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Russia-Ukraine Conflict Will Test Agribusiness Supply Chain Efficiencies And Consumers' Appetite For More Food Inflation


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Russia-Ukraine Conflict Will Test Agribusiness Supply Chain Efficiencies And Consumers' Appetite For More Food Inflation

Ukraine and parts of Russia are key agricultural producing regions for the global economy. Since the Russian invasion of Ukraine, agricultural commodity prices and other crop inputs such as fertilizers have spiked and remain volatile reflecting fear of supply shortages. Although the impact of the conflict on the agribusiness and food sectors is rapidly evolving, we have summarized our preliminary views of potential impact to companies we rate across the food supply chain.

S&P Global Ratings acknowledges a high degree of uncertainty about the extent, outcome, and consequences of the military conflict between Russia and Ukraine. Irrespective of the duration of military hostilities, sanctions and related political risks are likely to remain in place for some time. Potential effects could include dislocated commodities markets--notably for oil and gas--supply chain disruptions, inflationary pressures, weaker growth, and capital market volatility. As the situation evolves, we will update our assumptions and estimates accordingly. See our macroeconomic and credit updates here: Russia-Ukraine Macro, Market, & Credit Risks.

Agricultural Commodities With The Highest Exposure: Sunflower Oil, Wheat, Barley, And Corn.

Ukraine and Russia together are the largest global exporters of sunflower meal and oil, most of which is destined to the EU and Turkey for livestock feed and edible oil consumption. Although sunflower seeds make up a much smaller share of global feed and edible oils production, they are important commodities in Western Europe and will pressure farm inputs and the price of cooking oil.

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Wheat is the agricultural commodity that has spiked the most since the onset of the conflict with wheat futures traded on the Chicago Board of Trade now at historical highs. Ukraine's government has already announced a ban of exports of wheat, oats, and other staples. Even if the ban is lifted, prices are likely to remain high due to concerns that Ukraine may not be able to plant this year's wheat crop, which makes up about 10% of global wheat exports. Russian wheat production (closer to 20% of global exports) is unlikely to be disrupted and key trade partners such as China, the Mideast, and Africa are likely to continue importing. However, the sanctions on Russian wheat will inevitably lead to some reallocation of the global wheat trade flows. Most large importers are already scrambling to secure future supplies and are tapping into longer dated forward contracts, leading to further price escalation.

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Coarse grains like corn and barley are also grown out of Ukraine. Corn inflation will affect already high feed costs, while higher prices of barley will in turn affect food staples and have a modest bearing on some beer brewers' margins.

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While it is unlikely that these measures will meaningfully offset the loss of production from the Ukraine in the short-term, higher agri-commodity prices will encourage additional production by previously less competitive growing regions and farms. Governments across the world are also looking to incentivize more crop and feed production. For instance, EU member states are considering various measures to increase food production such as plans to allow farmers to grow protein food crops for animals on land left fallow or reserved for biodiversity.

Each year, a staggering one-third of food produced globally--worth almost $1 trillion--is lost or wasted, with unconsumed food contributing up to 10% of global greenhouse gases (GHG) in addition to emissions from farming, processing, and other activities. The Food and Agriculture Organization (FAO) estimates (2016) show that, excluding retail and households, about 14% of the world's food is lost between the harvest and retail stages. Higher cost of food products resulting from this conflict, will also lead to a greater focus and collaboration across the various players in the food supply chain and provide additional economic incentive to minimize food waste. For more details see "A Food Industry Reset Can Cut At Least 10% Of Global Emissions," Nov. 17, 2021.

The spike in key fertilizers should boost earnings for chemical producers but increase operating costs for farmers and possibly affect future harvests.  Russia accounts for 20% of global production of potash, a key input into fertilizer, while Belarus is also a large producer. Russian exports of these fertilizer types will almost certainly be constrained by logistical problems, as well as sanctions. Fertilizer prices remain a significant portion of farm operating costs. Recent historical estimates by the U.S. Department of Agriculture (USDA) place fertilizer costs at between 35%-45% of operating costs for corn production. While a shortage is unlikely to affect 2022 harvests, farmers could be hurt by longer-term supply challenges or higher prices of fertilizers unless they find alternative sources or substitutes, which we believe is unlikely.

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The conflict will exacerbate existing fertilizer supply constraints, which had driven prices to record or near-record levels in recent months. We expect prices will remain high by historical standards through most of 2022, at the very least, even if some nutrient prices decline from recent peak levels. Nitrogen fertilizer producers in particular may need to raise prices further to cover increasingly expensive natural gas. The runup in prices could strengthen earnings at U.S.-based fertilizer producers, such as The Mosaic Co. and CF Industries Holdings Inc.

The impact of higher fertilizer costs will reverberate down the food supply chain. For example, Russia supplies close to 30% of Brazil's fertilizer imports. While most planting for the 2022 harvest has been completed in Brazil, 2023 harvests could be affected. Farmers have increased stores of fertilizer as a buffer to supply bottlenecks observed in 2021, but in light of potential scarcity due to the conflict, are already seeking supply alternatives for late-2022 grain planting. Potential substitutes could come from Nigeria, Morocco, and Canada. Alternative farming processes using biomass biproducts of sugarcane crushing and poultry production could supplement conventional fertilizer. Finally, farmers can typically reduce fertilizer by up to 15% in one year without damaging crops' yields, but further reduction or doing so in consecutive years can impair the crops' productivity in the long term. We believe the majority of the companies we rate are well-prepared for this year's planting and harvests, and they could even benefit from higher prices.

The Impact On Operations

Direct operational exposure to Russia and Ukraine is not material for most global agribusinesses, which have shuttered operations to avoid jeopardizing the safety of their employees.  The issuer credit ratings of agribusinesses based in Ukraine, such as Kernel Holding S.A., Ukraine's largest sunflower oil and grains exporter, and MHP SE, Ukraine's largest poultry meat producer and exporter, have been lowered to 'B-' and placed on CreditWatch with negative implications because of the conflict. This reflects material risks to these companies' creditworthiness stemming from the deterioration in the economic and financing conditions in Ukraine and our recent revision of the country risk assessment on Ukraine to very high from high previously. In addition, these companies suffer from material operational risks stemming from logistical bottlenecks, disruption in supply chain, production, and trade flows.

Most other global agribusinesses we rate have somewhat limited operational exposure to the region. Manufacturing, processing, and storage facilities in the region also comprise only a small fraction of most these companies' physical plant assets, minimizing direct exposure to write-downs or lost title from potential nationalization of any assets in Russia.

Ukraine and Russia accounted for about 3% of Bunge Ltd.'s assets and a similar percentage of total EBITDA is attributable to operations in those countries. We believe Cargill Inc. and Archer Daniels Midland Co. derive similar or lower percentages of total EBITDA from their operations in the region. Louis Dreyfus Co. (LDC) and Viterra Ltd. also do not have a material exposure to the Black Sea region where they source primarily wheat, barley, and vegetable oil. Their asset footprint is not large as they have few processing facilities. These global merchandisers are geographically well diversified with a global reach and sourcing diversity across main agriculture growing regions. For example, LDC can source wheat from North America, Latin America, or Western Europe to offset a deficit from the Black Sea region. That said, sourcing large volumes of sunflower oil outside Ukraine could prove challenging so some businesses could suffer from lower volumes traded. We take into account the good commodity diversification of LDC also, being a large trader of coffee, cotton, and rice.

Despite the volatility, disruption to existing trade flows presents an opportunity for grain and oilseed traders and processors.  Global agri-commodity merchandisers should benefit from the high price volatility affecting most soft commodities like corn, wheat, and barley. We believe demand from emerging markets like China, the Middle East, and Africa, which are net importers of grains and oilseeds, should remain steady due to population growth and prioritization of food safety for governments to avoid social unrest. Food processors and large global food manufacturers will want to secure raw materials ahead of customer deliveries, which will provide a favorable pricing environment for grain originators to profit from. Markets are signaling this sense of urgency by bidding up spot prices to levels that haven't been seen since the financial crisis of 2008.

Nearby futures prices for key agricultural commodities are all trading at a premium over later dated contracts as buyers are willing to pay more for prices today to secure supplies given the risk of future shortages. Although traders' typical way to profit through storage margins (referred to as a carry trade) where supplies are secured at harvest and held for future delivery at higher prices are not present in the current tight supply environment, today's market conditions nonetheless favor global grain merchandisers like ADM, Cargill, Bunge, and LDC, which have the distribution infrastructure to deliver in-demand commodities. That said supply-chain bottlenecks could increase logistics costs while other factors like local trade finance availability and unforeseen export restrictions could hurt trading profits.

Processing margins are likely to remain favorable too, albeit with a fair degree of risk given rising input costs. Higher commodity prices coupled with continued strong demand should lift revenues in 2022. Moreover, reduced processing capacity for edible oils and meal if Ukrainian plants remain closed would support higher crush margins elsewhere where global grain originators are well positioned. The nearby futures for soybean crush margins have almost doubled since the onset of the conflict. Still, higher feedstock costs (notably grains and oilseed), rising energy prices, and increased labor costs are headwinds that could crimp margins. In addition, should food inflation accelerate, demand for edible oils could start eroding in more price-sensitive channels such as foodservice as consumers reduce dining out to conserve cash.

Feed and protein inflation are also likely to persist, in turn pressuring processors' margins, but strong global pricing may benefit beef margins.  Livestock costs are likely to continue to increase as key commodities for feed such as corn and soybean meal prices have spiked together with other agricultural commodities. Feed constitutes about 40% of raising costs for chicken and hogs. Feed cost for cattle in feedlots (as opposed to grazed cattle) are similar. In addition to higher feed costs, livestock supplies remain tight globally so the meat price inflation from strong global demand (especially out of Asia) of the past few years will likely persist and could offset the additional cost pressure. Beef packers in particular may continue to benefit to the extent farmers further sell down their herds in response to higher raising costs. Although we expect packer margins to normalize over the next several years as farmers rebuild their herds making supplies tighter, we believe the turn in the cycle may be delayed beyond 2022. So far, live cattle costs traded on the Chicago Board of Trade have fallen by about 8% since the start of the conflict in Ukraine, suggesting lower cattle input costs may continue to support strong margins for U.S. beef packers in the upcoming summer grilling season. Margins for more feed-sensitive proteins like poultry and pork and in other geographies may not benefit as much. Moreover, margins in local economies that purchase feed commodities in U.S. dollars may further face margin pressure if the dollar remains strong.

Consumer Goods Companies And Retailers' Margins Could Weaken As Disposable Income Shrinks

In our view, branded consumer products companies typically have a moderate to high ability to pass costs on to consumers. However, the wide array of competing brands and products often mean pricing action is taken typically after a lag and only after consideration of several alternatives. These include implementing cost efficiencies elsewhere in the value chain, promoting less, and modifying, rationalizing, or reconfiguring the product. Higher energy and commodity costs resulting from the Russia-Ukraine conflict will exacerbate the inflationary pressure these companies are already facing due to pandemic-related supply chain bottlenecks and elevated demand for food at home. These pressures have contributed to negative rating actions on several U.S.-based packaged food companies, such as Treehouse Foods Inc. and B&G Foods Inc., as they have struggled to raise prices apace with cost inflation. To date, the ratings impact of inflation has been limited on consumer goods issuers in other regions. Europe-based consumer goods companies exposed to food commodity prices, such as Unilever PLC, Danone S.A., and Nestle S.A., have reported strong underlying sales growth on back of price increases and solid demand, despite a significant rise in commodity and input costs.

Retailers have benefitted from extraordinary demand from consumers who continue to enjoy elevated savings and a strong jobs market. The vast majority of companies we rate have been able to sufficiently pass on elevated costs from suppliers, freight, transportation, and labor. However, retailers' margins are typically thin and most face tough competition. Throughout the pandemic, brands have continued to outperform retailers' private labels, and demand has not significantly dropped from recent price increases. That said, we believe the Russia-Ukraine conflict will worsen inflation, especially at the gas pump, causing consumers to trade down, hurting volumes for branded players and benefitting private labels. Consumer product companies and retailers will undoubtedly engage in tough negotiations on retail selling prices. We expect the pain from continued higher input costs and pressure on margins will cascade across the chain from producers right through to the retailers.

While we don't anticipate the Russia-Ukraine conflict to result in significant negative rating actions in the retail universe at this point, we are closely monitoring for signs that companies could have trouble navigating the indirect impact of higher commodity prices and the direct impact of lower consumer disposable income. Discretionary categories such as apparel, home furnishings, and specialty retail could be at risk if consumers' financial health worsens meaningfully. While deep discounters such as dollar stores and off-price could enjoy the trade down from grocers and department stores, fierce competition and their relatively price-sensitive customers could make it difficult to pass on inflationary cost pressures. We expect the most vulnerable consumer product companies and retailers to be those with highly leveraged balance sheets and relatively weak business risk profiles, especially due to lack of diversity, brand power, operating cost flexibility, and supply chain bargaining power.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Chris Johnson, CFA, New York + 1 (212) 438 1433;
Secondary Contacts:Raam Ratnam, CFA, CPA, London + 44 20 7176 7462;
Sarah E Wyeth, New York + 1 (212) 438 5658;
Flavia M Bedran, Sao Paulo + 55 11 3039 9758;
Paul J Kurias, New York + 1 (212) 438 3486;
Maxime Puget, Paris + 33(0)140752577;

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