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As China Threatens Retaliatory Tariffs on U.S. Agricultural Products, Which Ratings are Most at Risk?

 

The Trump administration's threat to levy 25% tariffs on at least $50 billion of Chinese imports--and potentially as much as $150 billion--has put several major U.S. agricultural exports in the crosshairs for potential retaliatory tariffs from China. They include pork, corn and related products (such as ethanol), soybeans, sorghum, and various types of wheat and beef goods. S&P Global Ratings has examined the impact these possible tariffs could have on ratings for U.S. grain originators and processors (which buy agricultural commodities for redistribution or further processing) as well as animal protein processors. In this report, we discuss our conclusions.

Impact On U.S. Grain Originators and Processors

Grain companies would face near-term profit pressure, but the markets don't seem to be betting on weaker margins.

U.S. rated agribusiness companies such as Archer Daniels Midland Co. (ADM), Bunge Ltd., and to a lesser degree Cargill Inc., have already endured a long cyclical downturn in origination and processing, and what was looking like a possible earnings rebound this year could get derailed by a trade war. EBITDA is at historical lows for some of these companies because of weak origination margins, which has led to credit measures falling to the weak end of our expectations, and any further weakening in earnings could pressure ratings. But historically, sudden disruptions to the grain markets have had an impact on that quarter's performance, and then profits normalize. This is largely because originators and processors act more as a middleman, locking in margins with largely dependable buyers once grains are bought from the farmer. Therefore, although the current tariff dispute increases the risk of a deflated rebound, we expect stabilization of earnings if not a modest uptick as origination margins benefit from a smaller crop out of Argentina and a resultant better soybean crush margin outlook.

The markets don't appear too worried yet. Soybean prices on the Chicago Board of Trade have fallen by about 6% on the tariff news, while soybean crush margins (an indicator for industry profit margins) are still up 174% from the beginning of the year.

The sector's geographic diversification and limited substitution prospects for China's grain needs may also mute the impact of an initial shock.

The three largest oilseed producing regions in the world--the U.S., Brazil, and Argentina, accounting for just under 60% of global production--are critical to supplying China with soybeans, given that it imports almost twice as much as it produces. All three of our rated U.S. agribusiness companies have significant sourcing footprints outside the U.S. from which they could redirect export volumes to China and soften the impact to profits from lost U.S. exports.

Certain players face additional margin pressure from ethanol tariffs, but the upcoming U.S. summer driving season, China's pro-ethanol policies, and new export destinations could provide some respite.

U.S. ethanol margins have been supported by declining inventory levels and strong export demand has consumed surplus domestic production. Tariffs on U.S. ethanol could mean fewer exports to China, which could pressure margins for producers like ADM. But weaker ethanol shipments to China are likely to be a short-term story given China's targets to blend more ethanol in its domestic gasoline to reduce pollution. This suggests the U.S. will continue to be an important supplier of ethanol over the next several years. Meanwhile, U.S. seasonal ethanol demand will be ramping up ahead of the upcoming summer driving season, while lost U.S. exports to China (which could turn into Brazilian exports to China) could be offset by the likelihood of more demand out of Mexico--another country now looking to blend more ethanol in its gasoline.

Impact On U.S. Protein Processors

Pork and beef processors could face margin pressure from weaker pricing, but broader trends, lower input costs, and limited export market exposure should keep margins from bleeding.

Pork prices have trended modesty lower following the tariff news, but we believe seasonality is a more relevant factor behind these declines. Hog futures prices on the Chicago Board of Trade have fallen 5% since the likely tariffs were announced and the seasonally low April 18 contract (reflecting built up inventories ahead of the U.S. summer grilling season) is priced to fall about 25% from current prices. Certainly lower pork prices could lead to hog farming losses, which would hurt the profits of hog producers such as Smithfield Foods Inc. (a curious development given that it's owned by Chinese parent WH Group). Still, U.S. hog prices, which have recently benefited from new domestic demand from two new plants coming on line in the beginning of the year, appear to be following their typical seasonal pattern of lower spring season prices as the summer grilling season inventory builds. Moreover, lower pork prices are likely to keep input costs low for further processed products, which make up the majority of the earnings mix of rated pork processing companies like Tyson Foods Inc., Hormel Foods Corp., and Smithfield. Therefore, profit weakness--and, in turn rating pressure--should be muted.

Similarly, cattle prices have only fallen about 5% since the tariff talk. Cattle markets continue to be in a broader low priced cycle after the U.S. herd was rebuilt from droughts several years back. This generally bodes well for margins for beef packers like Tyson Foods Inc. and Cargill Inc. In addition, we believe cyclically low cattle prices (currently more than 50% lower than peak prices following the drought) are falling from recent near-term highs more because of a rebound of cattle placements into feed lots. In short, the beef cycle continues benefit from large herds and lower cattle costs, so the risk to margins from tariffs appears contained.

Still, weak exports could hurt domestic pork and beef prices and pressure margins. But in our opinion this risk is not material enough to pressure ratings as most protein volumes are sold domestically. In aggregate, the U.S. exports about 10% of its beef production and about 20% of its pork production. This could pressure cut-out margins for fresh pork products, which are more sensitive to weaker prices than branded, further processed products. Still, rated protein processors do not have significant export market exposure. Take Tyson for example: less than 20% of its sales are destined to export markets, and its product mix is split across poultry, pork, beef, and prepared foods. Similarly, more than 70% of Smithfield's sales are domestic and the majority of its international sales are in Europe.

Promotional pricing of excess hog and beef inventories could pressure poultry prices and margins, but low feed costs should keep a lid on ratings risk for now.

To the extent a drop in beef and pork exports leads to excess domestic supply, promotional pricing could change the margin outlook for poultry producers like Pilgrim's Pride Corp., Tyson, and Simmons Foods Inc. However, feed costs remain relatively low, underpinned by low corn costs despite a recent rally in soybean meal prices (in response to the Argentina drought). Soybean meal prices did fall by about 10% following the news of the tariffs but have since rebounded to near $380 per metric ton. More importantly, other feed commodities like corn remain well below $4 a bushel, which should keep feed costs in check for poultry producers. Therefore, we don't believe price discounting will materially weaken poultry producers' profits and pressure ratings.

Ratings Impact

We have made no rating changes so far in response to the heighted trade tensions between the U.S. and China. We believe the risk to ratings is more pronounced for grain originators and processors than for the protein producers, primarily because their earnings have already been under pressure. In addition, sales volumes are more trade dependent and typically several products within their portfolio mix face tariffs (e.g. corn, wheat, soybeans, and ethanol). Still, we believe any short-term margin impact should normalize as markets adjust, while product and regional diversification are additional mitigating factors.