Powershares' Agricultural ETF: The Soft Commodities Slam Dunk

| About: PowerShares DB (DBA)

Recently, I've noticed that trips to my London supermarket have gotten a lot more expensive. And it's not just because the U.S. dollar is getting hammered overseas. My instincts weren't wrong. Turns out, food price inflation in the United Kingdom is running at a ten-year high. Prices of basic staples like fish and vegetables in the United Kingdom have shot up between 10 and 12% over the past year. Globally, the price of rice has risen by 50%, cattle by 40% and wheat by a third over the past two years. Corn prices seem to be hitting a record high almost every week.

Not that my neighbors in the Royal Borough of Kensington and Chelsea will be taking to the streets with pitchforks anytime soon. But the knock-on effects of such substantial increases on the less snazzy parts of the world are more serious. When the price of bread increased in Poland in the 1980s, it led to rioting in the streets. The price of onions has toppled governments in India. Just last month, riots broke out in Mexico when tortilla prices jumped 60%.

Investing in Soft Commodities: The Law of Supply and Demand

The rally in oil, copper, and nickel prices is almost yesterday's news. But the rally in "soft" or agricultural commodities is still off most investors' radar screens. Smart money -- like commodities bull Jim Rogers -- argues that "soft" commodities are where the big gains are to be made over the next 5-10 years. What has changed? Blame the law of supply and demand.

First, consider the demand side. Rising wages among the world's middle class are doing more than just creating demand for real estate and car loans. The new middle class also wants to eat. Thirty years ago, American children were told to finish what's on their plates because "people are starving in India." Twenty years ago, three out of four people on planet earth were living on 1600 calories a day. In What's So Great About America, Dinesh D'Souza wryly observed that Indians want to come to America where even the poor people are fat. Today, these same Indians can afford to eat just like us. We've seen the same trend in countries like Japan. The result? Japanese women are four inches taller than they were 50 years ago. And "curvy" among Japanese women is "in." Just think when the same thing happens in China, where average calorie-consumption is expected to shoot up 50% over the next decade.

Let's turn to supply. Here the bogeyman is climate change. Global inventories of soft commodities haven't been this low since Richard Nixon was president. China has lost fertile land equivalent of about the size of Maine each and every year for the past decade. To feed its population adequately, it should be adding that amount. Even Mervyn King -- Ben Bernanke's counterpart at the Bank of England -- recently blamed food prices on a weather-induced drop in supply.

Australia is facing such water shortages that the government is on the verge of turning off irrigation to 50,000 farmers. Rice production has dropped over 90% and cotton production has more than halved. Even wine grape production is impaired. With food prices set to triple, Australians may be set to go on a national diet.

Investing in Soft Commodities: The Biofuels Revolution

The emerging mania surrounding biofuel only exacerbates the problem. With corn-based ethanol the latest (government subsidized) rage, demand for crops as biofuel is set to double by 2030. Today, one out of five bushels of corn produced in the United States is going toward ethanol. With half of Detroit's cars set to run mixed fuels by 2012, ethanol demand is set to jump substantially. To meet its green goals, Europe will have to allocate 25% of arable land toward ethanol production.

Here the law of unintended consequences kicking in. Land shifted toward corn in the United States make soybeans more expensive. Ditto with wheat and barley, as traditional fields are turned toward rapeseed crops. The new demand for corn means a bidding war has erupted between livestock producers and the ethanol industry. We'll be driving cleaner cars, but eating less meat as global output of beef, pork and chicken is expected to plummet by $2 billion as a result.

Investing in Soft Commodities: Are Profits Possible?

With both supply and demand supporting skyrocketing agricultural prices, you'd think that investors would be making a mint. But you'd be wrong. Although the London Stock Exchange has ETFs for corn, soybeans, sugar and cotton, the boom has been harder to play for U.S. investors.

Enter the agricultural ETF (NYSEARCA:DBA) launched by Powershares in January. It seemed straightforward enough. The ETF invests in contracts for sugar, soybeans, corn, and wheat, with each commodity comprising 25% of the index. With prices for soft commodities shooting through the roof -- and little other alternatives available for small investors -- the DBA ETF looked like the slam dunk for 2007.

Sadly, it didn't turn out that way. In fact, the DBA ETF has substantially underperformed the S&P 500 over the past three months.

It turns out that by investing in futures, the DBA hasn't really tracked the underlying increase in spot prices. Like mainstream commodities indices, agricultural futures are trading contango. That means that because the market expects the price of agricultural commodities to go up, it's already reflected in the futures prices in which the ETF invests.

Looking at the big picture, we've actually had it pretty good. Just like we aren't paying much more for basic clothing than we did 20 years ago, the price of food hasn't nearly kept up with the pace of inflation either. Some research shows that since 1976, the price of most basic foodstuffs has actually fallen by 80%. But for the small investor, it's a trend reversal that's hard to profit from.

Disclosure: none