Andrew Mickey, Q1 Publishing

It’s been a long time coming. I don’t know who thought it would come this fast…or all at once.

A few weeks ago, uranium prices seemed to have a gained some footing. But uranium prices crashed through the floor and it could be another big step down from here. The energy metal could be headed even lower. This fall could be harder and faster all due to deleveraging.

The nuclear energy argument is still there. In fact, it’s even better than it was two years ago when the uranium market started to crack.

At the time there were plans for the construction of 222 new reactors. Today there are plans for 316 and 60 of them are expected to be on line by 2014. Although I think the world is starting to realize a lot of those will replace old reactors, but not all of them.

Also, the recent update on Cameco’s Cigar Lake project wasn’t very good news either. As most of us expected, it’s a long way from recovering from the flood. The doubts still loom if it will ever be fixed.

We also learned a bit more about the Megatons to Megawatts uranium deal with Russia. As it sits right now, Russia will be halting shipments of uranium in 2013.

As you can see, the uranium story has actually improved a good bit. But that doesn’t matter much now. There is a much larger storm cloud hanging over the uranium spot market and uranium stocks: hedge funds.

By now most of us are familiar with deleveraging. After years of success and taking big bets, hundreds of hedge funds are on the verge of collapse. The markets have taken a turn for the worse and investors are calling for their money back. Hedge funds have to pay up. Record redemption rates are forcing them to sell anything off at any price.

For many funds that trade actively in large-cap stocks, raising cash for redemptions is not much of an issue. It’s a much different story for the funds that were buying physical uranium a few years ago. If they have to sell, they’ll have to do so at any price. Any added selling pressure in a weak and illiquid uranium market could have a big impact on uranium prices. It looks like it’s already started to happen.

In the past few weeks uranium prices have fallen another 14%. Each week the price of uranium drops another few dollars per pound indicating a very weak market. It’s not just a one-time drop either. The fall has been consistent. That means the funds could be unwinding. If they are, there’s a lot more down weeks to come for uranium prices.

It wasn’t long ago that everyone was buying uranium. The stocks were the hottest thing around and funds were consistently buying up anything uranium.

During the uranium heyday, a uranium trader stated, “They sweep the market clean. Every pound they can find.”

The Wall Street Journal said back in 2006, “Many funds say they are holding their uranium off the market because they expect the price to climb.”

It was all artificial demand for uranium. It was unsustainable. They were just buying it with the only possible exit strategy of selling it. They had no use for it. There’s nothing wrong with that…as long as they stay aware of it.

And now it looks like we’ll be forced to become all too well aware of it. All the uranium the funds swept up has to go back onto the market. And that could push uranium prices to ridiculously low levels we haven’t seen in years. It wouldn’t surprise me to see uranium back at $40…or lower. It all depends on how fast they have to sell.

For instance, Adit Capital was one of the biggest buyers of uranium between 2004 and 2006. It’s estimated that Adit purchased between four and five million pounds of uranium. Citadel Investment Group controlled 2.3 million pounds of uranium.

The big wild cards here are GLG Partners and Fortress Investment Group. These multi-billion funds could be sitting on millions of pounds of uranium they may want or need to liquidate quickly.

In addition to all that, we can’t discount the impact of the artificial demand created by Uranium Participation Corp (TSX:U). As of September, Uranium Participation Corp was holding 5.425 million pounds of uranium and more than two million pounds of uranium hexafluoride.

Although Uranium Participation Corp is a holding company that probably won’t be liquidated any time soon and they have created a uranium loan program, the demand the fund created on uranium’s way up will not be there on the way down. In August, the fund only purchased 50,000 pounds of uranium. That’s nothing close to the 200,000 pounds a month it was bidding up when uranium prices were rising week after week.

Although we cannot determine exactly how much uranium these funds have left, we do know they throw another variable into the uranium mix. In a market like this, where even slight uncertainty can send share prices plummeting 10% to 20% in a single day, another variable is the last thing the market wants to see.

As a result, I recommending holding off on uranium stocks for the time being or wade in and use a prudent investing strategy that reduces risk. The trend is still down. We might have caught a nice run with Hathor Exploration (TSXV:HAT) and Denison Mines (AMEX:DNN), but uranium prices have broken through the temporary floor. The wide sell-off hitting almost all commodity stocks could get even worse and now the best place to be is on the sidelines.

Uranium prices could fall another 50% or more from here if these funds liquidate. There could be another 5 to 10 million pounds of uranium just waiting to go on the selling block. Considering the spot market is very illiquid (it only trades 26 million pounds a year), uranium prices could have plenty more room to slide. The consequences on uranium stocks would be even worse.

Do you remember what happened to natural gas stocks when the hedge fund Amaranth had to unwind its bet on natural gas in 2006? The fund single-handedly pushed natural gas prices from $7 per Mcf to almost $4 per Mcf. The same fate could be headed for the uranium market. If that happens, then uranium would be an easy buy.

For right now, I’m afraid; the risks just outweigh the rewards in uranium stocks. There could be a true fire sale for uranium stocks coming up. To me, the opportunity to pick up high quality uranium plays like Hathor and Denison around $1 per share or Cameco under $10 (it could happen) is something worth waiting for.

Good investing,

 

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

Andrew Mickey Chief Investment Strategist, Q1 Publishing

Pensions & Investments magazine warn, “Bloodbath Ahead.”

Reuters predicts, “D-Day for Hedge Funds as Redemptions Roll In.”

CNN cautions, “Hedge Fund Blues are Just Beginning.”

The markets sit perilously on the edge of disaster. A downward spiral is getting stronger and there’s not much that can be done about it. And one of the leading has been and will be hedge funds.

Frankly, the consequences can be dire if you’re holding the same stocks as the funds. The news isn’t all bad. As you’ll see in a few moments, the mass sell-off will create a few stellar short-term and long-term opportunities in three specific areas.

You see, hedge funds have been around for decades. They were originally set up for wealthy investors to participate in more exotic investment strategies. The funds chased after small market anomalies to try and beat the markets. There were rules in place to ensure only “accredited” investors could get in them.

The assumption was that accredited investors would be more patient and understanding of taking losses. They would be able to have their money tied up for longer. Volatility was part of the game. If you had $1,000,000 in assets or $200,000 a year in annual income (or said you did - the background checks were about as in-depth as the ones mortgage lenders used), you would understand that markets go up and down and wouldn’t demand your money back.

Well…as we’ve learned with a lot of other assumptions made over the past few years, they couldn’t have been more wrong. After watching the markets wipe away $19 trillion in wealth so far this year, hedge fund investors are calling for their money back. They are redeeming at a record pace.

The redemptions are playing a big role in the current market selloff. And they could spark the next round of a disastrous spiral.

It goes like this. A few investors say they want their money back. A hedge fund has to sell what it can to pay them back regardless of how bad the timing may be. They are forced to dump shares onto a market with very few buyers. The market slides even more. That slide leads to more fear, more redemptions, more selling, and on and on.

Normally any single fund unwinding its positions can be absorbed by a healthy market. But the market isn’t healthy. And if just a small percentage of the 9,000 hedge funds with more than $1 trillion under their control (and a lot more borrowed money that needs to be unwound) push the sell button at the same time, the impact on the markets can be huge.

Over the past few weeks a lot of them are pushing the sell button.

Hedge fund performance is down…way down. Eurekahedge, which tracks hedge fund performance, says less than one in 10 funds of the 4,000 it tracks are in positive territory. Even Maverick Capital and Greenlight Capital, two former top tier hedge funds, lost an average of 16.1% according to Bloomberg.

Hedge funds are falling apart. And investors are demanding their money back in droves. It’s getting so bad a record number of hedge funds are closing up shop altogether.

There are some big funds that have to sell out completely. Sowood Capital Management recently closed its doors after dumping what was left of its $3 billion in assets. The $2.8 billion commodity trading fund Ospraie closed its doors after its value fell 40% in August. Two Bear Stearns multi-billion dollar hedge funds practically took down the entire firm.

And those are just a few of the big ones. Hundreds of smaller funds are going through equally tough times. CNN reports, “By the end of the year, it’s estimated 679 funds will be shut down.”

They shut down and liquidated.

The spiral continues…

That’s why I recommend watching the following sectors very closely. Any more sell-offs from hedge funds can send these sectors plummeting even further. I realize most are down 60% or more, but it wouldn’t take much to fall another 20% to 50%.

Hedge Fund Sell-Off Opportunity #1: Emerging Markets

Emerging markets have been a bastion of hedge funds for years. The outsized returns offered by emerging markets have attracted a lot of fast money. For five years, a hedge fund manager could buy an index fund (borrow money to leverage up) in virtually any emerging market and watch his performance soar 40 to 60% each year. Then he could tell investors in his fund how great a stockpicker he is because he beat the S&P and the local indices.

It was a great strategy…for a while. The party had to come to an end sometime. And that time is now.

Emerging markets have gotten rocked. The mighty BRIC wall has come crumbling down and has brought dozens of hedge funds down with it. For instance, GWI Asset Management, which manages a fund focused on Brazilian stocks, is down more than 50% in the first nine months of the year.

Hedge Fund Sell-Off Opportunity #2: Agriculture

Agriculture sector stocks are still reeling from the hedge fund sell-off. After a fantastic run from 2006 through August 2008 the ag sector caught a lot of attention…and buyers.

Everywhere you turned, there were “experts” touting how the world is running out of food. There won’t be enough.

The story was perfect. Investors expected this to be the biggest boom of all.

Now, I first recommended buying fertilizer stocks in the summer of 2006. It was a great time to buy and we had a fantastic run. Of course, the run would not have been nearly as great without the help of the hedge funds piling in for two straight years.

When the markets first started to crack near the end of summer, we knew agriculture stocks would be hit hard. After more than a year and a half of the hedge funds buying and buying, they would have to sell. And given the state of the markets and record redemptions to meet, they would have to sell at practically any price.

The end result is we have agriculture stocks selling at drastically low valuations. Some of the highest quality companies that practically mint cash and are relatively immune from a recession are selling at fire-sale prices. Anyone caught in the sell-off easily could have lost 60% or more even though they focused on quality.

Hedge Fund Sell-Off #3: Commodities

The final hedge fund favorite over the past few years has been commodities. Again, it’s the same story. Hedge funds looking for big returns were chasing after anything that goes up. Over the last few years commodities and mining stocks have been top performers. That attracted a lot of buying. As they went up, more and more buying came in. They went up more…and on and on.

This went on for years. But once the sell-off started and the funds started to have to raise cash to meet redemptions, it was time to sell. And when everyone sold at once, it’s pretty easy to see the impact.

------------------------------------------------------------------------------------------------------------

The impact of the sell-off has been big. More than $19 trillion of global wealth has been eliminated this year. U.S. retirement accounts have shed more than $2 trillion in value so far this year. And if the redemptions continue, there will be more selling pressure. At worst, the pressure could be strong enough to sink stocks even lower. A best, selling pressure would probably limit the upside of a rally.

There is a plus side to all this. Once the aggressive selling is over, shares in these sectors could go on an absolute tear. There will be some fantastic buys amidst the rubble when the smoke clears.

But I’d wait to see an uptrend before stepping in. Remember, stocks go down a lot faster than they go up. And right now, trying to catch the bottom just to get the first 10% or 15% of a steady climb isn’t worth risking a further slide of 50% or more.

If you’re looking for the long-term, the best place to be is still on the sidelines. It’s OK not to buy stocks today.

Good investing,

 

By Andrew Mickey
Chief Investment Strategist, Q1 Publishing

P.S. Yesterday, a coordinated effort by most of the world’s central banks managed to help prop up the markets. Will it last? Will it spark a short-term rally? We’ll see over the next few weeks.

Over the medium-term, I don’t think any market rally is sustainable. The bear is growling and we’re probably in for a few months of generally flat markets…at best. There will be ups and downs, but the market will come back to reality soon. And the reality is the economy is still in terrible shape.

We’ve focused on the economy throughout all of the market ups and downs. The best indicator of the strength of the U.S. economy is jobs and unemployment. Goldman Sachs recently announced they expect unemployment to rise until to 8.5%. Considering the unemployment rate is at 6.1%, it’s probably going to get worse before it gets better.

High unemployment will just make the current problems worse. If Goldman is right and unemployment climbs to 8.5% over the next 18 months, the bear market will be growling again.

Don’t worry; flat markets can be a good thing. And we’ll go over easy ways to turn a flat market into big profits over the next few days.

 

Andrew Mickey, Q1 Publishing

Yesterday afternoon the sell-off in fertilizer stocks was reignited. Mosaic released its latest earnings report and the results good, but not good enough.

We were prepared for some rough times, but I don’t think any of us thought it was going to get this bad.

Mosaic (NYSE:MOS) down $104.
Potash Corp (NYSE:POT) down $139.
Agrium (NYSE:AGU) down $70.

Sure, Mosaic is growing profits, margins, cash flows, and sales, but they missed expectations. In a market like this, missing by just a penny could easily result in a disastrous sell-off.

Mosaic missed…and paid the price. Shares plummeted 40% today. For anyone looking to “buy on bad news,” there’s a lot more to consider. This sell-off in once-darling fertilizer stocks has happened for a lot of reasons. And those exact same reasons are what will limit fertilizers’ stocks upside from here.

1. Great Expectations, Big Disappointments

As I stated back in early August in reference to fertilizer companies,

“Expectations were just too high. Nobody could live up to them…From here it could be a long way to go before the uptrend resumes in these stocks.”

It has been a long way down since then. The fundamentals haven’t been able to stop the downward momentum.

Big expectations usually lead to big disappointments.

2. Basic Current Valuation

I know the basic arguments…Mosaic has a forward P/E ratio of 4, its margins have been regularly expanding, it sold off Saskferco, and the agriculture story (emerging markets, biofuels, no new farmland, etc.), but it hasn’t played out too well over the past couple of months for fertilizer companies.

By all traditional metrics fertilizer companies should be “screaming buys.”

 

Company	Trailing P/E	Forward P/E	Price to Sales	Price to Earnings Growth
Mosaic	8.7	2.4	3	0.54
Potash Corp	15	4.4	5.8	1
Agrium	5.8	3.2	1.2	0.45

 

But they have done nothing but fall over the past two months and many investors are left scratching their heads. But this one isn’t too tough to figure out.

As the world is finally starting to realize, many of the forward estimates were a bit too high. After all, high commodity prices usually have some impact on demand. And in this case, although total revenues have increased steadily for the Big Three and margins have increased, no one is expecting the great times to last.

These are mining stocks and are highly cycle. You have to price those discounts into the market.

Granted, it’s going to take some time to bring new supply on line (it takes 5-7 years to bring a new potash mine on line), but it will come. Rest assured there will be more fertilizer supply coming, which will help bring fertilizer prices back down and significantly reduce the long-term profitability of many of these fertilizer companies.

3. Long-term Value

The long-term is probably one of the biggest issues holding back fertilizer stocks. We cannot forget the importance of fertilizer, after all, in the last 50 years the amount of arable farmland has dropped 37% on a per capita basis. So fertilizer consumption will not disappear.

High fertilizer prices have done one thing though; they’ve brought a lot of competition into the market. Potash is the perfect example. The following companies are expanding big into potash. Here are a few examples, by no means all of them:

Mosaic – is still on schedule to ramp up its potash production by 50% over the next 12 years. In a plan laid out in April, Mosaic stated it will invest $3.15 billion in expanding its potash mines to increase production from 10.4 million tonnes to 15.5 million tonnes by 2020.

Uralkali (URALY) – Despite some setbacks, Uralkali is on pace to increase its potash production by 35% by the end of 2010.

Rio Tinto (NYSE:RTP) – Rio Tinto has been one of the top mining companies that has declared its intentions to move into potash mining. A little over a month ago the mining giant stated it will spend $3.5 billion to open a potash mine in Argentina.

At last report, Rio Tinto stated it expects this mine to produce about 2.3 million tonnes of potash in early 2012 and then ramp up to full capacity of 4.3 million tonnes by 2020.

BHP Billiton (NYSE:BHP) – has been one of the most aggressive mining majors to jump into the potash race. BHP shelled out $284 million to buy out Anglo Potash last spring. Anglo held a 25% stake in BHP’s Saskatchewan potash project.

BHP expects this mine to start producing potash as early as 2012 and has not confirmed a timeline since the takeover. But it should be on line between 2012 and 2015.

Potash One (KCLOF) – is one of the leading potash “junior” companies. Potash One and a handful of others are still chasing after the big potash prize. Many are well funded and are actively laying the groundwork for a big joint-venture (i.e. with a foreign country that would put up a big loan in exchange for a supply agreement) or takeover.

These companies would need massive amounts of capital to go into production. If you look at some of the management teams on them, it would not be overly surprising to see one of them become a producing mine in the next few years.

4. Agriculture Commodity Prices have Plummeted

Finally, the price of agriculture commodities has quite a bit to do with how much fertilizer farmers are willing to use. If they’re getting record high prices for crops, there’s not much worry over some extra fertilizer costs. But when their profit per acre have dropped by 40% (like they have recently) they’re going to tighten up the purse strings a bit.

Fertilizer demand does have some elasticity and it will be impacted by crop prices. And they’re all interrelated. Corn prices might be high and soybean prices may be down, they will reach equilibrium as farmers chase after the bigger cash crop.

So when you see Powershares DB Agriculture Fund (NYSE:DBA) drop 35% from its highs earlier this year when the “food crisis” story really hit the mainstream, you know fertilizer demand (and profit levels of fertilizer producers) will surely follow.

-----------------------------------------------------------------------------------------

As you can see, there is a lot more supply coming. We looked at a partial view of potash (Intrepid has some plans, Russia’s Silvinet recovers from sinkhole problems, etc.), but you the same is true for most of the other forms of fertilizer as well. As long as we value fertilizer companies for their long-term profitability, it’s easy to understand how they all came crashing down to reality over the past couple of months.

There is a lot of supply coming and potash prices will likely stay around $500 to $1,000 a ton over the long term. They won’t be too high to attract aggressive amounts of new supply and they won’t be too low where mines are going to have to be shut down. Potash prices will probably remain in a nice range where every company makes enough money (that’s even more likely since 2 cartels control more than 70% of world potash exports.)

Today, Merrill Lynch analysts offered a pretty much bearish report on potash (all commodities in general for that matter) and I’m sure some others will follow. All of the downgrades will surely add to the selling pressure and will finally push these stocks to a bottom.

Of course, all this is pretty good news. There have been a lot of investors plowing money into the fertilizer sector over the past year (on the way up and the way back down) and it looks like most investors weren’t prepared. Fertilizer companies are still mining companies and there will be plenty of volatility.

Blame the hedge funds for pounding down the share prices or just look at it as a bubble that burst with the regular accompanying consequences, but I’m now starting to turn cautiously bullish on agriculture again.

This time around it won’t be a huge speculation fueled rising tide that lifts all boats. The long-term opportunity in agriculture is still there, but the biggest wins probably won’t be in fertilizer stocks, they’ll be in other agriculture subsectors.

Fertilizer stocks are in for long period of ups and downs. I expect the then to have a few more months of rough going with plenty of false starts too. After all, there are still a few analysts with $300 and $400 price targets on Potash Corp that still have to turn negative before we can confirm a hard bottom.

Despite it all, anyone buying now should reasonably expect a 30% to 50% on Mosaic, Potash Corp, and Agrium despite any more ups and downs to come.  Even with a lot of road blocks down the road, there is some significant value in the fertilizer producers.

By Andrew Mickey, Q1 Publishing

Disclosure: No position in any companies mentioned

 

Andrew Mickey Chief Investment Strategist, Q1 Publishing

t’s all falling apart. The world fears the global financial system is on the verge of collapse and a long drawn out recession could be in our future. It’s going to be a long one and the commodity bull has been stopped in its tracks.

Oil, coal, uranium, copper, nickel, and other base metals are steadily declining in price almost every day. It seems like there is almost no let up in the selling at times.

The sell-off has wreaked havoc on the share of mining companies. All of the majors across the board have dropped anywhere between 50% and 70%. It’s been a tough couple of months for mining companies.

Of course, they expect the volatility. They’re used to the cyclicality of the industry. Mining stocks have been subject to huge swings for decades. The executives, engineers, geologists, and laborers are used to it. Frankly, it’s not about to change anytime soon. Imagine an entire country whose economy’s success was dependent on high commodity prices? How would it react?

Well…the world has one and it’s not reacting well.

Russia has taken the commodities sell-off on the chin. The Russian ruble has fallen 10% since its highs against the U.S. dollar in July.

The Russian stock market, as tracked by Market Vectors RSX ETF (NYSE:RSX), has fallen 62% this year. The Russian stock market has been halted twice in the past month in hopes of stopping the sell-off. The Russian Stock Exchange has also outlawed short-selling. And the Russian government has authorized the purchase of $20 billion worth of shares.

Just yesterday, Russian President Dmitry Medvdev rolled out Russia’s banking bailout plan. Russia’s plan involves pumping $36 billion dollars into the local banking system in the form of five year loans. On a comparative basis, this cash infusion is about 3.5% of Russia’s GDP while the U.S. plan is about 5.6% of GDP.

Clearly, Russia’s got some problems. But Russia is no stranger to problems. Just 10 years ago, the country’s financial system collapsed when the government defaulted on its debt. The default sent the Russian economy into a tailspin and was the straw that broke the camel’s back of Long-Term Capital Management.

At the time, the Russian economy was a total wreck.  80% of Russia’s exports were timber, oil, natural gas, and metals and commodities prices were sliding (like they are now). Russia was not prepared.

Hundreds of banks closed and people were lined up at banks for days to try to withdraw some virtually worthless rubles. No one could deny it was a true financial crisis.

It took a decade, but Russia eventually recovered. This time many are not about to make the same mistakes. Much like the Argentineans we met the other day, which have experienced their own financial crisis when Argentina’s banking system collapsed completely in 2001, Russians still don’t trust their banks. And they trust the government and ruble even less.

That’s why I couldn’t wait to speak with Grigory. He’s been a Russian stock market analyst for years. I met him on a research trip inside the Arctic Circle last year. What he had to tell me really got me thinking.

With Russia’s market in freefall, he’s a pretty busy guy. But I had his attention for a few minutes because he wanted to get the real scoop on what’s happening here in the United States. As you might imagine, Russia’s media outlets don’t always provide the whole truth.

So I explained it all to him and the laid out the possibilities from here, then I turned the table on him and asked, “How’s it going over there? Is there “blood in the streets?” Time to buy? Are you loading up on gold?”

His answer was a simple no too all of them. He warned it could get much, much worse.

But he did tell me his safe haven, the U.S. dollar. Grigory went to the bank two weeks ago and pulled out $25,000 in U.S. currency. Grigory explained to me that I just don’t understand the importance of the U.S. dollar in the rest of the world. He told me, “You’re too used to it. You grew up making and spending dollars. It’s still the world’s most respected currency.”

I fired back, “But there’s inflation, a recession, a financial crisis…”

He stopped me and said, “You know the U.S. dollar will always buy something. It will be there in 5 or 10 years. It will always be accepted by any merchant as far away as Siberia. It’s the world’s safest currency.”

Then I understood. Most of the rest of the world doesn’t trust their governments or currencies enough yet. Sure, we’ve had a nice boom for the last decade which has worked its way to almost every corner of the planet, but if you’ve ever been through a currency crisis or financial collapse, you just don’t know.

 The U.S. dollar is still the reserve currency of the world. The Euro had its day in the sun over the past year, but it hasn’t even been around for 10 years. It takes a long time for the world to switch to a new reserve. Whether that is eventually the mighty Chinese Yuan, the Euro, or gold remains to be seen.

One thing we do know for sure. It took a very long time. It took a couple of wars, and the Great Depression for the U.S. dollar to establish its dominance over the British pound. Now, it could all be changing again, but it’s going to be a long volatile process.

If the 10% rise in the Powershares DB U.S. Dollar Bullish Fund (NYSE:UUP) over the past two weeks is any indication, the almighty dollar is still the most trusted currency in the world.

Good investing,

 

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

Andrew Mickey

The agriculture sector has come down a long, long way since its recent highs. Leading the way down has been a sharp decline in agriculture commodities. The price of sugar is down 25%, soybeans are down 30%, corn is off 35%, and wheat is leading the way with a 40% decline since euphoria took the agriculture markets to unsustainable highs last winter.

Remember the food riots…the rice trading maven, who took a dozen barges, loaded them with rice, and tried to corner the market...expectations that ethanol production would push an already tight corn market into the stratosphere …the world was running out of food!

Or so everyone thought.

It was a great story. And it seemed like everyone got in on the act. Hedge funds were bidding up crop futures contracts. Food producers were hedging their bets to ensure they had raw ingredients. Agriculture reports were closely watched by mainstream media. Even Potash Corp (NYSE:POT) had an estimated 25,000 unique visitors to its company website according to Quantcast.com (a little anecdotal evidence never hurts).

Like all great stories, it had to come to an end. Now, fertilizer stocks have plummeted more than 60% across the board, the seed companies like Monsanto (NYSE:MOS) and Syngenta (NYSE:SYT), and the farm equipment makers are well off their highs. And Potash Corp’s web site traffic was cut in half.

All the bad news for farmers and the agriculture industry has created what could be an excellent buying opportunity in another subsector of agriculture stocks, livestock and meat. They directly benefit from lower crop prices because the biggest expense they face is feed costs.

Just take a look at what rising crop prices did to the profits and margins of Smithfield Foods (NYSE:SFD). The world’s largest pork producer and processor missed already low earnings expectations in each of the past two quarters. The culprit was feed costs. Smithfield stated the following its most recent quarterly report (emphasis added):

International segment operating profit declined in spite of significant sales growth. The decline is mainly attributable to less favorable results from our equity method investments and significantly higher raw material costs.

The [Hog Production] segment incurred an operating loss due to significantly higher feed costs.

Other segment incurred an operating loss as a result of significantly higher feed costs and less favorable results at Butterball.

It’s all about feed costs. But it’s not just isolated to Smithfield. When costs rise the entire industry takes a hit. They simply can just pass costs on to end consumers.

In the chart below, the U.S. Department of Agriculture shows how tough times got for meat producers during the agriculture bull market of the mid 90’s. The price of feed costs spiked 30% and ended 10% high after two years. Meanwhile the price of end products only increased 5%.

In essence, the meat producers watch their costs rise significantly and they were unable to pass them on.

Normally, when input costs rise 10% and half of that can be passed on to end consumers, a company will be just fine. But this is the meat production industry and that 5% gap is very important.

If we go back to 2005, before agriculture commodities rose significantly, gross margins were pretty small. That year gross margins for Smithfield, Tyson Foods (NYSE:TSN) and Pilgrim’s Pride (NYSE:PPC) were 10%, 6.5%, and 13% respectively. As a result, we can see how rising costs can quickly erode profits for meat producers.

Under normal circumstances the market anticipates the impact of higher feed costs. As you can see in the chart below, Smithfield, Tyson, and Pilgrim’s Pride move inversely to agriculture commodity prices.

If you use Powershares DB Agriculture Fund (NYSE:DBA) – which tracks the prices of wheat, soybeans, corn, and sugar – as a broad measure of crop prices/feed costs, then we can see a strong correlation between feed cost increases and the value of meat producer shares.

When crop prices rise, meat producers shares went down. This pattern held strong until late May when credit concerns started to wreak havoc on the share prices of meat producers. The credit crunch, which hit all meat producers in significant ways, sent shares prices plummeting across the board.

So, is it time to buy meat producers? I don’t think so…but the time is coming.

For instance, Sadia (NYSE:SDA) recently announced it was on the wrong side of some currency bets. All of its expected profits for this year have disappeared on one single misstep. On top of that, Sadia had to rush to acquire a short-term loan to ensure it can stay in business. The failed bet was some very bad news that took the market by surprise shares of Brazil’s largest meat producer sunk 45% in two days.

And that’s the biggest reason why meat producers aren’t a buy yet. With Pilgrim’s Pride on the verge of bankruptcy and Tyson and Smithfield having cash flow problems, there could easily be some more violent downward swings.

The industry is on the verge of crisis and it’s not going to improve anytime soon. Jim Clarkson, a livestock analyst for A&A Trading, stated in an interview with Reuters, “It's the start of a recession. It is going to cut the demand for everything, including beef and pork.”

The meat production industry is going to benefit from lower agriculture commodity prices, but credit issues and a recession are going to have a far greater negative impact that will more than offset any positive savings that would come from lower feedstock prices.

It’s best to take a wait and see approach for the meat producers. So far they’ve been able to fend of significant credit concerns by raising capital with extremely good terms for the investors. If that capital dries up and the companies can’t get any credit, the industry will truly be in a crisis. The markets are going through some wild mood swings and I wouldn’t put a single dollar in until and shares are far too cheap to pass up.

Disclosure: I have no position in any of the companies mentioned.