As assets all around are taking a tumble, agriculture is showing signs of life. But just how healthy are these green shoots? Tim Bennett finds out.
The ‘great recession’ has been painful for investors in most asset classes, and agricultural (‘soft’) commodities have been no exception. Last February we warned readers to be wary of a bubble in softs when the price of wheat shot up by 25% in a single day after Kazakhstan announced it would impose export tariffs. Now that this bubble has popped along with the rest of them, evidence of the fall-out is everywhere.
Schroder’s Agriculture Fund, for example, is valued at around $1.5bn, down from $6.4bn at the time of our warning. Land prices in the once red-hot Ukraine have tumbled: at the start of 2008, leases of between two and 20 years were being sold for around $1,000 per hectare; now they’re more like $250 per hectare, say consultants Brown and Co. And the broad Rogers International Commodity Index fell by around 50% in 2008.
But recently, agriculture has shown signs of life – corn prices, for instance, have risen by around 26% since December, while soy beans and wheat are up 20% and 10% respectively. The US Department of Agriculture (USDA) reports that despite falling profitability, total farm income will still be 9% higher this year than the ten-year average of $65bn. And now last year’s froth has been largely blown away, it’s clear that the long-term fundamentals of growing demand and tighter supply are intact.
The ghost of Malthus
The demand-side arguments put forward by prophets of global population doom are hardly new, but they’re still relevant. Thomas Malthus (1766-1834) warned in 1798 that humans were breeding faster than they could grow food, and we haven’t grown any less fond of reproducing since then – the US Census Bureau reckons we’re adding new bodies to the food queue at a rate of around 75 million a year, with the rate of growth expected to rise until 2030. Between 2000 and 2012 a billion more of us will have been born, taking the total global population up to around seven billion.
Not only does agriculture have to feed all those extra bodies, but many want better diets that include more meat. As Bedlam Asset Management puts it: “Three-quarters of the world’s population now has enough money to eat like us; and they are”. Since 1985, average Chinese meat consumption per head is up around 2.5 times. JP Morgan estimates it could grow another 50% by 2020.
Consultants at McKinsey reckon around 1.1 billion people will join the middle-class income groups in China and India between 2005 and 2025. Most want a much meatier diet. Given that it takes around 7kg of grain to produce 1kg of beef, the demand pressures on agriculture are huge.
At least demand is fairly predictable. But that’s not true of supply. For reasons we’ll discuss in a moment, global grain supplies have fallen from 342kg per head in 1984 to 302kg in 2006. The combined average grain stock levels of Australia, Canada, the US and European Union dropped from 47.4 million tonnes between 2002 and 2005 to 27.4 million in 2007. Most important of all, between the world’s five largest grain exporters, the ratio of stocks to consumption-plus-exports has fallen to 11% in 2009, below the ten-year average of more than 15%. As a result, food prices are proving sticky – in Britain, for example, while food-price inflation eased in April, it was still running at 8.6% a year, compared to a 1.2% fall in the retail price index.
The wrong kind of weather
So why is food supply under such pressure? First off, we can blame the weather, with 2009 looking to be “a humanitarian disaster around much of the world”, according to Eric deCarbonnel on Bestwaytoinvest.com. His roll call of countries plagued by crop-unfriendly weather is a long one. Northern China is still suffering its worst drought in 50 years, threatening the entire wheat crop in eight of the region’s ten provinces. Between November and February this year, Henan – China’s largest crop-producing province – saw its least rainfall since 1961.
And Australia has been in drought mode since 2004, with around 40% of its growing regions experiencing the worst conditions for 117 years. In the US, California is facing its worst drought in recorded history, resulting in forest and bush fires. In South America, emergencies have been declared in Uruguay, 50 rural districts of Chile, Bolivia and Paraguay. That’s less than half of the countries on deCarbonnel’s list, but you get the picture.
The yawning yield gap
The weather might not be a problem if boosting supply by other means was simple – after all, farmers have had to cope with bad weather since the dawn of agriculture. But increasing supply is harder than you might think. There are two obvious solutions: bring more land into use, or use what we have more efficiently. For decades, both happened. Between 1825 and 1927, forests and prairies were cleared, notably in Russia and North America, doubling the land available for farming. The pace then slowed, but between 1927 and 1960 global arable land still rose from a billion hectares to around 1.4 billion.
Mechanisation also meant agriculture became more productive, with machine oil replacing human sweat. However, from around 1960 the world has not gained much, if any, new arable land. That’s not to say the same fields are always furrowed and ploughed. It’s just that for every new acre, an old one is lost either to degradation (in developing countries the problems range from over-using fertiliser to poor irrigation techniques), or expanding cities.
So what about increasing yields? After all, between 1975 and 1986, rice yields rose by 32% and wheat yields by 51%, says Mark McLornan in the Gloom, Boom and Doom report. The so-called Green Revolution brought better seed varieties, wider use of fertilisers and pesticides, and improved irrigation techniques.
But that revolution is largely over. China, the world’s largest producer and consumer of grains, shows why. Even though average fertiliser usage per acre is three times the world average, and 75% of its cropland is under irrigation, “they don’t even achieve average yields”. In global terms, that sort of statistic explains why, having risen an average of 2% a year between 1970 and 2000, global productivity (measured by the USDA as the average aggregate yield) declined by around 1.1% a year between 1990 and 2007 – and is expected to keep falling. Wheat yields have been virtually static since the 1980s, even allowing for the impact of GM strains. Falling yields will be made worse this year as credit-crunched farmers cut back on fertilisers.
The ethanol squeeze
But that’s not the only problem. Lorry loads of US corn still end up on US forecourts rather than in supermarkets. This may come as a surprise to anyone who bought into the ethanol bubble, as Scott Brown, CEO of New Energy Capital, admits to Barron’s. “The industry has a black eye financially. It’s been a bit of a poor performer.”
The reason is simple: aggressive targets set by George Bush for ethanol use in fuel, plus a surging oil price that peaked at $147 a barrel, led to too much capacity being “built too fast”. Of 175 corn-based ethanol production units, around 150 are still running and 25 are idle. You can’t just switch off these plants to save cash – it costs $200,000 to $500,000 a month just to keep a large plant idle.
Meanwhile, in the past 12 months, spot ethanol prices have dipped from $2.54 a gallon to $1.72, taking the average profit per gallon on average from 50 cents to more like five cents, says TD Bank.
Yet ethanol is far from being a dead issue for agriculture. At its peak last year, the industry was using around 23% of the US corn crop. President Barack Obama is a renewable energy fan and shows no signs of abandoning his predecessor’s ethanol targets. The US Environmental Protection Agency is even considering raising the proportion of ethanol that must be blended into gasoline from 10% to 15% to help beleaguered producers, who also happen to have influential lobbyists in Washington.
Meanwhile, although the oil price may have subsided to around $60 a barrel, it’s still stubbornly high compared to even a few years ago and well above the $32 low it hit in December. The higher it goes, the bigger the interest in alternative fuels. So the knock-on impact for US agriculture looks set to continue. Some analysts expect the corn price – at $4.30 a bushel, around half the peak last summer – to hit $5 within the next few months.
Merrill Lynch summed it up in a recent note: “A pick-up in global oil demand next year could drag millions of tonnes of corn, sugar and wheat out of the food pool into the fuel pool”. So after last year’s lull (when soft prices didn’t even dip as much as some other assets), they advise investors to position themselves for “a second round of food and fuel competition as soon as next year”.
A dead cow bounce?
Despite the compelling demand-and-supply story, some analysts smell a rat. Isn’t the recent rise in grain prices simply part of the bear-market rally that has boosted oil prices and driven the FTSE 100 up by around 30% since the start of the year? And in agriculture, this rally has been compounded by a Chinese buying binge that has seen US soy-bean sales to the country rise 42% year on year. Remove both drivers and prices could collapse, the sceptics argue.
Some caution in the near term is indeed warranted, says Bedlam. Prices of individual soft commodities may dip should investors get nervous and flee risk, which is why we would avoid buying into specific individual softs. However, as Dan Basse, President of AgResource puts it, any dip is likely to be short-lived: “Nine to 18 months from now, I think we’ll be right back in the food inflation cesspool”. Record recent shortages of grains would have seen to that even before central banks started to print money. And as more and more dollars chase fewer and fewer commodities, rapid price rises for ‘real’ assets become ever more likely.
What to buy
You can get exposure to crop prices themselves. One of the easiest ways is through the range of exchange-traded commodities (ETC) from ETF Securities. As noted above, we’d avoid buying individual grains just now, but a basket, such as the ETFS Agriculture DJ-AIGCI (LSE: AIGA), may be a better bet. This ETC tracks the Dow Jones-AIG Agriculture Sub-Index and gives exposure to seven softs, from soy beans to corn to cotton. The annual management fee is a reasonable 0.49% a year.
As for stocks that might profit, those involved in improving crop yields through technology are worth considering. One interesting play is fertiliser – we look at how to profit from that in the box on page 26. Meanwhile, genetically-modified (GM) crops are a controversial area, but as David Morgan of agribusiness group Syngenta (Zurich: SYNN) argues, “we need to grow more from less”.
As Henk Potts at Barclays Wealth Management notes, Syngenta “ranks favourably both in terms of its valuation and its short-term momentum”. Its first-quarter results beat hopes, and while the growth outlook is “modest” this year, it will be “double digit” in 2010, Potts believes. The firm is cheaper than larger rival Monsanto, trading on a forward p/e of 14. It offers a dividend yield of 2.6%, covered 2.7 times, while the price-to-forward earnings growth ratio is just 0.9.
When farmers make decent profits, they tend to buy more tractors and other farming equipment. Bedlam tips the world’s leading agricultural and forestry machinery maker, Deere & Co (US: DE). The shares have halved in the past 12 months, even though the firm beat analyst estimates for second-quarter profits. According to analyst Stephen Volkmann of Jefferies & Co, “the farm business is performing well”. The forward yield of 2.7% is covered 2.4 times. The forecast p/e ratio is 13, while the price-to-book ratio is a reasonable 2.6 times. Bear in mind that all these stocks trade in dollars (or Swiss francs in the case of Syngenta), so there is currency risk to sterling investors.
How to profit from fertiliser: buy sulphur
A key tool in the battle to improve yield is fertiliser. However, thanks to the global downturn and the need to tighten belts, “farmers haven’t been laying crop nutrients on as thick, much to the dismay of fertiliser companies,” as Forbes puts it. But given that the immediate supply outlook is so grim, especially for corn – “by far the most fertiliser-intensive of the major row crops” – farmers will soon be scrambling to boost yields. Indeed, as Morgan Stanley analyst Vincent Andrews notes, “cutting back on fertiliser doesn’t eliminate costs, it merely delays them”, as more of the stuff is then needed to reverse soil depletion. And that could soon mean a “surge in sales”.
Investors can gain exposure via one of the large chemicals firms, such as Mosaic (NYSE: MOS) or the Potash Corporation (NYSE: POT). Both have enjoyed a rebound already this year (Potash is up 73% since we last tipped it in March), but are still well off last year’s peaks, so if you own them already, they’re worth holding.
An alternative option with a bigger potential upside is Chemtrade (TSX: CHE.UN). The group stores, markets and distributes bulk chemicals. It is one of the world’s largest suppliers of one chemical with a particularly fizzy future – sulphuric acid. Around 60% of global production of the acid goes into making phosphate fertilisers of the type now imported in large quantities by China and India in particular. Some Western farmers are also keen, because applied neat, sulphuric acid kills potato plants, which makes harvesting them much easier. And its uses don’t stop at agriculture – it’s a key construction chemical too. China’s infrastructure stimulus will require large amounts of iron and steel. Sulphuric acid is used to de-oxidise both prior to galvanisation or electroplating. It is also a vital component of lead-acid car batteries, as well as many plastics.
Demand slumped last year and early in 2009 as use in many industries slowed, and Chemtrade’s share price is down by around 50% from when we tipped it last May. But that makes now a good time to get back in before demand, and prices, rise again. The group trades on a current p/e of just six – depressed in part due to the temporary closure of a major plant in Beaumont, Texas, and a first-quarter profits slump to $1.3m, compared with $9.5m last year.
The scramble for soil
To see how seriously some countries are taking the crop supply crunch, look no further than Africa, where China recently secured rights to grow palm oil for biofuel on 2.8 million hectares of the Congo. That’s enough land to create the biggest palm-oil plantation in the world. And it’s not just China – the International Food Policy Research Institute says 15 million to 20 million hectares of farmland in poor countries has been the subject of talks or deals with foreigners since 2006 – equivalent to all of France’s agricultural land, says The Economist.
These deals are big enough to topple governments – one involving a lease on 1.3 million hectares to Korea’s Daewoo Securities was so unpopular it contributed to the downfall of Madagascar’s president. And there’s enough concern for Japan to have called for a set of investment principles to be formed at the latest G8 summit, reports the FT. This is to encourage “responsible investing in agriculture” – and to prevent African countries from being ripped off by wealthier predators. So what’s going on?
Countries such as China and the Gulf States, who are capital-rich but lack land, are hoovering up other people’s land in a string of government-to-government deals. In return they promise goodies such as improved seeds, schools, clinics and roads. The aim is simple: rather than remain exposed to the open market, Beijing and Riyadh are taking food security into their own hands by planting crops on these vast overseas plots and shipping them home. One Sudanese official reckons his country will set aside around 20% of its cultivated land for Arab governments.
As for why the land-grabbers don’t just grow their own, they’ve tried and failed. The Saudis, for example, found that growing wheat in the desert consumes hideously large quantities of water. Meanwhile, demand has already dried out swathes of former breadbasket country in China, such as the North China Plain.
So what if you want to get your hands on quality overseas farmland as a British private investor? Be warned that the area is riddled with possible pitfalls – currency risk and low legal transparency in less developed countries are two of the biggest. But if you’re still interested, Andrew Shirley, head of property development at Knight Frank, tips Australia and Canada, which offer “relatively cheap land in a low-risk political and economic environment”. Both are drawing investors who “might otherwise have considered South America or eastern Europe”.
If you’ve a stronger stomach for risk, Bulgaria and Romania have decent long-term potential as farm prices gradually catch up with the rest of the EU, says Shirley. A purchaser is betting on “improved national stability” and the benefits both should derive from “unfettered access to EU markets”. An extra bonus came from the recent Budget: UK agricultural property relief, which can cut inheritance tax by up to 100% (subject to conditions) is being extended to farmland and forestry across the European Economic Area. But we’d be very wary: eastern Europe has been among the regions hardest-hit by the credit crunch, so stability may take time. Any investor in these countries would need strong local knowledge to be confident of striking a good deal.