How the Impending Food Shortage Will Impact Agriculture Stocks

During 2007, equity markets were in love with the agriculture boom and related stocks began to price in this investor sentiment. However, many pundits laughed at the idea of a food shortage and that one was far too Draconian of an event to occur.

However, I believe that the case for food shortages is real and that this impending issue will cause the value for goods and services that increase the efficiency in the production of grain and meat to increase.

To examine the effect of income changes and the subsequent changes in the demand for certain foods, I will use China as an example. Even though much research has been done on the Chinese growth story, it has been done so with good reason. China’s current population makes up approximately 18-20% of the world’s entire population and in real GDP terms it is currently ranked as the 2^nd or 3^rd richest country (source). This means that the decisions of the Chinese economy’s participants have very similar repercussions to those of the United States’ economy.

Since 1949, China has been ruled as a communist state. After 1978 and 1980, numerous reforms took place that focused on integrating China into the international trade market mostly in a shift from central planning ideals to more open market policies. Since 1990, China has experienced rapid growth in Real GDP terms as well as real GDP per capita. See chart below:

This growth has caused a change in the value of different goods and services. In economics, when a change in income induces a change in the demand for a good or service, it is called the good’s income elasticity of demand or YED. You can learn about YED here. Goods like “Internet use” have a positive YED, meaning that if income increased by 10%, demand for internet use would jump by more than 10%. Goods like bus tickets have negative YEDs, meaning that as income increases the demand for bus tickets falls, most likely because people can avoid other forms of transportation (cars for example).

Goods that have YEDs between 0 and 1 are known as necessities. The most prominent of necessities, food and oil have YEDs just above zero. If income increases by 10%, the demand for food and oil hardly increase at all (perhaps .10%-.20%).

Especially after 1980, the Chinese have been changing their consumption habits of food to favor more elastic, luxury foods, such as meat. This paper from the USDA outlines this idea.

Luxury goods are typically those that have YEDs above 1, for example, jewelry or expensive sports cars. With regard to food, I would like to provide the assumption that goods can have relative YEDs to each other. Even though meat would be classified as food, relative to grain products, meat could be considered a luxury. As incomes increase, the increase in the consumption of food is weighted more towards meat than grain because of differences in the relative YEDs.

So the Chinese are eating more meat, big deal, what does this have to do with the commodity bull market? It would have nothing to do with it if meat and grain could be substituted without any interaction effect. But, meat doesn’t grow on trees; instead it grows on farms, by farmers who have to feed the animals that are slaughtered for their meat. They feed these animals grain products. So inherently there is a relationship between a pound of meat and the amount of grain needed to produce that meat.

Most estimates show that producing one pound of meat requires between 10 and 16 pounds of grain. You can see how even though consumers may be substituting grain products for meat products, when incomes increase they are actually increasing grain demand by more than they are reducing it.

This is the main argument for those bullish on the Agriculture space. This large increase in the demand for commodities such as grain makes those goods and services which increase grain yield more valuable. Such companies such as POT, MOS, MON, and AGU are all excellent examples of equities that have seen there stock prices appreciate due to this expected outcome.

The main underlying expectation is that income increases in 3^rd-world countries such as China and India will continue on for some time creating substantial demand in grain as well as the other inputs needed to produce meat products.

Disclosure: No positions in the stocks I've mentioned

Comments

[Asitoughtobe:]

There will absolutely be an increase in the world consumption of food stuff, meat products and the like that will drive the need for agricultural products for which insufficient farming capacity exists. As a result there will certainly be a rise on the price of commodities over these next years.

Add to the population growth, the increase in discretionary income to peoples around the world, and a little inflation due to the monetary policies of the advanced economies of the world and voila!

Healthy Trading!



OT: Nice shoes,

Jun 30 09:11 AM

[Mad Hedge F...:]

I agree. During the sixties, new dwarf varieties, irrigation, fertilizer, and heavy duty pesticides tripled crop yields, unleashing a green revolution. But guess what? The world population has doubled from 3.5 to 7 billion since then, eating up surpluses, and is expected to rise to 9 billion by 2050. Now we are running out of water in key areas like the American West and Northern India, droughts are hitting Africa and China, soil is exhausted, and global warming is shriveling yields. Water supplies are so polluted with toxic pesticide residues that rural cancer rates are soaring. Food reserves are now at 20 year lows. Rising emerging market standards of living are consuming more and better food, with Chinese pork production rising 45% from 1993 to 2005. The problem is that meat is an incredibly inefficient calorie transmission mechanism, creating demand for five times more grain than just eating the grain alone. I won’t even mention the strain the politically inspired ethanol and biofuel programs have placed on the system. It is possible that genetic engineering, sustainable farming, and smart irrigation could lead to a second green revolution, but the burden is on scientists to deliver. The net net of all of this is that food prices are going up, a lot. Entertain core long positions in corn, wheat, and soybeans on the next dip, as well as the second derivative plays like Agrium (AGU), Potash (POT) and Monsanto (MON). You might also look at DB Commodities Tracking Index Fund (DBC). These will all surpass last year’s stratospheric highs at some point.

Jun 30 10:20 AM

[basehitz:]

Good article. I have been building a position in DBA as it corrects. Today it broke th 200d ma, so further selling should be triggered.

Jim Rogers interview: 6/5/09 on CNBC
www.cnbc.com/id/31106964
Key points: currency crisis imminent, not shorting anything cause of money printing, but long commodities either due to recovery or inflation. Either way, commodity fundamentals are improving. Wildly bullish on commodities. Prefers silver to gold, prefers agriculture to either. Maybe some natural gas.

(My take on NG: persistent supply/demand imbalance, plus final hurrah for USD as safe haven triggering short term oil correction , may produce a final washout in NG. Even more attractive are international oil drillers and commodity itself.)

Jun 30 10:56 AM

[berated:]

I'm still new to ag investing, but can anyone point me to a resource to better explain today's dip in DBA? Or, provide a brief summary of the reason(s) behind the dip? Thanks.

Jun 30 12:16 PM

[T. Marc Sch...:]

This morning, the USDA raised its 2009 corn acreage forecast by 2.0 million acres to 87.0 million acres and its forecast for soybean plantings by 1.5 million acres to 77.5 million acres. Grain prices were sharply lower (corn down almost 8% and triggered the daily trading limit of 30 cents) as the planted acres forecast was considerably higher than the consensus estimate. Also weather conditions have been favorable in the Midwest.

Despite the large increase in planted acres, supplies will still be constrained. I expect the market to now be focused on yields for the remainder of the summer.

Jun 30 03:42 PM

[berated:]

Thx, Marc.

Jun 30 05:43 PM

[Stone Fox C...:]

This is all already pretty well documented. The real key is what is the best way to profit from it. The fertilizer stocks attractive, but it might just be best to do what Rodgers suggests and go buy farmland.

Jun 30 06:55 PM

[Peter Iwano...:]

I know that this article was pretty much beating a dead horse, but I decided to explain in more economic terms because it seemed many people still didn't understand the idea and wrote off the Ag stocks.

But I do agree that the next step would be how to play the move. I personally think those companies that have products that improve yield are the best bet. They offer the ability for people to improve efficiency which I believe is more important than increasing capital.


On Jun 30 06:55 PM Stone Fox Capital wrote:

> This is all already pretty well documented. The real key is what
> is the best way to profit from it. The fertilizer stocks attractive,
> but it might just be best to do what Rodgers suggests and go buy
> farmland.

Jul 01 09:12 AM

[DM226:]

Other than buys shares of CRESY, what is there that the average investor can do to invest in farmland?


On Jun 30 06:55 PM Stone Fox Capital wrote:

> This is all already pretty well documented. The real key is what
> is the best way to profit from it. The fertilizer stocks attractive,
> but it might just be best to do what Rodgers suggests and go buy
> farmland.

Jul 01 01:25 PM