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Top of the crops

FEATURE: Investing in crops is a demanding proposition, but with global demand set to rise, avoiding soft commodities altogether may be the biggest risk, says John Hughman

While most of this issue has been dedicated to commodities of the inedible kind, soft commodities – crops, in plain English – have been leading the price action for the last year or two. Over the past 12 months crops including wheat, sugar, cotton and cocoa have all hit long-term highs, rocketing back towards the levels that sent shivers through the world's economy back in 2007. Has this rampant bull market in soft commodities been driven by speculation, though, as some suggest, or are we experiencing a fundamental shift in global demand for food? The answer is more than likely a little bit of both.

Food fundamentals

Let's start with the fundamental case, which is based on the simple fact that rising affluence and booming population growth in emerging markets is creating a serious supply/demand imbalance that's pushing prices higher. According to the Food and Agriculture Organisation (FAO) of the United Nations, the world population is expected to expand from 6.8bn today to 9bn by 2050, and will require a 70 per cent increase in food production to feed it at an extra cost of more than $80bn a year. If that level of investment falls short, competition for resources will push prices higher.

But why a 70 per cent increase when the population will not rise at anywhere near that rate? "It is not just that there will be more mouths to feed but, with rising GDP per capita, these mouths will require a richer diet, more typical of the dietary requirements of the developed nations today," says analyst Doug Hawkins at research group Hardman & Co in its World Agriculture Report. That, he points out, specifically means more animal protein – and because it requires several kilos of grain to produce a kilo of meat, the demand on agricultural resources is substantially increased.

But is that enough to explain the scale of recent spot price increases? Humanity has so far proved adept at expanding production to keep up with population growth.

That's mainly down to improvements in agricultural technology, with the introduction of better seeds and improved fertilisers steadily increasing crop yields over the years. The increased use of nitrogen fertiliser after the second world war underpinned a 4 per cent annual improvement in yields up to the 1970s, and although the rate of improvement of yield has now slowed to around 1 per cent a year, better plant breeding has the scope to keep gains going.

Innovative companies like Syngenta and Monsanto are at the forefront of this agricultural arms race.

An apparent scarcity of land is, in fact, one of the key justifications soft commodity bulls use to justify the rampant market, but in essence crop technology does create more agricultural land, whether it is reclaimed from sea or desert, or simply good land left fallow at present. There are vast tracts of as yet unfarmed areas in places like Africa, Russia, the Ukraine and Central Asia – according to Hardman there could be as much as 1.5bn hectares that could be brought under the plough, a similar amount to the area being farmed.

That's not to mention developing regions where land is already being farmed in a labour-intensive manner well below optimal production, which will benefit from further mechanisation of their agricultural processes. This process will be accelerated by a shift in small-scale subsistence and family-led farming to ever larger commercial operators.

High prices cure high prices

However, while it is possible to discount the idea that long-term demographic drivers are responsible for high prices, imbalances do exist on a shorter timeframe which can lead to sharp price movements. Grains and cotton have both, notably, seen prices rise sharply this year partly as a result of unusual weather patterns – wildfires in Russia (a key grain producing region), and floods in cotton-growing countries such as Pakistan and China.

Prices can move quickly in the opposite direction, too, because high crop prices also encourage further investment in agriculture – put simply, farmers are more likely to plant – or invest in expansion of livestock herds – when they are guaranteed a good return for their efforts. And when plantings increase or herd numbers rise, prices fall soon enough – as the famous agricultural adage goes "nothing cures high prices like high prices."

Facts & figures

Cotton index +166% (since april 2009)

Bales of cotton produced by India 35m

US cotton produced using gm technology 76%

Average daily calorie intake in china versus the US 68%

Percentage of degraded world farming land 42%

US CPI for food* 218 (*1984 = 100)

The cotton market once again provides a case in point. According to retailer Debenhams, the rising raw material prices that have forced it and others to push through unwelcome price increases may actually have peaked. And the US Department of Agriculture thinks that India – the world's second largest producer – will produce a record 35m bales of cotton this year, with farmers looking to cash in on the lucrative crop by increasing plantings by 12 per cent.

And according to the UN's FAO, food prices in March did fall back sharply from recent highs, with its Food Price Index down 2.9 per cent from its February peak. Sugar led the drop, down around 10 per cent, with oils and cereals also experiencing falls.

However, although farmers may indeed respond to high prices, it's no guarantee of favourable growing conditions, and in the case of many crops the excess plantings this year may just be helping to rebuild stock levels after the poor weather hit harvests of 2010 and the record levels of demand. That means even if soft commodity markets do regain some kind of equilibrium, it will be a fragile one at best. "Low stock levels, the implications for oil prices of events in the Middle East and North Africa and the effects of the destruction in Japan all make for continuing uncertainty and price volatility over the coming months," says David Hallam, director of FAO's Trade and Market Division.

The organisation points out that if, for example, cereal production is not enough to replenish inventories this year, prices will remain firm. Cereal prices are still 60 per cent higher than they were a year ago, while food prices overall remain 37 per cent higher. The USDA notes that although overall cotton planting will rise this year by 15 per cent, that’s less than the market had expected to make up for declining production in other key producing regions Pakistan and China, also the world's largest importer. According to S&P, its GSCI Cotton Index climbed 166 per cent last year.

A trader's market

Those swings are what makes it an attractive market to trade, though – stable food prices might be great for those concerned about food security, but flat markets are a trader's worst nightmare.

And while those imbalances have always existed, it is highly likely that there is now more speculative activity than ever looking to take advantage of fast-moving crop prices, which in turn is exacerbating the volatility. It is intriguing that in a recent speech, Deputy Governor of the Bank of Canada John Murray said that although the growth of emerging market economies can explain most of the upward movement in commodity prices, it can't explain all of it. Nor, he says, can it explain why commodity prices fell back so sharply after the spike of 2008.

But as S&P notes, given that many soft commodity investment products track future-based indices rather than offering exposure to spot markets, they should have little bearing on spot prices because they never make or take delivery of the underlying commodity. "There have been many misconceptions about the relation between commodity investing and commodity prices," it said. "The bottom line in any commodity is that in order to have a long-term impact on price, supply or demand must be directly affected."

Tuck into agricultural trading

If you can stomach the idea that there may still be an unsavoury side to crop investing – that rising prices do indeed create hardships in less well off nations – then it's certainly easier than ever for retail investors, too, to gain exposure to soft commodities, given the rise in vehicles such as exchange-traded commodities (ETCs). ETF Securities is particularly active in the soft commodities sphere, and .

Despite the fierce debate over whether soft commodity markets are being driven by fundamental demand or speculative activity, it is more likely that, as John Murray at the Bank of Canada says, volatility is simply the commodity market's natural state.

While this uncertainty is what makes agricultural commodities an attractive market for traders, it's also what makes it so difficult to invest in. There are huge amounts of information to keep on top of – crop reports and stock levels – as well as unpredictable weather.

That’s partly why, , investing in the picks and shovels (or, more accurately, combine harvesters) could be a better way to play the agricultural markets than investing in the crops themselves. An alternative would be to buy into one of the many funds that target these companies, one of which, the Sarasin Agrisar fund, was our best performing fund tip of 2010.

Either way, not gaining exposure to agriculture may be the biggest risk of all. John Murray at the Bank of Canada thinks we may have been underpaying for food for many years, and that the real price of food is still well below the level it was in 1970, even though in nominal terms food prices have more than trebled.