Not All Commodities Are Created Equal: A Look At Agriculture

In this article I would like to cover two points about the outlook for agricultural commodities:

1. The role of agricultural commodities prices in the current food price inflation environment
2. Some projections about the impact of climate changes on agriculture over the next ten years.

There has been a lot of talk, and many words have been written about soaring commodity market prices. It appears that the best instruments to participate in such markets are ETFs and ETNs. Some of them target one specific sector, like DB Multi-Sector Commodity Master Trust (DBA) for agricultural commodities (25% each of wheat, corn, soybeans, and sugar), while others offer exposure to a basket of sectors, like iShares S&P GSCI Commodity-Indexed (GSC), that includes energy, industrial metals, agriculture, livestock and precious metals.

Three articles on this site are in my opinion particularly interesting and well written: “Commodity ETF Overview”, by Tim Iacono, “Commodity ETFs and ETNs”, by the SA Editors, “Is Commodity ETF Slicing and Dicing Necessary?” by Richard Kang, and “Food Prices Will Only Rise: The Time to Buy is Now”, by Graham Summers.

Agricultural commodities are different from all other commodities. For one, agricultural commodities reflect a kind of consumer staples that does not allow trade-offs. You cannot decide to stop eating and use that money to buy stocks instead. Other commodities, like precious metals, simply reflect expectations about global monetary policies. As such, demand is dictated by opportunity factors that are cyclical in nature.

In a nutshell: we eat bread, we cannot eat gold. Having said that, let’s look at food price inflation. About food price inflation According to a research piece by a Swiss bank, in OECD countries consumers spend on actual agricultural commodities is only 20% of their total food budget. The real inflationary factor is labor, which includes processors and distributors. Given an international scenario that shows a weaker labor market, particularly in regard to lower skilled labor, looking ahead it seems reasonable to expect upside pressure on food price inflation to ease. If labor is the key, we can conclude that the correlation between food price inflation and the price of agricultural commodities is quite low.

There in fact an almost negligible correlation between bakery CPI prices and the trend in wheat price. For those who fear the risk of government actions on commodity prices to fight food price inflation, I believe the low correlation makes it clear to public officials that any intervention would make little sense. The price of at least some agricultural commodities should continue to rise reflecting changing eating habits in the new economies such as China and India, the increase in world population on one hand, and the stagnant amount of arable land on the other. (As a matter of fact, given the monetary value of land available for industrial development in China, I suspect Chinese farmers may choose - or be forced - to sell, thus reducing the amount of arable land available.)

About the impact of climate changes on agriculture worldwide, there is an interesting, although unfortunately quite old, study conducted by Columbia University and the Earth Institute (1993) that offers a mathematical model that takes into account various levels of increase of CO2 measured in ppm (parts-per notation) and the consequent producers’ level of adaptation (e.g. additional irrigation systems, shift in planting dates, etc.). Using the two variables mentioned above, the model provides multiple possible scenarios for a large number of agricultural commodities. I find the results quite interesting. Assuming a level 1 adaptation (small scale adjustments) and CO2 concentration level of 555ppm by 2020 (current level is around 390ppm), and looking the top 10 producers, the results look like this:

• Change in Rice production (top 10 producers): -6.2%
• Change in Corn production (top 10 producers): -2.9%
• Change in Wheat production (top 10 producers): +8.7%
• Change in Soybeans production (top 10 producers): +14%

Considering that wheat, maize and rice account for about 85% of the global cereal export and soybeans for 67% of trade in protein cake equivalent, the sample seems acceptable.

According to some estimates, world population should reach about 8 billion around 2020, an increase of 23% from current levels.

Conclusions

Long rice positions are the most attractive.

Corn also appears to be a good long investment going forward.

Production of soybeans and wheat is set to increase in more developed countries while population will rise in poorer regions; this may result in increased demand for exports.

Production in both soybeans and wheat looks set to increase at lower rate than the growth in global population.

Instruments

The ETF DBA seems to be the best instrument to gain direct exposure to Corn, but it doesn’t offer access to rice, and it includes soybeans and wheat that don’t look as attractive. It also includes Sugar, for which I have no data. The iPath DJ AIG Agriculture TR Sub-Idx ETN (JJA) offers exposure to a broader variety of agricultural commodities than DBA, since it includes also soybean oil, cotton and coffee. It doesn’t include rice. Unfortunately, I’m not aware of any vehicles that give exposure to rice, except its futures, which are not particularly liquid.

If we assume at least some level of adaptation to climate changes in the form of crop protection, there is company in that arena that seems to be doing pretty well: Syngenta AG (SYT). It may be worth taking a look.

Disclosure: Author holds positions in the above-mentioned securities

Comments

[RichardSchweitzer]

It does appear that you are saying that "food cost price increases" are not the way to evaluate the trends in prices for foodstuff commodities.

Omitted are reference to "stockpiles,"... rates of variable consumption (and substitution) as compared to rates of potential increases in production (covered). Still, all in all a very useful discourse - stored for future reference.

No one seems to follow through on the possibilities of (or opportunities for) investments in land - arable land - in relatively developed productive areas, or in areas that may be re-developed (Kenya, Ghana, etc.) Which are the remaining "Plantation Companies?"

[LucaAvellini]

Richard,
Thank you for your comments. You are absolutely correct in pointing out the importance of current stockpile levels. I have gathered the following data: At the end of 1999 the world grain reserves covered 119 days of consumption. Today, we are looking at 50 days for corn and 70 days for wheat. During the period 2000-2005 cereal reserves covered 18 weeks on average. Today we are at 12 weeks, with corn at 8 weeks. The most striking aspect of these numbers is, in my opinion, the velocity at which reserves are contracting despite slightly increase in production.
As far as the relationship between foodstuff prices and commodity prices, it was my intention to point out that the correlation is less intuitive than one may expect due to a variety of factors, such as labor and transportation costs. Thus, commodity prices are not always a satisfactory leading indicator of where Food CPI inflation is headed.

[Georealist]

A couple of points..one macro the other micro...From my perspective 3 things will drive the food base (by that I mean the cereals and grains..etc that make up most of what the world eats (exclusive of fish which is an entirely different disaster)
1. Droughts and a real diminishing of the worlds great aquifers...try and cure that with political sudsidies.
2. Topsoil depletion and the need for HEAVY HEAVY HEAVY fertilizer supplement..expensive and diminishing.
3. Peak oil production..it takes oil and gas to make food..process it and distribute it..
Which brings me to my Micro point!
It isn't labor that eats up so much of the food CPI input..its fuel...and that is most certainly not coming down.
My suggestion Luca...don't invest in ETFs..buy bags of rice! I could have made 300% on the stuff last year selling it out of my garage...

[StatGuy]

The Rogers International Commodity Agriculture ETN (RJA) has a small exposure to rice (~1.43%). It also gives exposure to a very diverse set of other agriculturals.

[hysun6512]

The Elements ETN linked to the Rogers International Commodity Index -- Agriculture Total Return (RJA) offers exposure to rice (1.43%).