While the drought in the U.S. is bullish for crop prices, it’s taking its toll on farmer sentiment, which can be equally important when it comes to equipment buying decisions.

In a July 17 note, JP Morgan analyst Ann Duignan downgraded shares of Deere & Co. from “overweight” to “underweight” because of the “deteriorating fundamentals in the Midwest.”

With the drought now impacting more than 80% of the region, crop yield expectations are diminishing with 2012 drawing comparisons with 1983 and 1988 when corn yields came in 20-30% below trend.

“This year, a 20-30% below trend line yield would result in a yield of about 140 bushels per acre, coupled with lower harvested acres, could result in a 12 billion bushel corn crop vs. the 14 billion bushels initially forecast,” says Duignan. “All else being equal, this would mean an 800 million bushel deficit in corn, implying higher prices will prevail until sufficient demand is destroyed, that is ‘high prices fix high prices.’”

The analyst notes that overall farmer sentiment is deteriorating. “While mathematically cash receipts continue to rise on higher prices, farmer sentiment is driven by both prices and volumes,” Duignan says. “While it is hard to quantify ‘sentiment,’ we have spoken with a number of our farmer contacts in the Midwest and what is different this cycle is: 1. The drought is extraordinarily broad based (>80% impacted); and 2. farmers have been spending at an elevated level for 4-5 years, implying that they can hold off on spending for a season in order to rebuild confidence and cash.”

Also adding to concerns is the impact the falling yields will/is having on ethanol production. Rumors are flying that EPA is getting ready to waive the Renewable Fuel Standard in response to anticipated shortages of corn.

This morning, the Renewable Fuels Assn. issued a statement saying, “There is no justification for such a waiver and the EPA can't just arbitrarily decide to waive the program based on speculation about the impacts of the current drought (http://bit.ly/NwShCX).

“The facts are clear: no evidence exists to support a reduction in the renewable fuel requirements of the RFS. Strong supplies of ethanol in storage, an oversupply of 2.5 billion Renewable Identification Numbers (RINs), and a smaller gasoline market that reduces the actual 2012 RFS requirement to just approximately 13.04 billion gallons are all indicators that the RFS will work in 2012 and 2013.

“We have heard these cries of wolf before,” RFA says. “To be certain, conditions facing American farmers are challenging. However, the market will act to ration corn demand and the RIN mechanism of the RFS will provide a cushion for refiners and other obligated parties to comply with RFS requirements.”

But according to Duignan, “Rationing has already started and we have seen a reduction in ethanol production in recent weeks. In the meantime, ethanol producers are losing money and production is already being curtailed — down 11% last week from a recent high of 920 million gallons per day. The EPA can lower the mandate temporarily, but this would take some time; in the meantime higher corn prices will continue to put downward pressure on production.”

In her note, Duignan concludes, the impact on equipment demand is likely negative. “Year-to-date sales of over 100 horsepower tractors are up 9% and were up 25% last month; combine sales are down 23% but were up 33% last month. We expect weaker sales from August into next spring, at the earliest, as farmers deal with low yields this year and the impact on sentiment into 2013.”