Cattle Industry update

Even though the ban has indeed been partially lifted, there are still 4 or 5 other measure the government took during the last 12 months that continue to keep the prices depressed about 40% for cattle that is not being exported (our case).
From March 06 until now mainly 5 measures where taken by the government that went in direct detriment of our investments: raised export duties by 10% and remove a subsidy (reimbursement) of 5%, exports ban, imposed a minimum slaughtering weight of 280 kilos that then was changed to 300 kilos (i will come back to this later because it was very impactful) and finally they simply intervened the spot market with a list of maximum prices. Last but not least the price of corn (thanks to ethanol, bad
weather in the Midwest of the US and who knows what else) increased exponentially
(corn was the main input). all this happened in the span of just 6 months. In an industry where you need time to plan, where the minimum fattening time is at least three months if intensive and 8 -12 months if extensive (which is the stage where your cattle was at the time of the measures) the way these events took place makes it impossible to predict said events which would have allowed an investor to have enough timely information to make decisions.

The slaughtering weight limit changed the business model almost completely. the whole model was based in fattening cattle up to about 260 kilos. The market for this category called "bolita (little ball)" which was between 240 and 260 kilos approx was eliminated overnight with the strike of a (presidential) pen. This meant that the feedlot model (intensive corral corn fattening) which is based in a "conversion rate formula" suddenly was no longer possible because that conversion rate (of 8 kilos of corn per each kilo of beef gained) is only profitable up to around 260 (+-) kilos. beyond that the animals start eating more corn to produce the same kilo of beef but the costs of the extra corn eats away the margins.  So all the plans now had to be rewritten and figure out a way to make the best out of this situation. The operators (Ganadera Mallin y Piedra) then decided to take all the animals to the
open range for extensive breeding which takes at least eight months but can last for up to 3 years depending on the age of the cattle but it needs no feed except for the grass. In the meantime the prices in the market have collapsed and the expensive (now sunk) costs that were incurred to feed them (corn and concentrate and the like) can not be recuperated at these price level. While all this was happening and while
everybody involved in the industry was hoping that this was the last intervening measure, new measures would come into play and would make things worse. Should operators have informed investors while all this was happening? probably, but nobody expected this to unfold like this and so fast.

So what happens now? it appears the storm has passed and now its time to rebuild. A couple of weeks ago the Agriculture Minister was sacked (due to the conflict between the government and the producers) This is the first good news in almost a year and a sign that there is political will to change the situation, may be because it is election year and they don't wont the farmers against them?. There have been attempts to re-establish the talks and they announced some measures that if and when
implemented they should have some positive impact in the cattle industry. Said measures have to do with increasing subsidies and reducing intervention in the Liniers spot market (price controls and such) but have not addressed neither the export ban issue nor the high retentions (export duty) just yet, which means that we have to wait an see how much will this changes really impact on the prices. For now they are still very depressed and there have been very little change. not enough to justify selling anything yet. It could take a year before prices accommodate again. But it is also true that these whole ordeal has been a disincentive for a lot of farmers and those who could have switched from cattle to grain, which in the long term should mean lower supply of beef and higher prices.

In my opinion there has been no negligence from the part of the operators but rather a very unexpected and unusual set of measures (war like) from the government against a sector of the economy that has (unfortunately) a high impact on inflation. The whole industry has seen their profitability gone this year due to this very adverse conjuncture.

I nevertheless agree and empathize with investors opinion with regards to this entire ordeal. I am not going to repeat in this report the plethora of attacks the Industry has had to endure in the last 12 months because i have gone in great detail in previous reports about it and at this point i think you are fully aware of the complexities of this entire industry wide situation (operative words are: industry wide). This is not a problem exclusive to one investment in particular.

The life cycle of cattle growing is at least 3 years (from the moment they are born) if you want to eat young steer and can go up to 5 years if what you are selling are cows. This means that the cattle can still remain in the farm for quite some time before it needs to be sold.

Before these set of events cattle fattening was indeed a great opportunity and nobody in his right mind could have ever predicted that the government would start a war against it. This is to say that investments have been lost. it will just require a bit of time and patience to get it back.

For now it appears investors will have to wait a few months before the cattle can be sold at least at close to break even prices.

Cattle Industry lock-out

A few weeks ago the cattle industry finished an unprecedented 9 day "lock out" and second strike of the year - the first one was last July-, due to the disorientation and preoccupation - caused by the continued official interventions in the cattle industry -, that has suffered in the last few months, the exports ban, a depreciation as consequence of the ban of 35-40% in the price of the kilo vivo, reduction of the slaughtering weight, and maximum prices imposed by the interior commerce minister, Guillermo Moreno, in the (supposedly free) spot market (Mercado de Liniers). In short, the market is intervened.

The paradox is that what would have been a blessing in any other industry or market, the fact that raising international prices would result in higher prices (and profits) for the local breeders, ended up being a curse. What happened was that the government understood that the export boom in beef was responsible for pushing inflation higher, due to the high weight of beef in the Consumer Price Index CPI, and decided to clamp down on inflation by implementing anti market measures against the cattle industry such as the elimination of the 5% reimbursement of the export duties, the increase of export duties from 5 to 15%, the exports ban, etc...

Here is a chronological table describing in detail the interventionist policies implemented by the government in the last few months and which resulted in loss of profits and the impossibility to operate under normal and predictable circumstances in the Argentine cattle market and which had a direct impact in the returns of our investments. I put next to the event the approximate effect in the industry returns, from said measures.

Reimbursements and Export Duties:

- 21/12/05   The then minister of finance, Roberto Lavagna, imposes the minimum slaughtering weight at 260kilos and 10 days later he suspends the 5% reimbursements n export duties. Impact on industry profits = -5%
- 18/01/06    The government decides to increase beef export duties from 5 to 15%. Impact on industry profits = -10% due to the fact that this increased duty meant a disincentive to export and therefor increase supply in the local market pushing prices down.

Exports:

- 08/03/06   The government imposes a ban on beef exports to stop the increase on beef prices and their effect on inflation. Impact on industry profits due to oversupply in the local market = -20%

Do not buy beef!

- 14/03/06     Kirchner asks the Argentine people not to buy any more beef unless prices go down, Impact on industry profits = 0% nil. Argentines consume beef just as much or even more than before.
- 27/03/06     First rural demonstration, in Salliquelo. Days later another one takes place in Trenque Lauquen.
- 06/04/06     Government agrees with producers, slaughterhouses and meet packers on reduced prices for 11 popular cuts.

Meet Moreno:

- 13/04/06   Gulliermo Moreno, Interior Commerce secretary starts implementing control measures to curb the price increases. Imposes maximum prices below producers break even. Impact on industry profits = -5%

- 26/05/06   Government starts freeing up the ban to export beef. impact on industry profits = +5%

The first strike:

- 12/07/07     CRA announces the first rural strike against Kirchner's administration.
- 17/11/06     The government intervenes the beef market again and new maximum prices list are imposed. Impact on industry profits = -5%

In short, the battery of interventionists policies imposed by this government have cost the producers (and us) a loss of profitability between 30 and 40%. Just to have an idea, in todays Argentina to produce 555 kilos per hectare , the costs are U$440. With this scheme, which yields a net income of U$416.3 , there is a negative return of U$23.8 per hectare. When producers obtain negative returns that means the operators can not cover their fix or infrastructure costs. These costs are however
inevitable if they expect to continue with the enterprise. This means they operate at a loss until the prices increase enough to justify start selling cattle again. Selling before this level would mean the loss of capital and hence the investments. This is why most operators have tried not to sell any cattle and the reason why most investments have been paralyzed.

Foot-and-Mouth disease outbreak in Argentina

As some of you may already know, authorities in Argentina have reported an outbreak of foot-and-mouth disease near the border with Paraguay. This same thing happened to Brazil last October 2005.
The National Service for Food Safety and Quality said it had found some 70 cattle showing signs of the infection in a district in the province of Corrientes, Argentina and they said that the latest outbreak was isolated and that its origin was still unclear. Because of this outbreak, more than 3000 heads have been sacrificed and they have sealed off a 20 sq km area to contain the disease.

For those of you who are not entirely familiar with Foot-and-mouth, it is a highly contagious (for animals) illness that affects cows, sheep, pigs and goats. It does not harm humans, but it can definitely  hamper the meat trade between nations.

The question all of us who are involved in cattle growing must be asking right now is: How is this going to affect our investment?

To understand the real implications of this, we need to take a look at a few numbers, to wit:

Argentina, the third largest exporter of beef in the world, exports around 20% of its yearly production equivalent to approx. 600,000 tons of beef out of the 3.2 million tons of beef that are produced every year. The other 80%  of course is consumed locally at an average of about 70 kilos of beef per capita a year. Argentina is by very far the largest consumer of beef in the world on a per capita basis. Second comes the US at a much lower 43 Kilos per year (per capita).

Argentines complain regularly (it is in every newspaper's front page) at the current price of beef. Which means that if the price was lower, demand would be even higher than the 70 kilos per year.

The 20% that Argentina exports per year represents to the national economy U$1.4 Billion approximately or 0.7%  (less than 1%) of the yearly GDP of approximately U$200 Billion.

Out of the total Argentine current beef exports, approximately 2% comes from the province of Corrientes.

Now, most of Argentine's beef largest foreign buyers have decided to "regionalize" the 6 month ban imposed on beef trade (same as they did with Brazil) and limit it to the 1 district in Corrientes where the outbreak was discovered and the 7 districts that  could have been affected (where the 3000 animals where slaughtered). The only exception was Chile, which was the only country not to regionalize the outbreak.
Chile buys the equivalent to U$50 million a year. Corrientes accounts for less than 2 percent of Argentina's overall beef exports. Meat from other regions of Argentina which are free of FMD can continue to be exported.

Now one may wonder... why would any country (Russia, EU, Israel, etc..) decide to regionalize the outbreak and accept beef from the rest of the affected country (be it Argentina or Brazil)? The answer is twofold:
First, they trust that the problem has been properly dealt with, duly informed and contained in a very timely manner (as opposed to concealing info about the outbreak and letting the world try find out and decide what measures should be taken). The EU Commission praised Argentina for having taken "rapid action" to prevent the disease from spreading into other areas. Second, beef is a limited non-fungible commodity. There is only so much of it and there are almost no other countries that could pick up the slack (when a country like Brazil or Argentina falls off the market) and supply beef to the rest of the world overnight. Cattle growing is a biological business and the cattle cycle takes 3 years so if these things are not planned ahead, there is very little that can be done to compensate for the shortage.

What does all this info mean to us? According to the Argentine government it means that, for the next 6 months, there could be a decrease of approximately 15% in beef exports which could translate in a decrease in the price of beef of about 5%, that might or might not be transfered to the final consumer. After the 6 month ban period (standard in this kinds of outbreaks), and provided the Argentine government does a good job at recuperating the credibility and trust of the foreign markets, trade should go back to normalcy (same as it was before the outbreak). This means that we could expect a small decrease in the returns we should obtain in the next 6 months or so. Said returns should recover after the ban has been lifted.

Can the ban last longer than 6 months or can the buyer countries decide to go with their money somewhere else? Could be, but this scenario is very unlikely. There is a deficit (shortage) of beef in the world, hence its high price, and the world market can not afford to lose the 1st and 3rd largest exporters of beef in the world (Brazil and Argentina) even if it is one at a time, let alone both at the same time (specially now that new outbreaks were discovered in Brazil's Matto Grosso as recently as this week). There is simply no other countries that can supply the shortage. In addition to this, the world is starting to get seriously hit by the Bird Flu (aka the Chicken Curse), in Asia and now also in Europe. Unlike Bird Flu, FMD does not affect humans and is much easier to contain.

Russians and Europeans will have no choice but to lift that ban as soon as possible unless they expect their people to either eat potatoes for the rest of the year or have them pay 100 euros the kilo of beef. Both highly unlikely scenarios.

Those investors who decide to stay put and let the 6 month ban pass might have an opportunity to recover any decrease in their returns from this round due to the FMD.