DBA: El Nino Impact Start To Show Up In The Data; Maintain Buy

At the beginning of the summer, I recommended the Invesco DB Agriculture Fund ETF (NYSEARCA:DBA) as a buy, as I believed a developing El Niño could cause upward pressure on the price of food commodities. Since my recommendation, the DBA ETF has performed inline with the booming equity markets (Figure 1).

As the fall harvest season approaches, let us review the relevant news for agricultural commodities and refresh my thesis on the DBA ETF.

Brief Fund Overview

First, for those not familiar with the Invesco DB Agriculture Fund ETF, the DBA ETF uses a portfolio approach to invest in agricultural commodities.

The DBA fund tracks the DBIQ Diversified Agriculture Index, a rules-based index composed of liquid futures contracts on agricultural commodities. The DBA fund is rebalanced annually in November. Figure 2 shows the default commodity weights of the underlying index at each rebalancing.

Unlike physical commodity ETFs like the SPDR Gold Shares ETF (GLD) that hold physical gold in vaults, the DBA ETF does not invest in physical commodities. Instead, it owns a basket of commodity futures. As the futures near maturity, the DBA ETF must 'roll' the maturing futures contracts to ones further out in maturity. This 'roll' causes the DBA ETF to decay over time as futures tend to be in contango (contracts further out in maturity are higher in price) and makes the DBA ETF less suitable for long-term buy-and-hold strategies. However, for short- to medium-term trades, the roll decay is relative small so investors can use the DBA for 'swing trading'.

The DBA fund has $858 million in assets and a 0.91% expense ratio.

El Niño's Impact Being Felt Across The Globe

The main reason I was bullish on agricultural commodities is due to the developing El Niño event. El Niño is a climate pattern in the Pacific Ocean that affects weather across the globe. El Niño typically brings hot and dry weather to North America, Asia, and Australia while it brings increased rainfall to South America. Historically, El Niño has been associated with droughts and weak crop yields, as seasonal weather patterns are disrupted.

So far, my thesis is playing out as expected, as we have the current El Niño event negatively impacting multiple crops.

For example, warmer and drier weather caused by the developing El Niño is wreaking havoc with rice production across Asia, causing many Asian countries to reduce their forecasts for the 2023/24 rice harvest. This has caused countries like India, the world's largest exporter of rice, to ban the export of non-basmati white rice to curb domestic inflation, creating angst among rice importing nations (Figure 3).

Other exporters like Myanmar are also temporarily halting rice exports, while importing nations like the Philippines are capping the domestic price of rice to protect its poorest consumers.

Sugar is another crop where El Niño is having a major negative impact, as key sugarcane-producing regions like Maharashtra and Karnataka in India have reported rainfall deficits of up to 50% below average. Thailand, the world's 3rd largest sugar exporter, is also facing droughts (Figure 4).

Although South American production of sugar is expected to increase due to higher rainfall from El Niño , this not expected to replace reductions in India and Asia. Sugar prices have surged to multi-year highs as a result (Figure 5).

Grain Prices Muted For Now

The one area where prices have remained muted for now has been in the grains sector, where corn, soybean, and wheat prices remain weak. I believe the main reason for a muted response in the grain sectors is because the United States Department of Agriculture ("USDA") has been forecasting sufficient supplies of grain crops, tempering rallies in the grains like wheat.

For example, for the 2023/24 wheat harvest, the USDA initially estimated 1,056 million tons of supply and ending stocks of 264 million tons (Figure 6).

That estimate was increased to 1,067 million tons of supply and 271 million tons of ending stock in the USDA's June WASDE report, despite other agriculture reports showing crop quality was declining due to drought conditions.

However, the trend of sufficient supplies may be about to change, as the most recent September WASDE report suggest the USDA forecasters are finally responding to reality and downgrading their supply forecasts. The latest report showed 2023/24 supplies of wheat are projected to decline 7.2 million tons YoY to 1,054.5 million due to lower production estimates across the globe.

If the forecasts are accurate, this will be the first YoY decline in wheat production since 2018/19, and may pave the way for lower supply revisions in the coming months (Figure 7).

The September WASDE report cited dry weather in Australia and Canada as main reasons for the reduced wheat supply estimates, which are precisely the expected effects of El Niño mentioned above.

Looking forward, I expect supplies to further tighten in the coming months, as the negative impacts of El Niño flow through to the actual data as crops are harvested, boosting grain prices.

For example, if we look at the global Ending Stocks / Use forecast for wheat from Figure 7 above, the current forecasted level of 0.32 suggest supply/demand is back to 2015 levels and implies 10-15% upside in wheat prices, adjusted for inflation (Figure 8). I used the same Ending Stocks / Use ratio to warn on wheat back in November, when the ratio of 0.34 did not support $9+ wheat prices.

Speculators Net Short And Primed For A Squeeze

Looking at the futures markets, speculator sentiment remains bearish, with the 6 major crop futures markets in net short territory, despite the positive fundamental picture from El Niño (Figure 9). This means that if the USDA estimates start to turn bullish for grain prices, there is potential for short squeezes in the futures markets.

Geopolitics Is The Wildcard

One wildcard for the global agricultural market is the ongoing Russia/Ukraine war. Russia and Ukraine are both large exporters of grains like wheat. Recently, Russia allowed the key Black Sea Grain Deal to expire in July.

Following the expiry of the grain deal, Russia has stepped up its attacks on Ukrainian ports, targeting cargo ships. This has deterred grain ships from going to Ukraine and has effectively shut Ukraine out of the global grain markets.

Russia's goal is to use the Black Sea Grain Deal as a bargaining chip to reduce western sanctions on Russian exports. If Ukrainian wheat is taken offline for an extended period of time, then a repeat of 2022's surge in wheat prices may occur if El Niño disrupts wheat production in other major exporting nations like Australia and Canada.

Risks To DBA

On the downside, given enough time, farmers around the globe can usually switch their crops to take advantage of high prices. For example, farmers in the U.S. routinely rotate between planting soybean and corn, depending on the relative attractiveness of the crop pricing and to replenish the nutrients in their fields.

That is why on an inflation adjusted basis, global food prices have been relatively stable since the 1960s, although on a nominal basis, they have roughly quadrupled (Figure 10).

However, Figure 10 also suggest that investing in food commodities could be an effective hedge against inflation, since the amount arable land is finite and the world's population continues to increase year after year.

Conclusion

I believe my bullish thesis on agricultural commodities remain valid, as a developing El Niño continues to disrupt global weather patterns and negatively affect food production. Looking forward, as we enter the Fall harvest, the negative impacts on crops like wheat should begin to show up in the data, causing agricultural commodity prices to rally.

One wildcard is geopolitics, as Russia has a blockade on Ukrainian wheat exports. If Ukrainian wheat is taken offline while production suffers in El Niño affected regions like Australia, then we could see another surge in agricultural commodities like in 2022. Overall, I maintain my buy rating on the DBA ETF.