set at $47.5 billion since June and would double if the Federal Reserve picked up the pace to $95 billion.
The only other modern examples of the Federal Reserve increasing interest rates while also shrinking its bond holdings was the period between 2014, when it ended quantitative easing purchases, and 2017, when it started reducing its balance sheet. Economic conditions were much different then. Unemployment in 2014 was 6.2% and dropped to 4.4% by 2017. Today, unemployment is 3.5% -- and is coupled with inflation levels not seen since the early 1980s. The Fed’s current balance sheet also is double the size of 2014 – roughly $8.9 trillion today vs. $4.5 trillion. Simply put, the U.S. economy is in uncharted territory, and uncertainty creates market volatility.
Producers need to plan for continued volatility in 2023. The best way to do this: Focus on what you know and can control, not on the many unknowns that can derail even our best plans. We know the Federal Reserve wants to maximize predictability to minimize market disruptions. It’s likely that interest rates will continue to be the Federal Reserve’s primary tool to effect policy. We also know the Prime rate, as shown on the chart to the right, tracks closely with the Federal Funds rate. During the past 30 years, the spread between the Prime and the Federal Funds rates is just over 300-basis points (306-basis points to be exact).
When penciling out your 2023 budgets, use and keep up with the probabilities chart from the CME FedWatch Tool. Then incorporate the historical spread between the Federal Funds and Prime rates and tailor it to your operation. Your Farm Credit financial advisors are here to help you stay current on the interest rate environment and what it means to your business.
What to Watch in EU and Fertilizer Markets
- European gas storage, a priority heading into winter as a result of reduced and unreliable flows from Russia, was 79.94% full on August 28, 2022. This is on par with the five-year average and on pace to reach the European storage goal of 80% capacity by November.
- The European Union (EU) and the United Kingdom (UK) came out of 2021 with low inventories. As the chart on the left shows, the EU’s natural gas storage was roughly 54% of capacity – and this was before Russia reduced flows in retaliation for Europe’s support of Ukraine in its war against Russian invaders. Both the EU and UK have been restocking by importing record levels of liquefied natural gas. In the first four months of 2022, imports from the U.S. to the EU and UK have more than tripled compared to 2021.
- Although the EU is on pace to meet its storage goals for November, market focus will be on the overall outlook for winter consumption and Russia’s gamesmanship with natural gas flows to the EU.
Why This Matters
Russia was Europe’s largest natural gas supplier in 2020 and 2021, with its market share comprising 42% and 39.2%, respectively, of EU supplies. Gazprom, Russia’s state-owned energy company, has reduced flows through the Nord Stream pipeline to roughly 20% of capacity in retaliation for Europe’s support of Ukraine. Damage to pipelines owned by the Caspian Pipeline Consortium also has disrupted exports. As a result, Europe’s wholesale natural gas price has increased significantly. Since August, the price is up 128%; for the year, it’s up 300%.
Natural gas markets continue to react to conditions in the EU, including to Gazprom’s recent announcement of a three-day, maintenance-related cut in supplies -- just as the EU nears its winter storage goal of 80% by November and Germany, the EU’s largest economy, its goal of 85% by October 1. Already bullish, the outlook for winter is highly volatile and natural gas prices are contributing to concerns about a recession in Europe.
How does this impact the U.S.? Here, natural gas production has returned to pre-COVID levels. But the EU is now competing for supplies in the global market. This includes a 242% increase in imports of natural gas from the U.S. since the start of the year. Prices are up and supplies have been impacted. For agriculture, this could limit global production of nitrogen-based fertilizers, which would keep fertilizer prices elevated.
Continued Domestic Volatility, Despite More U.S. Natural Gas
- Natural gas prices rose 18.6% between July and August due to robust demand here and abroad. In August, prices topped $9.85 per million BTU – comparable only to July 2008 and February 2021 when the COVID pandemic sent shocks waves through the market.
- The chart on the left shows the historic 30-day volatility level, which averaged 48% since January 2012. But for 2022, volatility has been well above this average. Volatility of U.S. natural gas prices peaked at a 20-year high of 175% in February 2022.
- As indicated on the chart to the right, U.S. natural gas production has caught up to pre-COVID levels of 2019, and is projected to increase 4% between July 2022 to December 2023.
Why This Matters
The natural gas market has been a roller coaster in 2022. In June, the Freeport terminal, the nation’s second largest exporter of liquified natural gas, shut down. While global prices soared, the U.S. market saw prices drop as a result of increased supplies domestically. This was short-lived. A hotter-than normal July and increased domestic demand pushed U.S. prices higher. U.S. natural gas climbed 66% between June and July. Volatility remains in the market. In addition to EU demand and weather-related consumption, the market also is feeling the impact of changes in inventory levels; unplanned pipeline maintenance and outages; and storms and other unforeseen weather events.
The 30-day historical volatility level remained high at an average of 92% in August (through August 23). Prices have encouraged more drilling, but production has not kept pace with overall demand. U.S. natural gas inventories ended July at 2.5 trillion cubic feet, 12% below the average for 2017-2021. By the end of October, the EIA projects, inventories will be 6% below the five-year average.
Markets will closely watch the winter outlook for both the U.S. and EU, as well as any political shift from Russia. EIA’s Short-Term Energy Outlook for August projects U.S. natural gas prices to remain elevated at an average of $7.54 per MMBtu in the second half of 2022 and into 2023. With increases to U.S. production, average prices could fall by next April to $5.10 per MMBtu. Higher natural gas prices will certainly impact and keep prices for by-products elevated.
Pencil in Fertilizer Prices for 2023 Budget
- As of the week ending August 26, the national average per-ton price for anhydrous ammonia, MAP and potash was $1,331, $1,026 and $880, respectively. Although record high for this point in the year, prices have either declined or stayed the same for several weeks for anhydrous ammonia (13 consecutive) and MAP (15 consecutive). Potash has stayed within the range of $875 to $885 per ton since the first part of April.
- For August, the monthly average cost compared to the 10-year average is up 126% for anhydrous ammonia ($165.21/acre vs. $73.13/acre); 85% for MAP ($51.50/acre vs. $27.91/acre); and 98% for potash ($88.13/acre vs. $44.48/acre).
Note: Analysis of fertilizer cost per acre assumes an application of 200 lbs. of nitrogen; 100 lbs. of MAP; and 200 lbs. of potash, with an expected yield of 200 bushels. Results can vary producer-to-producer.
Why This Matters
Fertilizer prices trending lower is a welcome sign for producers. But each fertilizer remains above both its five- and 10-year average as shown in the charts above. Compared to this time last year, prices for anhydrous, MAP, and potash are higher by 78%, 36% and 55%, respectively.
If we take a historical look, fertilizer prices typically follow a pattern: lower in the summer heading into harvest as usage declines and higher later in the fall months heading into spring as applications begin and producers lock in crop rotations for the coming season. It’s important to watch and monitor if this trend plays out and holds given the volatility in the market.
Pencil today’s market prices into your preliminary 2023 budgets. The charts above show average fertilizer prices per acre for August. And remember, a pencil has an eraser. As markets change in the days and weeks ahead, update your budget. Or you might want to set a target price level that makes you comfortable with your overall margin. This work will allow you to better understand and manage your margins at different cost and price points.
Volatility in markets, including the natural gas market, is unlikely to disappear, and the best way to beat a volatile market is to plan, monitor and continually update budgets.
U.S. Corn and Soybeans Headed in Different Directions
- The 2022 corn and soybean crop look to be heading in different paths. Midwest farm tours pointed to disappointing yields, and a smaller U.S. corn crop is expected heading into the September WASDE. Meanwhile, a large U.S. soybean crop is expected. Markets will closely watch weather conditions over the next couple weeks as soybean pods continue to fill.
- Both beans and corn have been in a weather market for the past month. After December (2022) corn and November (2022) soybean futures fell a respective 20% and 14% from their weekly May and June high, prices have rebounded. Weekly average futures for corn were up 16% to $6.83 per bushel and for soybeans, 7.5% to $14.38.
- The bullish weather market also has lifted 2023 futures, with December (2023) corn futures (daily close) increasing 7.8% to $6.23 per bushel to begin the month of August, and November (2023) soybean futures (daily close) up 3.7% to $13.62 per bushel. (Note: Daily close period from August 1 to August 29)
Why This Matters
The center of attention heading into September is how USDA reports corn and soybean yields in its upcoming WASDE. In addition, soybean markets will be watching for any late season rains, especially in the dry regions of the western Corn Belt, where the National Weather Service is forecasting below-normal precipitation in September.
The Midwest farm tours suggest national corn yields below the August WASDE projection of 175.4 bushel per acre – 167.2 bushels per acre from one tour and 168.1 from a second. A yield scenario of 168 bushels per acre would drop production to its lowest level since marketing year 2019/20.
Keep an eye on USDA expectations for both corn yields and total usage. The current stocks-to-use ratio of 9.6% is relatively tight compared to the 10-year average of 12%. Assuming no further change in USDA’s corn balance sheet from the August WASDE, a yield scenario of 168 bushels per acre would drop ending stocks to 772 million bushels and the stocks-to-use ratio to 5.3%. If realized, both ending stocks and the stocks-to-use ratio would be at their lowest level since marketing year 1995/96. The corn market has a long way to go with continued downside potential to production and usage.
As harvest approaches and planning for next season knocks at the door, it’s likely that costs (land and non-land) will be high (maybe even higher) in 2023. It’s critical to protect margins and have a solid risk management plan in place. Now is a good time to start estimating 2023 crop margins.
If you think your variable costs will increase or futures prices and/or yields at the county level will decrease, you might want to talk to your crop insurance agent about Margin Protection and whether it is a good option for your operation. Producers should keep an eye on daily closes from August 15 through September 14 for December 2023 corn and November 2023 soybean futures as this is the price discovery period currently ongoing. The deadline to purchase Margin Protection is September 30.
