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Higher Wheat Prices Cropping Up

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Wachovia Capital Markets

WHEAT PRICES CONTINUE TO SPROUT, as all wheat prices we track rose last week (durum gained 33%, soft red rose 4.3%, hard red added 6.3%), while corn (rose 11.9%) and soybeans (gained 4.0%) also applied inflationary pressure. Sugar (U.S. rose 0.7%) and cocoa (rose 7.9%) joined the party as the Federal Reserve's accommodative stance provided a lift across both hard and soft commodities.

Further exacerbating the weak dollar impact, global supply continues to lag growing demand. Australia's drought-driven wheat production estimate cut (down 31% to 15.5 million tons) is the main culprit for a doubling in U.S. exports this summer. Other key regions also continue to have weather-limited output (Canada, Ukraine, Pakistan, and Russia).

We do not expect any near-term relief as there is plenty of competition for acreage from corn and soybeans, given surging global demand for protein and renewable energy -- providing a challenge to wheat-reliant producers (i.e., American Italian Pasta).

Warmer U.S. temperatures drove power consumption to three times normal levels as people tried to keep cool. Additionally, an accommodative 50 basis-points cut from the Fed had a twofold effect on the energy complex. First, it rejiggered growth expectations for the U.S. (largest oil consumer) and the world. Secondly, the incidentally weak dollar is having an inflationary effect on commodities priced in the U.S. dollar.

Crude's 3.2% advance crowns its 32.5% year-over-year increase -- and it will likely take a global economic slowdown, or increased Saudi Arabian production to curb crude prices. Unleaded (which has gained 3.8%) and diesel (which rose 3.0%) were also up last week, while natural gas fell (posting a 3.2% decline), despite warm weather and possible tropical storms being ushered in by autumn. Stubborn summer heat and a more active Atlantic represent potential catalysts for natural-gas prices.

Typical seasonal weakness continued to pressure protein as hogs (which fell 6.4%), chicken breast (which fell 4.7%), and chicken legs (which fell 2.1%) declined. Meanwhile, live cattle (rose 1.5%) moved up on a bullish Cattle on Feed report and chicken wings (flat) were spared the seasonal pressure other chicken-meat parts typically face this time of year. Following a half-year of expanding broiler production, we don't expect recent chicken weakness to stop here.

On the red-meat front, the hog market has now digested some bearish commentary from the Chinese government suggesting pork inflation is easing and it is effectively correcting problems with hog disease. We remain skeptical, because it sounds similar to the commentary throughout the dramatic rise in Chinese pork prices -- we look for more evidence that the problem is in hand before becoming more neutral (less bullish) on the sizable Chinese hog opportunity.

After a modest 1.5% decline, the advanced milk price for October is 73.8% above its year-ago levels. While that is far less punishing than September's 101.9% year-over-year increase, it's clearly a far cry from relief for heavy milk users ( Dean Foods, Kraft Foods ). Cheddar cheese prices (which fell 4.5%) joined in the retreat on expectations that dairy farmers will continue to expand their herd, despite still-high feed costs (alfalfa hay prices rose 26% year over year).

The USDA's estimate that alfalfa hay production will be 2.5% lower than last year and 8.2% lower than 2005 should be supportive, but we expect the expanding herd to prevail and continue to pressure prices back to more moderate inflation levels as we get into 2008.

-- Jonathan P. Feeney, CFA, senior analyst

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