In this environment, we see the risks to agriculture prices tilted to the downside, as global economic and financial headwinds continue. As has been the case of late, most vulnerable to further selling are crop prices, which despite the clearing off of much of the speculative froth built up in 2007-08, remain especially prone to further liquidation of commodity positions by hedge funds and other institutional investors. Livestock prices – notably hogs – have less scope for declines since they are already at low levels.

Still, there are several reasons to suggest that any further weakening in crop prices from current levels will likely represent an “overshoot”, with prices undergoing a firming trend throughout the remainder of 2009 and into 2010. For one, most crop markets are heading into this period of global downturn enjoying relatively well balanced supply-demand conditions. Even then, demand for food tends to be less sensitive to deteriorating global income gains than other commodity areas. Furthermore, a bigger threat to the credit crisis is on supply rather than demand, as ongoing credit problems globally could dampen sales of machinery, fertilizer and other inputs, thus impeding next year’s output.

Higher price plateau for crops to remain intact

Above all, we continue to see longer-term support for agricultural prices still at play – a development that was front and centre in last year’s TD Economics’ report discussing a new era for agriculture. For several decades, crop prices globally had been falling in real inflation-adjusted terms as the contribution of rising productivity on global supply outstripped the impact of gains in demand. However, even discounting the major up and down in prices in 2007-08, a trend pickup in global consumption growth vis-à-vis productivity has reversed the long-term decline in real crop prices since the early 2000s. And, we don’t foresee that trend halting over the next several years.

Certainly, one catalyst has been the growth in demand from expanding economies in China, and India, among others. China, in particular, has made waves in agricultural markets, with imports of food and live animal products more than doubling since the start of the decade. And, while these economies won’t buck the trend to slower growth next year, they are likely to continue to grow at a clip at least 3 times of that of developed countries over the next decade. TD Economics forecasts the economies of China and India to expand by 8.5-9% and 6-6.5%, respectively, in the 2009-10 period. This growth will continue to benefit both crops and livestock sectors.

But as importantly, we have not dropped our assumption that growing ethanol and biodiesel production will continue to underpin crop demand in the United States, Canada and elsewhere around the globe next year and over the longer haul. Recent developments on this front have been mixed. The push to develop alternative energy sources, such as ethanol, has been dealt a setback by the recent dramatic decline in prices of competing crude oil, while more individuals are questioning the longer-term environmental benefits of ethanol vis-a-vis fossil fuels. What’s more, the recent flare-up in concerns about the global economy appear to have pushed the environment lower down on governments’ list of priorities, at least temporarily. On the flip side, the easing global food shortages has also pushed the “food versus fuel” debate to the backburner, which had been a growing threat for grain-based biofuels. As well, the newly-elected U.S. President appears steadfast in his support for the development of alternative energy sources.

We expect that the latter forces will win out, keeping the existing biofuel mandates and subsidy programs intact in the United States. Supported by this incremental demand, crop markets are projected to stay relatively tight and prices at a healthy margin above their 5-year averages.

From a Canadian perspective, the growing ethanol industry is a mixed blessing. While ethanol provides support to prices received by crop farmers, it raises the cost of livestock feed. Canada has traditionally grown more feed corn than demanded by livestock producers, with the surplus then shipped abroad. But with a growing amount of domestic production of corn used in the ethanol process, the country now records a corn trade deficit, which places prices on a higher import basis. These impacts on feed costs are mitigated by the fact that a byproduct of grain used in ethanol production can be enhanced and used as cattle feed.

Canadian livestock prices may not follow U.S. prices higher in 2009

With tightening global credit conditions and slowing economies around the world to lead to a slackening in red meat demand over the next few quarters, the hog and cattle markets are not expected to buck the continued downtrend in prices in the near term. However, we not only see scope for further near-term price declines in U.S. markets relatively limited, but we see some significant upside once the global economy begins to gain traction later in 2009 and into 2010. The price story is linked to the outlook for tightening supplies, reflecting in part the recent weakness in financial returns in the industry, the Canadian federal government’s Cull Breeding swine program and new legislation on country-of-origin labeling (COOL). These factors are expected to have a major negative impact on Canadian exports to the United States over the forecast period.

Given that Canada is an important market for the U.S. – accounting for about 90% of U.S. live hog imports and 60% of live cattle – the impact of these developments is likely to leave the U.S. market in somewhat of a tight spot as 2009 progresses, thus boosting U.S.-dollar prices. But while higher U.S. prices normally spill over to Canadian prices, and particularly during a period of a downtrend in the loonie, the weakening demand Stateside for Canadian hog and cattle exports will likely preclude a lockstep increase on this side of the border. Thus, as we discuss next, the top lines of livestock producers are expected to remain under pressure next year.

Outlook for Canadian farm incomes in 2009

Based on recent price patterns, we turn to the near-term outlook to Canadian farm incomes. The most recent data cover 2007, when realized net farm income rose to $1.7 billion. While this was double its 2006 level, it remained below the levels of $2-$3 billion recorded earlier in the decade.

For 2008, the picture is decidedly mixed. So far, only figures on farm cash receipts (a proxy for top-line farm revenue performances) for the first and second quarters of the year have been released. And by that count, Canada’s farm sector is poised to turn in a stronger showing this year. During the year’s first half, total receipts shot up by 11% Y/Y, as a 31% surge in crop receipts more than offset a 4% decline in the livestock tally. Such a strong start to the year might suggest that farm incomes should exceed the level in 2007. In reality, the picture is considerably murkier for several reasons.

First, crop prices have retreated significantly since mid-year, so the year is likely to end off on a weaker footing. But even there, the Canadian dollar has plunged in tandem with U.S.-dollar prices, partially shielding Canadian farmers.

Second, in addition to prices, output is a key driver of revenues. And early readings of Canadian crop production in the all-important autumn harvest have been generally favourable. As of September, total wheat production is expected to rise 36% in 2008, with canola and barley up 14% and 2% respectively over year-ago levels. With prices of these crops on the rise, farmers increased acreage at the expense of corn. As such, corn production is expected to fall 15% in 2008. Still, the jury remains out on the grade/quality of the crop. In contrast, in view of the impact of COOL and the Swine Breeding program, cattle and hog production almost certainly lost ground this year. In the hog industry, Canadian inventories fell by about 11% Y/Y as of October. Cattle inventories, which are reported semi-annually, were down 4% as of July 1st.

Third, perhaps the greatest uncertainty revolves around how much profit margins in 2008 were reduced by rising costs. Sky-rocketing energy and fertilizer costs, tight markets for labour and high freight costs were a major challenge for crop farmers in 2008, despite some likely reprieve in some of these areas later in the year. Within the livestock industry, farmers were not only forced to deal with pressures in these areas, but also escalating feed prices. Many farmers attempted to lessen the cost blow by implementing changes in technologies and in process, including expanding farm sizes to reap economies of scale and moving away from the expensive corn feed, towards lower cost feeds such as barley and wheat.

Unfortunately, even fewer indicators have been released on farm input prices for 2008, so forecasting whether the cost or revenue side will win out in 2008 is a tough call. In our view, total net realized farm income will come in moderately higher than last year – in the $1.5-$2 billion ballpark. Keep in mind that this tally hides the stark divergences in sector and regional performances. Many farmers that are highly reliant on livestock farming – and notably hogs – will face a struggle recording a profit this year. On the plus side, many livestock farmers in Canada also own significant crop operations, which have been providing an important counterbalance.

A look ahead to the net income picture in 2009 also contains significant cross-currents. In general, the price side will be a downward influence on net incomes next year compared to 2008, especially on the crop side. However, a number of other factors will provide offsetting support to bottom lines in the farm sector: