Dissecting the Ag business!

You have heard the expression “learn something new everyday.” It’s my motto… well sort of.

Today I learned something new about option quotes on the MX Web site. When you go to the quote box of the MX, you input the symbol for the underlying stock, press OK and get an option chain. The chain provides option prices and implied volatilities. Great stuff.

But, when the underlying stock has moved dramatically, the listed strike prices do not always wrap around the current price of the underlying stock. Notable recent examples include Agrium (symbol AGU) and Potash (symbol POT).

My first thought was that new strike prices had not been set up. In fact they had been, but often with new wrap symbols that cannot be displayed by typing in the root symbol for the underlying stock.

To get around this, you have to type in the root symbol with an asterisk at the end. For example, AGU becomes AGU*, POT becomes POT*. When you do that, you get the complete option chain with the new wrap symbol at the bottom of the page. Of course, this may be old news to everyone else. For me, it was something new.

Dissecting the Ag Business

Early today, POT released their quarterly earnings. The numbers were strong, although they were slightly less than consensus estimates.

To be fair, consensus estimates in this sector is imaginary. As a headline grabbing business, agriculture is still in its infancy. Analysts are still shaping long term business models. Investors are quick to pull the trigger on news… good or bad. Which means short term sentiment driven spikes in volatility.

Options on AGU (implied volatility 67%) and POT (IV 58%) are positioned within the top quartile of implied volatilities in the Canadian option market. For opportunistic option traders, that can spell opportunity or… disaster.

Before getting to that, some background. We know that the real business of AGU, POT and US based, Mosiac (MOS), is to enhance crop yields. That’s not news.

What is new, is the surge in demand for food staples. Form a number of quantifiable sources. The search for bio fuels has increased demand for corn and soybeans. A growing middle class in the emerging markets has increased demand for more protein in their diets. Protein comes from cattle… cows needs to eat. And the circle of life is again complete.

Bottom line… to meet increased demand farmers are willing to pay higher prices for products that can enhance crop yields. Seems like a perfect storm for companies like AGU, POT and MOS.

But there is another side to this. When demand increases, food prices rise. If you are moving up to middle class status, you can probably absorb price increases. No so, with those in the world’s underdeveloped regions. Many of whom can no longer afford the basic staples in life. Where you might afford bread at 30 cents, you cannot possible afford it at 60 cents.

Make no mistake; starvation trumps profits. As it should. We simply need to recognize the risk to companies in the business of increasing food supply. They by definition, have a double edged sword.

Certainly there will be increasing demand for their product (i.e. fertilizer), which will enhance their bottom line. But, there is a point where these companies will not be able to increase prices off-the-cuff. Either morally or politically!

When it comes to food, there is a political brick wall that can stop a price increase in its track. So far, that has not happened. But longer term, the potential inelasticity of prices in this sector, has made it difficult to model a long term value proposition.

That said, I believe this is a sector you should have some exposure to. And with the recent decline in share prices of AGU (price at time of writing $85.22) and POT ($198.90), together with the aforementioned implied volatility numbers, this is probably a good time to write May, June or July cash secured puts.

If you like the sector, consider selling the AGU May 80 puts at $3.50, the AGU June 82 puts at $6.50 or the AGU July 76 puts at $5.00.

The POT May 190 puts at $7.15 look attractive, as do the June 190 puts at $$13.50 and the July 185 puts at $14.10.