Mean Green

There are a lot of things to distract the investor in today’s climate of news driven swings on the stock market. Clearly progress on a rescue package for the country’s financial services sector is dominating proceedings at the moment. Supply of capital and credit are of major concern. However, supply destruction as well as the insatiable and refined appetite of the developing world are at the root of a crisis of a different kind.

In this case, we are referring to agriculture. Feeding an ever larger and more affluent world population is putting a strain on supply which in turn is driving up prices. In addition, the rise of the biofuel industry is adding to the robust demand side story. Yet weather, access to fresh water and diminishing areas of arable land are among the factors hampering the supply response. Add to this our bearish view of the US dollar and an anticipated shift in government spending priority and the outlook for higher food prices is compelling in our opinion.

The US is the world’s biggest producer of two of the world’s staple commodities. In the case of corn, the country accounts for approximately 70 percent of global exports and approximately 40 percent for soybeans. In our view, as we will see below, both commodities are set for an increase in price.

This month, the US Department of Agriculture (USDA) warned of a lower than previously expected corn harvest courtesy of an arid August. In addition, the USDA commented that harvests for corn will produce 1.8 percent less corn than forecast last month, while the soybean harvest will drop 1.3 percent.

While US harvests yield less and less, the US dollar is set to purchase less and less.

Despite the recent bout of dollar strength, the bailouts of Fannie and Freddie followed by AIG and now a massive $700 billion rescue package present a more accurate harbinger of things to come. The Fed may have resisted a rate cut this month in a bid to control inflation, but the potential inflationary impacts of recent bailouts should not be underestimated. And the resulting weaker dollar will in our opinion only serve as rocket fuel for commodities prices.

The flood of US dollars circulating around the world economy is only matched by floods of a literal kind which seem to batter the US on a regular basis. If it is not Gustav, it is Ike.

Whether or not global warming is to blame the fact is that the planet’s climate is becoming increasingly volatile and acute. Droughts, severe winds and floods are hitting the headlines on a more frequent basis. These events, more so than for other goods and services, can have a significant influence on agricultural supply.

Indeed, the supply crippling hurricanes which are erasing the Midwest grain crops are precisely the kind of natural disaster that, under many climate forecasts, will become routine a few decades from now.

Hurricane Ike for example made its effects felt far beyond the Gulf States. It dragged its winds and rains up the Mississippi River Valley and across the eastern ‘Corn Belt’, flooding or flattening crops.

Supply is struggling, but that is just one side of the equation.

Arguably the main force behind the soft commodities juggernaut is the growth of the world population. It is anticipated there will be 9 billion mouths to feed on the globe by 2050. And no matter the economic climate, the population has to eat.

Not only is population soaring, but many of the newcomers are wealthy enough to eat meat. Given that it takes an average of eight pounds of grain to make a pound of meat, the dietary requirements of the world’s burgeoning middle class is resource intensive.

While an economic malaise presides over the western world, over in the East it is business as usual. The Chinese and India freight trains continue to race ahead as economic growth is supported by both global AND domestic demand.

In China, (where annual GDP growth could fall as ‘low’ as 9 percent) is it estimated that 500 to 600 million people are set to relocate into cities over the next 10 years. China’s urbanisation represents the single biggest mass migration ever and is a sign of the burgeoning prosperity within the country.

As a result, current levels of demand for refined food are soaring while production levels are struggling to keep up.

Adding further fuel to the fire, the US has a desire to reduce its dependence on oil whilst stepping up the use of biofuels. So as the need to feed the burgeoning human population puts strain on supply, the search for alternative energy is exacerbating the situation.

We are far from convinced that ethanol is the answer to soaring energy costs but as the price of oil remains high, the pursuit alternative sources of energy continues at pace. Doubts have arisen about ethanol’s ability to lower net CO2 emissions (processing is energy intensive), and the diversion of crops to biofuels has contributed significantly to higher food prices.

The question of whether biofuels can be produced in a manner that does not send food prices shooting up, and brings an environmental benefit, is crucial to the future of the entire nascent biofuels industry.

For the time being, the alternative energy industry is playing its part. But there are additional factors.

Global water shortages are adding to the problem. Food production is highly water intensive. And according to the UN, agriculture is the number one consumer of freshwater. And looking ahead as the price of water is propelled skyward, we believe food prices will inevitably surge forward.

Scarcity is also a major issue for farmland. The majority of arable land is already under cultivation and with more and more land being used to produce corn for fuel less space is available for food production. And as the level of housing and business development increase, it is farmlands that are making way.

Furthermore, subsidies in countries where production is uneconomic will eventually and reluctantly fall as government spending is diverted away from agriculture. Indeed, right now in America it is not difficult to see that the government has other serious cash calls on its resources.

All factors considered high food prices are set to get even higher. Indeed, the refined appetite emanating from the East ensures that the effects of lagging global supply are set to have an alarming effect on food prices over the long term.

As such, we believe exposure to soft commodities can form an important part of a well diversified portfolio. A relatively ease way to accomplish this is through the PowerShares DB Agriculture Fund (AMEX, DBA), which we have recommended to our own clients in the past.

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