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In the last week the ECB has announced QE programs such as the aggressive buying of Spanish and Italian bonds (in order to drive the yields of those bonds down) and the resumption of the long-term loan facility. With lower bond yields, Spain and Italy may be able to manage their way out of their current financial problems given time. This plan has merit. Shortly after the ECB announcement, the U.S. Fed announced plans to extend low Fed interest rates until at least 2013. All of the above actions are inflationary. If the ECB is really just monetizing Spanish and Italian debt, the ECB’s actions are very inflationary.

What does this mean to the investor? It probably means that commodity prices are not going to fall through the floor in the near term as some had feared. In fact it probably means they are more likely to trend upward. If the overall market, which has fallen roughly 20% recently, starts going back up, I would expect agriculture futures to go up with it. If the market continues downward, the above described inflationary actions should make the agriculture commodities more resistant to downward moves. They might even move upward against the tide. Agriculture futures should be a hedge against the above described inflation pressures. You might invest in agriculture futures in much the same way and for the same reasons that people invest in gold.

On top of the above considerations, agriculture crops were bad last year due to many natural disasters, droughts and floods. This year has brought more of the same. This means the supplies of the agriculture commodities will be abnormally low this year. As the summer harvest season comes to an end, the final numbers for the shortness of supply will be undeniable. Agriculture futures should go up. Some of the fundamental data that brought me to this conclusion are below.

The USDA Crop Report (from the Week of Aug 1-7, 2011) is bullish for agriculture futures. The USDA reported an overall worsening of drought conditions with abnormally high temperatures for the last week, especially the record temperatures in Oklahoma and Texas. Also, 60% of the corn crop was reported in good to excellent condition, down 2 percentage points from last week and 11 points below last year. In addition, 61% of the soybean crop was reported in good to excellent condition, up slightly form last week, but 5 percentage points below a year ago. The harvest of the winter wheat crop was 26 percentage points behind normal. Meanwhile, 30% of the cotton crop was reported in good to excellent condition, unchanged from last week, but 35 percentage points below normal. Also, 27% of the sorghum crop was reported in good to excellent condition, up 3 points from last week, but 39 percentage points below a year ago. Sixty-six percent of the rice crop was reported in good to excellent condition, up 2 points from last week, but 6 percentage points below a year ago. Also, 52% of the oat crop was reported in good to excellent condition, down 3 points from last week, and 25 percentage points below a year ago. Seventy-two percent of the barley crop was reported in good to excellent condition, unchanged from last week, but 11 percentage points below a year ago. And 66% of the spring wheat crop was reported in good to excellent condition, down 4 percentage points from last week and 16 points below a year ago. Finally, 43% of the peanut crop was reported in good to excellent condition, unchanged from last week, but 17 percentage points below a year ago. Overall this news was very bad for this year's crops, which makes it very bullish news for agriculture futures.

On Tuesday Aug. 9, 2011, President Obama approved a new $105 million drought and famine aid package to East Africa. Africa is experiencing its worst drought in 60 years.

Dry weather in France, Germany and the hottest April in 352 years in the U.K. damaged crops across Europe. This was followed by heavy rains which has delayed harvesting of German wheat. The German wheat harvest is already expected to be 4% below last year. Wheat yield in France is expected to drop by 3.6 million tons. U.K. wheat is down 40%. Farmers/ranchers are having to slaughter large parts of their livestock herds to get the money to feed the rest.

Parts of Western Australia have suffered severe drought this year.

The government in Manitoba, Canada, declared an emergency due to flooding.

Crops in northern Japan were destroyed by the earthquake and ensuing tsunami.

In March a freeze in the Sinaloa Valley of Mexico killed 90% of the corn crop.

Excess rain destroyed 50% of Brazil’s soybean crop.

China had its worst drought in decades followed by its worst flooding in decades.

Tropical Storm Muifa just damaged North Korean crops.

Bolivian farmers lost their crops to the worst snowstorms in 20 years. Bolivia’s seasons are opposite those of the Northern Hemisphere.

Hail damaged Brazil’s coffee crop.

Other countries with flooding problems include India, Bangladesh, Laos, etc.

Let’s not forget the U.S. Mississippi River flooding or the farmland damaged by the opening of the floodgates to save Baton Rouge and New Orleans.

It is safe to say that grain crops have suffered a sub par year after a bad year the prior year. On top of that the demand for food has increased due to normal increases in population and to the still strong emerging markets growth we have been seeing. At last glance, 45 Asian countries were slated to grow at 7.8% or more.

How can you use this information to make money? One way would be through fertilizer stocks such as Potash (NYSE:POT), Mosaic (NYSE:MOS), Agrium (NYSE:AGU) and CF Industries (NYSE:CF). Another way would be through seed suppliers such as Monsanto (NYSE:MON), DuPont (NYSE:DD) and Sygenta (NYSE:SYT). Yet another would be through farm equipment makers such as Deere (NYSE:DE), CNH Global (NYSE:CNH) and Agco (NYSE:AGCO).

The problem with all of these avenues of investment is that they go up and down with the market. In fact most of them have Betas significantly above 1.0. This means they go up and down faster than the overall market. If you are worried the market may go down, you may wish to choose a different vehicle for investment in the inflation/agricultural crop shortage play. Of course if you are sure the market will go up, you may want to use one or more of the above vehicles. If you are lacking conviction in market direction, you could play the futures in agricultural commodities directly. However, these are volatile and scary to many investors.

As a substitute you could invest in ETFs and/or ETNs which invest in these futures for you. Some of the ETFs and ETNs available are described below.

DBA - The Power Shares DB Agriculture Fund seeks to track the price and yield performance of the Deutsche Bank Liquid Commodity Index - Optimum Yield Agriculture Excess Return. Its approximate weightings are feeder cattle (4.43%), cocoa (11.14%), coffee (11.61%), corn (12.12%), cotton (2.60%), lean hogs (8.51%), live cattle (12.55%), soybeans (12.78%), sugar (12.00%), Chicago wheat (5.99%) and Kansas wheat (6.26%).

JJA - iPath DJ-UBS Agriculture TR Sub-Idx ETN seeks results that correspond to the performance of the Dow Jones - UBS Agriculture Total Return Sub-Index. The index is composed of seven futures. The approximate weightings are: soybeans (24.49%), corn (24.19%), wheat (15.17%), coffee (9.84%), soybean oil (9.81%), cotton (8.99%) and sugar (7.51%).

GRU - ELEMENTS MLCX Grains Index TR ETN seeks to replicate the MLCX Grains Total Return Index. This is composed of four futures. The approximate weightings are wheat (47%), corn (36%), soy meal (10%), and soybeans (8%).

JJG - iPath DJ-UBS Grains TR Sub-Idx ETN seeks results that correspond to the price and yield performance of the Dow-Jones UBS Grains Total Return Sub-Index. The index is composed of three futures contracts: corn (23.60%), wheat (30.00%) and soybeans (46.60%).

FUD - UBS E-TRACS CMCI Food TR ETN seeks to track the price and performance yield of the UBS Bloomberg CMCI Food Total Return Index. The fund is designed to be representative of the entire liquid forward curve of each commodity in the index. It is comprised of the 11 agriculture and two livestock futures contracts in the CMCI with three target maturities for each individual commodity. Its composition is: SRW wheat (10.27%), corn (15.69%), soybeans (18.53%), soybean meal (4.72%), soybean oil (7.00%), sugar #11 (18.40%), sugar #5 (6.07%), cocoa (2.90%), coffee “C” Arabica (3.97%), live cattle (7.36%), and live hogs (5.09%).

AGF - PowerShares DB Agriculture Long ETN seeks to replicate the price and yield performance of the Deutsche Bank Liquid Commodity Index - Optimum Yield Agriculture. The fund is a senior unsecured obligation. The index is composed of corn (28.32%), soybean (27.05%), wheat (23.56%) and sugar (21.06%).

RJA - ELEMENTS Rogers Intl Commodity Agri ETN seeks to replicate the Rogers International Commodity Index (Agriculture Total Return Index). The index represents the value of a basket of 20 agriculture commodity futures contracts. The components are: corn (13.610%), CBOT Wheat (13.610%), cotton (12.034%), soybeans (9.599%), coffee (5.731%), live cattle (5.731%), sugar (5.731%), soybean oil (5.731%), cocoa (2.865%), lean hogs (2.865%), lumber (2.865%), milling wheat (2.865%), rubber (2.865%), KCBT wheat (2.865%), canola (2.149%), rice (2.149%), soybean meal (2.149%), orange juice (1.719%), oats (1.433%), rapeseed (0.716%), Azuki beans (0.430%), greasy wool (0.286%).

DAG - PowerShares DB Agriculture Dble Long ETN seeks to replicate the price and yield performance of the Deutsche Bank Liquid Commodity Index - Optimum Yield Agriculture (200% leveraged -- Double). The fund is a senior unsecured obligation that allows investors to take a leveraged view on the performance of the agriculture sector. The index is composed of: soybeans (12.5%), live cattle (12.5%), sugar #11 (12.5%), corn (12.5%), coffee (11.11%), cocoa (11.11%), lean hogs (8.33%), wheat (6.35%), KC wheat (6.25%), feeder cattle (4.17%), and cotton (2.78%).

If you are like me, you prefer to keep things simple. I am mostly interested in pure grain plays so I can understand what is going on better. The closest of the above ETFs and ETNs that fit this description are AGF, JJG, GRU and possibly JJA. Let’s look at the two year performance of these. The charts are below.

Click to enlarge charts

The two year AGF chart:



The two year JJG chart:



The two year GRU chart:

 

The two year JJA chart:

These charts are all very similar. They ran up considerably last fall. Then they have been generally falling slowly in 2011. They are currently oversold. It makes sense that they should rise. The reality of the bad crops this growing season is about to become a hard reality. This may push prices upward in the near future. None of these look like a sure fire investment. However, the current crop situation worldwide does argue for higher grain prices in the near future. The recently added inflation pressures from the ECB and the Fed should help to push these ETFs and ETNs upward. In addition these ETFs and ETNs did not drop precipitously as stocks did recently. This combination of these factors makes me think there is likely some upside coming soon. I haven’t made up my mind which one(s) to buy, but the odds seem favorable for this trade. At worst the potential downside should be very small, that in itself is attractive in the current market.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in GRU, JJG over the next 72 hours.