If you can't water the crops, you can't grow produce or the hay to feed cattle. That's why companies like Chipotle Mexican Grill (NYSE:CMG) have been complaining about rising prices for both produce and meat. It's a problem that the U.S. Department of Agriculture says is going to get worse.
The first hit
Mike Wade, executive director of the California Farm Water Coalition (CFWC), explained to Modern Farmer that a drought induced price hit, "may not be 5 or 6 months from now -- it might be tomorrow." That's because key products like broccoli, lettuce, and bell peppers have already seen production fall. And California, probably the hardest-hit state, is the primary source of some items this time of year, such as almonds, olives, and plums. CFWC estimates that the drought could knock as much as 10% off the farm industry's sales.
Chipotle is living proof of the drought's impact. In the first quarter, Chipotle noted that, "Food costs were 34.5% of revenue, an increase of 150 basis points driven by higher commodity costs. Higher commodity costs were primarily driven by inflationary pressures in beef, avocados, and cheese prices." Further, "Restaurant level operating margin was 25.9% in the quarter, a decrease of 40 basis points from the prior year period. The decrease was driven by higher food costs."
Beef, avocados, tomatoes, lettuce, and peppers are all key ingredients in the fresh Mexican food that Chipotle customers have come to love. That's a problem. For example, beef prices alone are up 25% so far this year at the restaurant chain. Chipotle is looking to pass that increase, and others, on to customers. Keep a close eye on the sales impact as rising prices start to get pushed through to customers -- they may decide that the cost benefit analysis isn't as good as it once was.
The long view versus the short view
And that's a big issue. Chipotle has held prices steady for several years, choosing to pinch margins over pinching customers. Expanding the store count virtually demanded that prices stay as low as possible. Indeed, it's the combination of good food and low prices that make fast-casual restaurants desirable.
But that may not be possible longer term. For example, according to Modern Farmer, the drought is forcing some cattlemen to "cull their herds" and other farmers are letting plants die and fields lay fallow so they can focus what little water they have on their best opportunities. This is part of the reason why the USDA has warned that the drought could have a "large and lasting effect" on some markets.
In fact, even U.S. energy independence could be at risk. That's because California is also the home of a key oil drilling region.
The problem is that it requires over 100,000 gallons of water to drill a well. Since government officials can't exactly ban growing food, the state's leaders have been considering a ban on hydraulic fracturing. That's an industry already under pressure for its environmental impact. Such a ban would put a damper on plans to increase production in the state.
Trade-offs are being made
While the drought may not seem like a big deal to consumers right now, its impact is only just starting to work through the system. Chipotle Mexican Grill's customers will see it soon, and it could even hit you at the pump if California goes ahead and bans fracking. That won't put drillers out of business, or kill the U.S. oil and gas boom, but it will put a big roadblock in front of the industry. That's doubly true if other drought-hit states like Texas follow California's lead.
If you don't think the drought is big news, you're wrong. Watch closely, because we're only starting to see the far-reaching impact it will have.
Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.