The Unexpected Consequences of the 2012 Drought

On my way to Fool HQ Monday morning, I hadn't been outside of my apartment for more than two minutes before I started sweating through my shirt. Unless you're from Maine, Florida, or the Upper Northwest, you're likely dealing with an equally uncomfortable situation. And along with the excessive heat has come unusually dry conditions.

As you can see below, the vast majority of America is in the middle of the worst drought since 1956. The darker the color -- orange, red, or purple -- the worse the drought is.

Source: NOAA

But the effects of droughts don't necessarily play out as you'd expect. Take corn, for instance -- the crop is used in a dizzying array of products, from corn syrup to livestock feed to ethanol. One look at where our corn belt is located and you'll see that supply is going to be far tighter than in a normal year.

Source: USDA, data for 2010.

Though certain sections of Minnesota are actually getting a steady drizzle, the same can't be said for the rest of the Midwest or Great Plains states. On a very basic level, one would assume that this would spell disaster for farmers.

But that's not actually the case. Farmers can buy insurance from private companies like ACE Limited (NYSE: ACE  ) , and almost universally participate in the Federal Crop Insurance Program. Therefore, farmers are saved from the brunt of the lower yield, and because crop insurance only covers a portion of revenues for private insurers, they will avoid severe punishment as well.

But that doesn't mean there won't be losers. As the corn yields lower, the price for a bushel of corn has skyrocketed, increasing 30% since Jan. 1 and 50% since just June 15.

Source: CNBC

When an input cost rises that much, someone is bound to feel the pinch. Again, it would seem to make sense that consumers at grocery stores would be the main losers.

But once again, that's just not the case. As Ricky Volpe, an economist with the USDA, explains, "A 50% increase in the price of corn tends to raise total shopping bills by about 1%." No one likes to see food prices rise, but it seems like the average U.S. consumer is dodging the drought bullet as well.

If you're looking for who loses from rising corn prices, there are two places to look: livestock producers and corn processors. Morgan Stanley recently downgraded Archer Daniels Midland (NYSE: ADM  ) , one of the country's largest corn processors, over concerns that margins for high-fructose corn syrup would be pinched.

And whereas farmers can rely on insurance to provide a safety net in uncertain times, livestock producers have no such protection. Bill Tentinger, president of the Iowa Pork Producers Association, predicts that "high corn prices ... will force many pork producers out of business."

For the average American, that means meat prices may increase more than the average 1%. And companies like Chipotle (NYSE: CMG  ) may see a disproportionate increase in input costs to serve up their burritos.

What about water?
There are several ways that the lack of rain will affect the water industry, as well. But in the interest of examining how consequences may not be what they seem, let's investigate the toll on the natural gas industry.

Take a look at where the majority of natural gas wells are located, and you'll see that they are centered in some of the hardest-hit areas in the country.

Source: EIA, U.S. Department of Energy

Fracking, a process that revolutionized the industry by making previously inaccessible resources open to exploration, uses tons of water. The drought has caused some states, like Pennsylvania, to suspend fracking operations.

Again, it would make sense to assume that natural gas companies would stand to lose from reduced output. But America's largest natural gas producers, like ExxonMobil and Chesapeake Energy (NYSE: CHK  ) , may actually benefit from the drought.

As it is, we have built up a vast oversupply of natural gas in the country. That has led to rock-bottom prices for natural gas, and reduced earnings for several companies. If production decreases, then supply can tighten, and prices can rise to levels where natural gas producers can remain sustainably profitable.

Instead, companies like Heckmann (NYSE: HEK  ) stand to be bigger losers. The company is building out the infrastructure to meet the water demands of the fracking process. But if fewer companies are paying Heckmann to use its water system, the company will be collecting far fewer fees.

As you can see, it can sometimes be difficult to predict who will be most affected by major world events. Let The Motley Fool help you in navigating such occasions. Our analysts have issued a special free report to help you with a different major event on the horizon: the presidential election. The report shows how you can benefit no matter who the winner is. Get your copy today, absolutely free, and you'll be the one celebrating come November!

Fool contributor Brian Stoffel owns shares of Heckmann. You can follow him on Twitter, where he goes by TMFStoffel. The Motley Fool owns shares of Chipotle Mexican Grill, ExxonMobil, Heckmann, and Chesapeake Energy. Motley Fool newsletter services have recommended buying shares of Chipotle Mexican Grill, and creating a bear put spread position in Chipotle Mexican Grill. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (24) | Recommend This Article (70)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 21, 2012, at 12:17 PM, daliya wrote:

    iF THERE IS NO CORN SYRIUP WE WILL ALL BE HEALTHIER. THE STUFF IS TOXIC.

  • Report this Comment On July 21, 2012, at 12:48 PM, jc09058 wrote:

    This is one of the best articles I've seen in a while that actually points indirect consequences and downstream effects. I'm am sure there is much more to this but I like the point it makes about how interconnect everything is.

    These are the kinds of articles we need to see more of in the future.

  • Report this Comment On July 21, 2012, at 12:52 PM, xetn wrote:

    Eliminating corn from ethanol production would benefit consumers and reduce the consumption of water.

  • Report this Comment On July 21, 2012, at 1:02 PM, Viking70 wrote:

    @daliya,

    Corn syrup is no different/worse for you than cane sugar or sugar from sugar beets. The media just has everyone convinced based on no real science that HFCS is bad for you. What's bad for you is consuming 50% more calories than you expend.

    @ Brian,

    Just a clarification: "A 50% increase in the price of corn tends to raise total shopping bills by about 1%." Total shopping bills include items not dependent on corn, so the price of products reliant on corn will increase by more than 1%. My guess is that this biggest jump in prices will be on beef, pork, and chicken (eggs too probably). It will be a bit more than 1%. At least 10% but maybe as much as 25%. And you are correct, restaurants will be hardest hit--both by increased input costs and decreased customer traffic if they raise prices or decreased margins if they keep prices the same to keep customers coming in.

    Also, I am not sure how universal crop insurance is. My father has only purchased crop insurance twice in the last 15 years because if you buy it every year, it is hard to turn a profit as a farmer. Luckily, he bought it this year based on what he was seeing last summer/fall. If farmers didn't buy crop insurance, there is going to be some stress on them especially if they bought the land in the past few years as land prices were skyrocketing.

  • Report this Comment On July 21, 2012, at 1:24 PM, gatorjaw wrote:

    Correction, there is a misunderstanding about

    what technology made this boom in natural gas.

    It wasn't fracking It is horizontal drilling, We have been fracking for 30 years. Schlumberger designed and perfected horizontal drilling.

    Schlumberger is leaps and bounds ahead of the rest in this area, make no mistake Schlumberger also has a fracking business,

    but they make their money at the bit! They can place a 6 inch bit in an area the size of a basket ball goal five miles away and in any direction. That's what made all this hupla about shales gas possible.

  • Report this Comment On July 21, 2012, at 1:38 PM, TMFCheesehead wrote:

    @Viking70-

    The comment about the 1% overall increase came from an research economist with the FDA. Of course, some products will jump more than others, but one of the largest input costs is actually the cost of oil.

    @jc-

    Many thanks.

    @gatorjaw-

    You're right in that horizontal drilling has also helped produce more natural gas. But far more water is being used as well. The fracking from 30 years ago is not the same as fracking being done today.

    http://www.fool.com/investing/general/2012/03/09/what-every-...

    Fool on!

    Brian Stoffel

  • Report this Comment On July 21, 2012, at 2:35 PM, 123kenchris wrote:

    Don't forget about the ethanol industry.

    Ken J.

  • Report this Comment On July 21, 2012, at 2:52 PM, wjcoffman wrote:

    I live in Florida and this time of year when it's not raining and you are outside you are sweating like crazy. Dry as in no rain fall is different from dry as in no humidity. We are not lacking in humidity!

    Burning corn for fuel (ethanol) is false economy. Efficiency is reduced by the amount equal to or greater than the percent of ethanol added to the fuel. Then you can take into account the corrosion effects of running ethanol in your tank and fuel system. I can't run ethanol mixture in my 2 cycle engines. In less than a year of use both chain saw and weed eater had their carburetors replaced.

    Burning food has always puzzled me, too. I'm not talking about meat on the grille, but diverting corn into fuel. Really?

  • Report this Comment On July 21, 2012, at 3:14 PM, caps4cy wrote:

    In the short term we will see early marketing of Beef because there is limited feed for them. Mcdonalds and others are going to cash in on cheap beef.

    Buy now on bad news.

  • Report this Comment On July 21, 2012, at 11:50 PM, brucereno2 wrote:

    What's the bear put spread and was it put on before or after the 25% drop?

  • Report this Comment On July 22, 2012, at 7:33 AM, crtpicks wrote:

    Check out GasFrac (GSFVF). This company has patented process for fracing that does not use water. They use LNG and a process that is environmentally friend, demonstrated higher well production, and since it is natural gas based there is no clean up of contaminated waste water.

  • Report this Comment On July 22, 2012, at 6:35 PM, jmlerche wrote:

    Ditto on GSFVF - I was going to mention them as a potential beneficiary of this drought as well. I do have a small long position.

  • Report this Comment On July 23, 2012, at 1:20 PM, zgriner wrote:

    "... it can sometimes be difficult to predict who will be most affected by major world events."

    How true!! Remember, we were supposed to have $5 gas by Labor Day. Of course, if Iran keeps pushing the way they are, it might happen, regardless financial upheavals in Europe.

  • Report this Comment On July 23, 2012, at 5:25 PM, cpr1200r wrote:

    I noticed a few comments regarding corn/ethanol.

    So soon we forget...one of the two reasons for ethanol in gasoline is to lessen the USA's reliance on foreign oil (a/k/a War on Terror) and the second is to get MTBE out of gasoline and out of our drinking water.

  • Report this Comment On July 23, 2012, at 11:04 PM, TMFRhino wrote:

    Very nice article, Brian.

  • Report this Comment On July 25, 2012, at 10:54 AM, buttex wrote:

    The real losers are the poor who spend 2/3rd or more of their income on food and those who cannot pass on their increasing costs as things progress up the food chain. buttex1

  • Report this Comment On July 27, 2012, at 8:32 AM, Darwood11 wrote:

    Good article.

  • Report this Comment On July 27, 2012, at 11:34 AM, cellofool100 wrote:

    Plant a garden quick! save your rainwater with a water barrel connected to your downspout. Can your excess vegies, share with neighbors, get some rabbits and 3-4 chickens, plant some potatoes and you are set.

  • Report this Comment On July 27, 2012, at 10:49 PM, Zombie111 wrote:

    When you see how inter-connected everything is it becomes easy to see why making predictions accurately is so tricky. maybe we should be tracking people like Viking 70's father, who only bought drought insurance because he accurately predicted a drought.

  • Report this Comment On July 29, 2012, at 7:10 AM, beaconlight wrote:

    Ditto on the Gas Frac. It saves the water need and disposal problems. Don't forget the earthquakes in Ohio from injecting waste water deep in the earth.

  • Report this Comment On August 01, 2012, at 6:54 PM, Marmadukemark wrote:

    cpr1200r,

    You missed one reason, at least in Missouri, in that law mandates a certain amount of ethanol blended fuels.

    A group of large corn farmers went into the ethanol business, lobbied state government, and viola! we MUST have ethanol.

    Stupid. Stupid. Stupid.

  • Report this Comment On August 01, 2012, at 8:39 PM, mythshakr wrote:

    Been saying since 2008 if we want a large public works project to boost employment and smooth out the economy it should the same one used in the 1930s. Water storage and management.

    And no one is complaining about ethanol. They are complaining about corn ethanol because it is so inefficient to produce compared to other feed stocks.

  • Report this Comment On August 07, 2012, at 4:21 PM, FF2point0 wrote:

    Kudos to Stoffel for publishing **ahead** of today's drop.

  • Report this Comment On August 15, 2012, at 11:47 PM, ettyg wrote:

    I think its disgraceful that Congress went on recess and did not pass the farm bill. Those poor farmers struggling with a deadly drought and no relief in sight, will reflect next year in considerably higher food prices. Congress is so consumed by their reelection they forget just who put them in that nice cushy, well paying, great benefits and all for part time work. We all should be so lucky, especially those Americans who have been out of work or looking for work for a very long time. Those not working or under employed American voters should demonstrate their displeasure at the voting booth.

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