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You might have recently read about the severe drought that is affecting the Midwestern United States and the 2012 corn crop. The drought conditions are reported to be the worst in more than half a century. Normally I wouldn't write about the subject of corn, or the weather, being that such topics tend to fall outside the realm of traditional investment research and analysis. However, there are so many unique facets to this situation that I consider it to be worthy of our attention, as it provides insights about globalization, interconnectedness, unintended consequences, emerging markets, inflation, resource scarcity, and climate change -- all subjects that are relevant to investment research and analysis.

First the facts: The United States produces more than one-third of all of the corn grown in the world, a crop that happens to be the single most valuable crop grown each year in this country. Presently, about 40% of our domestic corn crop is used in ethanol production; another 40% is used as animal feed for the worldwide production of livestock, poultry, and pork, while the remaining 20% is used primarily in processed food products. Due to the extreme and exceptional drought conditions across most of the Midwestern United States (see the Drought Monitor below), it is now expected that U.S. corn production in 2012 will be at least 13% lower than last year's crop, making this the worst corn crop in many years and reducing domestic stockpiles to a bare minimum going into 2013.

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In just the past few months, as drought conditions have worsened, the price of corn has risen by about 60% from $5 per bushel to roughly $8 per bushel. This represents a nearly 400% increase in the price of corn since the year 2000. As we are about to see, the worldwide effects of the corn price spike are somewhat startling and have presented us with some difficult policy decisions.

Crude Oil/Corn Relationship: The Renewable Fuel Standard, otherwise known as the biofuel mandate, is the law overseen by the U.S. Environmental Protection Agency which requires that 7.5 billion gallons of renewable biofuels be blended with gasoline in 2012. The vast majority of this biofuel blend stock comes from corn-based ethanol. Remember, 40% of the entire U.S. corn crop goes into ethanol production. Given the decline in crop potential for 2012, unless the biofuel mandate is waived for the current year, it is possible that more than 50% of all the corn grown in the United States will be required (conscripted, you might say) for ethanol production, reducing the amount of corn that would be available for animal feed and food production.

For the first time ever, we are nearing the point where more than half of all the corn grown in the United States will be burned in our cars, while less than half will be left over for human and animal consumption. One result of the biofuel mandate and the rapid growth of the ethanol industry is that the global price for corn is now inseparably linked to the price of crude oil, the latter of which has quadrupled in price over the past 10 years or so.

Commodity Interconnection: As the price of corn goes up, so too go the prices of soybeans and various other agricultural commodities. Firstly, the same drought that is affecting corn crops is also affecting other agricultural crops. Secondly, farmers around the world will react to the higher price of corn by attempting to plant more of it, thereby causing them to plant less of other food commodities such as soybeans.

Furthermore, given that corn is the primary feedstock used by meat producers, any increase in corn prices will ultimately translate into higher meat prices. According to Tyson Foods, it takes 2.1 pounds of corn to make 1 pound of chicken, 4.5 pounds of corn to make 1 pound of pork, and 6.2 pounds of corn to make 1 pound of beef. Of course, cows used for dairy production may also be fed corn, as well as chickens used in egg production, so you can see how this same price spike in corn ultimately works its way through the entire system. Livestock producers, along with various state and federal lawmakers, have recently petitioned the EPA to temporarily suspend the biofuel mandate in order to ease the price pressure stemming from the depleted corn crop, but so far the EPA has rejected these calls. The bottom line is this: a food price shock, such as the one we are now experiencing, is really a multi-commodity shock that ripples throughout the entire food supply complex and, due to the EPA's mandate, spills over into energy markets as well.

Globalization: Just this past week, the director general of the United Nation's Food and Agriculture Organization said that the U.S. should suspend its biofuel mandate and allow what remains of the depleted corn crop to be used for food and feed purposes, rather than being used to fuel our automobiles. Such a decision would almost certainly ease global food prices this year and next, but may or may not be the best choice, depending on one's point of view.

Regardless, it is interesting to see a U.N. official essentially asking the EPA to exercise its authority and suspend the biofuel mandate in order to alleviate suffering amongst poor nations. This demonstrates that we live in a world that is more globally interconnected then at any other time in history. What we are witnessing is a domestic fuel policy in the United States, coupled with a severe weather phenomenon, which is leading to food scarcity and inflationary pressures across the globe, bringing us to the next point…

Emerging Market Inflation: The inflationary impact of rising corn prices will be relatively muted here in the United States; it is estimated that overall food prices will rise 2-3% this year and approximately 5% in 2013. The inflationary impact is muted because U.S. citizens only spend 7-8% of their income on food. By contrast, citizens in the emerging markets have a much more subsistence-based lifestyle and generally spend 25-50% of their income on food. The result is that food price inflation in the emerging markets tends to be a much greater problem, to the point of creating social instability, and even humanitarian crisis.

You may recall that many of the protests throughout Africa and the Middle East in 2011 were actually sparked by discontent over rising food prices. These protests swept through the region and later morphed into widespread nation-by-nation uprisings known as the "Arab Spring." Needless to say, politicians in emerging market countries fear food price inflation and its consequences.

Climate Change: I won't take a position on the subject of climate change or global warming because these particular topics tend to foment a religious-like disagreement between believers and non-believers. Instead, let me simply state the facts, as I understand them: the U.S. National Oceanic and Atmospheric Administration (NOAA) has identified July 2012 as the single hottest month ever recorded in the United States, with records dating back to 1880.

The exceptional heat and drought conditions in the Midwest led Fred Below, a plant biologist at the University of Illinois in Urbana, to recently characterize the situation by saying, "It's like farming in hell," as recently reported by Bloomberg. The 12-month period ending in July of 2012 was also the hottest 12-month period ever recorded in the United States.

Furthermore, according to NOAA, the month of July 2012 was the fourth warmest July ever recorded globally, as measured across all land and ocean surface temperatures. Finally, this past July also marked the 329th consecutive month in which we experienced a global average temperature that was hotter than the average of the entire 20th century. Now, I am neither a scientist nor am I a statistician, but I am willing to go out on limb and speculate that when something happens for 329 consecutive months in a row, it probably means that there is a firm trend in place.

Regardless of the root causes of climate change, anthropogenic or not, we can be reasonably assured that our future will be warmer, and our weather more volatile, than what we have experienced in our recent past. I'll leave it at that. Anyone who disagrees with me can take up their beef with NOAA and the National Climate Data Center.

So, where does this leave us? What do we do? In the very least, this leaves us with another example of how complex and interconnected the world has become. If the U.S. and the EPA choose to do nothing, then much of the emerging and developing world may face moderate to severe food shortages and significant food price inflation later this year and next. We will begin 2013 with even lower global corn inventories then we have at the moment, thus creating the potential for a greater problem next year.

Domestically speaking, this would be a bad decision for those in the livestock industries, as well as for lower income consumers who are disproportionately affected by rising food prices. Globally, this would be a bad decision from a humanitarian perspective. What we effectively have here is a federal government policy that will require the citizens of the United States to put more than 100 million metric tons of corn into their automobiles this year, while simultaneously starving millions of people in the developing world.

What if, on the other hand, the EPA does the opposite and decides to temporarily suspend the biofuel mandate? Such a decision would undermine the entire ethanol industry, create enormous uncertainty for corn farmers and ethanol producers going forward, and temporarily increase our need for hydrocarbon energy sources. Depending upon what you believe about the "greenness" of ethanol, and climate change in general, you might even conclude that a temporary suspension of the ethanol mandate, coupled with the commensurate increase in crude oil demand, would simply increase greenhouse gas emissions further, thereby exacerbating the long-term problems brought about by climate change itself!

The long-term outlook presents the world with an even greater dilemma. What we are witnessing here is a rare glimpse into our collective, global future -- a future of resource scarcity and interconnectedness that will present us with increasingly difficult choices. As the world's population grows from 7 billion to 9 billion people over the next few decades, and as emerging markets seek to achieve higher standards of living for their citizens, and as the world faces increasing demand for resources, both renewable and non-renewable, we may be faced with some terribly difficult choices.

All of this would be true even in the absence of climate change, but when we add the climate change factor into the equation, it becomes apparent that our challenges could become much more daunting. If climate change does bring about a multi-decade period of increasing weather volatility, undermining the global food supply apparatus, then our long-term challenges are magnified and the potential solutions to such problems are more limited.

Investment Implications: It is likely that the EPA will do nothing this year and allow the mandate to continue. What happens in 2013 is impossible to say, but from a global supply perspective, we'll be going into the year without much breathing room, so to speak. Therefore, from a short-term investment perspective, investors' attention should be tuned in to the emerging markets, watching for signs of rapid food price inflation and civil unrest. Longer term, the ideas discussed herein support the notion that investors should have at least a modest allocation to commodities and resource-related holdings within their portfolios.

There are numerous ways to play these themes, depending on whether you are a trader or an investor, and also depending upon your time frame. So, I'll just provide a variety of short-term and long-term ideas and offer a few ETFs in each category. Over the near term (next 6-12 months), it probably makes sense to avoid the emerging and frontier markets throughout Africa and the Middle East, where the food price pressures are likely to be the worst. It probably makes sense to avoid, or even to be short, some of the fund vehicles such as the SPDR S&P Emerging Middle East & Africa ETF (NYSEARCA:GAF) or the Market Vectors Africa Index ETF (NYSEARCA:AFK).

Brazil, on the other hand, might fare reasonably well given its substantial food production capacity, and since this market has underperformed global equity markets year-to-date, this is probably the worst market to be short, although not necessarily a good near-term long position either.

Also, despite all of the comments made in this article, I would not be inclined to go long the agricultural commodities at this point. That would have been a great idea three months ago, but the grain commodities have moved so rapidly in the past few months that I am not sure the risk/reward trade-offs favors a long position in the actual commodities at this time. If anything, it might make more sense to fade the market and be on the short side of these ETFs, such as the PowerShares DB Agriculture ETF (NYSEARCA:DBA) or the ETFs and ETNs that trade on individual commodities.

Longer term, as I stated, there is a strong case to be made for the agribusiness companies that will benefit from a continued global boom in agricultural investment and activity. Some of the ETFs that hold such companies include the Market Vectors Agribusiness ETF (NYSEARCA:MOO) and the PowerShares Global Agriculture ETF (NASDAQ:PAGG). There are also some newer, smaller entrants into this space including the iShares MSCI Global Agricultural Producers ETF (NYSEARCA:VEGI) and the Global X Farming ETF (BARN), which might merit consideration.

Finally, Brazil might be one of the best emerging markets to own during a long-term bull market in agriculture, due to the country's extraordinary production capacity, and vast supply of arable land and fresh water. Within Brazil lies 14% of all the fresh water on earth and 11% of all the arable land on earth. Brazil is already the world's leading producer of numerous food commodities, and is growing larger every year. There are numerous Brazilian ETFs that investors can consider for long-term investment, with the iShares MSCI Brazil Index (NYSEARCA:EWZ) and the Market Vectors Brazil Small-Cap ETF (NYSEARCA:BRF) being the most popular.

Source: Farming In Hell: Emerging Markets Inflation & Commodities