How Will the Drought Affect Consumer Food Prices?

This morning's USDA report on crop production revealed that projections for corn production are being revised down from June estimates as a result of the drought in the Midwest, the revisions were significantly more than expected. Over the last 30 days the price of corn is up 18.9 percent.

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This big move is sparking concerns that food products that use corn will see price increases as manufacturers pass cost increases on to consumers

Corn is one of those products that's in many of the items on grocery store shelves including cereals, chips, and packaged foods. Corn syrup is used in soft drinks and corn is a primary feed source for livestock. Given its ubiquity, there's good reason for concern over pricing.

CEOs questioned about commodity cost increases seem to be remaining relatively calm. For example, Ken Powell, the CEO of General Mills, said in an interview Tuesday that the company expects its prices to remain stable. He also stood by its forecast for cost inflation of 2 to 3 percent this fiscal year.

Powell also said that General Mills is about 50 percent hedged on commodity costs for the fiscal year. In fact, hedging is a strategy that many companies employ to try to cope with commodity volatility.

How much each company hedges "varies and [is] highly guarded info" according to Jonathan Feeney, Managing Director, Food/Beverage at Janney Capital, "but 50 percent exposure about six months out is a good rule of thumb."

Grocery stores have not seen direct price increases from the drought yet, however should the severe weather continue throughout the summer, manufacturers might be forced to take action.

A wait-and-see approach seems reasonable, given the fact that price changes at the grocery store don't take long to implement, increases on "non-seasonal items can happen almost immediately," Feeney said.

Should companies implement price increases it could trigger some interesting consumer trends. For example: Consumers might switch to generic brands, buy cheaper cuts of meat, or cut out the extras all together, like junk food. Package volumes could also shrink; that's one way to increase prices in a less obvious way.

With respect to the switch to generics, it may not be as enticing as some suspect.

"Trade down to store brands typically responds to gaps, not levels. If store brands are raising prices — pushed by costs — then not necessarily," Feeney said.

And remember, food products are items that people cannot live without, they will be prioritized in household grocery budgets and compensated for with cuts elsewhere.

"Food costs peaked last August, then declined sharply until about 8 weeks ago - [they're] now whipsawing back up. People have to eat so, in aggregate, the level of prices has no impact on demand, but volatility makes it harder on the food chain," Feeney added.

However, the threat of rising food prices doesn't just impact the consumer. Investors are watching food related stocks closely to see how they will respond.

At this point the analysts don't seem to be hitting the 'sell' button just yet on names like General Mills, Kraft , Sara Lee, JM Smucker , or Kellogg . They also don't seem to be dramatically changing their calls on protein producers like Hormel, Tyson and Smithfield — but if the current weather trends continue over the next month the situation could change.

"I don't think retailers are expecting price increases right now, and volumes are very poor in certain spots — so I think this round of pricing, if more were needed, would be particularly tough" Feeney said.

- By CNBC's Jackie DeAngelis

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