Plowing Through The Fundamentals Of Agriculture

February 11, 2008

HAI contributor Nik Bienkowski surveys the hottest market in the commodities space: agriculture.

  • Tight supply and rising demand: a detailed look at the data
  • Why the supercycle makes sense for Ags
  • The "Chindia" effect


The past 12 months (to end of January 2008) have been another good year for most agricultural commodities, and for grains in particular. The DJ-AIG Agriculture Total Return Sub-IndexSM and the DJ-AIG Grains Total Return Sub-Index 3 Month ForwardSM increased by 40% and 51% respectively over the past 12 months. Among the index components, the best performers over the past 12 months have been wheat (up 82%), soybeans (up 64%) and soybean oil (up 72%).

Higher commodity prices have increased the cost of staple foods such as bread, tortillas and pasta, becoming a political issue in several countries. As of November, the IMF food price index is at its highest level since 1980, when data was first made available. Increasingly, a number of governments are becoming more involved in trying to limit domestic food prices through cuts in import tariffs, limits or higher taxes on exports and price controls.

Even after the spectacular returns over the past 12 months, where will prices head now? Agricultural commodities are often known to be cyclical in nature; however, world agriculture markets are currently undergoing fundamental change:

  • Historically low inventories;
  • Increasing demand from the world’s emerging economies coupled with an increasing population;
  • High oil prices causing inflationary pressures on production, fuel and labour costs while increasing the incentive to produce biofuels;
  • New sources of demand;
  • Global warming; and
  • A strain on output due to reduced resources and falling yields.

Historically Low Inventories

World inventories for many agricultural commodities are at very low levels by historical standards. The charts below show that corn, wheat and soybeans are almost at 40-year lows, while soybeans fell rapidly last year due to rotation of acreage towards corn. Soft inventories are also low, which means a tight supply-demand balance will result in more price sensitivity caused by shortages or disruptions.


Rising Incomes in Emerging Markets

Over the past 10 years, GDP growth in countries such as China and India have begun to increase rapidly, such that GDP growth in 2008 is expected to be close to 10%, five times more than in the U.S. Increased incomes means that higher-protein foods can be afforded, and also (often) that tastes become “Westernized.” An example of this is shown in the chart below, which shows that meat consumption is positively correlated to income. Additionally, this is amplified by population growth which is adding more than 75 million people every year, most of which is in emerging countries. Due to the sheer size of their populations, a small percentage change in per capita consumption can have significant impact in absolute amounts of meat consumption.


The China Effect

The “Chindia” effect – the impact of the phenomenal growth of China and India on the commodities market – is often mentioned in the press and is easy to see regarding commodities like oil and industrial metals; increasing car ownership and increasing infrastructure put pressure on those commodities. However, the “Chindia” effect is also being experienced in the agricultural commodities. The charts below show that meat consumption per capita in China is increasing towards developed market levels, having doubled in the past 10 years. As a result, this demand for meat has caused Chinese soybean consumption to triple over the same period, driven by China’s growing appetite for soy-fed pork, poultry and beef. Feedstock now represents more than 60% of China’s soybean consumption, up from about 15% in the early 1980s. China’s reliance on imports has been increasing steadily since 1995, when it turned from exporter to net importer. Today, China is the world’s largest importer of soybeans, contributing 45% to world imports. With consumption increasing and production flat, this pattern is likely to continue, drawing down further on inventories to levels seen with the other grains.


The boom in biofuels has been driven by a number of factors, including depletion of oil reserves and the increased following of “peak oil,” reliance of the U.S. on imports, the threat of global warming and record high oil prices. As a result, a number of markets including the U.S. and the European Union have implemented biofuel agendas. For example, the U.S. Energy Bill, passed in December 2007, mandates a sixfold increase in U.S. biofuel production by 2022. Already, U.S. ethanol production (which is almost entirely processed from corn) has been surging by over 20% per annum since 2002, while the share of ethanol demand for U.S. corn has grown from 10% to over 20% over the same period. A similar effect could occur for sugar where sugar is used to produce biofuels in Brazil. The increase in corn acreage has also benefited other crops since total U.S. grain-planted acreage has remained relatively constant over the last decade; as a result, soybean acreage declined by 15% in 2007.


Limited Resources And Diminishing Yields

Increased demand for livestock and biofuels has resulted in increasing demands for feed, water and land. Combined with an increasing world population and emerging market GDP growth, this rising demand will increase the stress we are putting on natural resources up to a point that may not be sustainable in the long run. Accelerating urbanization and land scarcity may limit emerging economies’ ability to expand production to meet growing domestic demand, without increasing imports of feed and livestock. In addition, some new land which could be harvested would require big and lengthy infrastructure investments.

Additionally, agriculture is the biggest consumer of water in the world (74%). If the trend towards higher protein diets continues, then according to the United Nations Environment Programme (UNEP), water consumption is likely to increase since producing 1kg of beef meat requires 15,000 litres of water and producing 1kg chicken uses 4,000 litres ... while production of 1kg of rice uses just 1,400 litres. With water becoming scarcer each day, the cost of water is also likely to rise, which will increase the cost of producing commodities.

For much of 1970 to 2000, supply kept up easily with demand due to increasing yields from technological and farming improvements. However, the chart above shows that there has been a diminishing rate of return to yield improvements. Future yields could be improved through the use of drought-resistant, pest-resistant or high-yielding genetically modified seeds. However, it could take a decade or more before genetically modified seeds overcome resistance from governments, public opinion and environmental organizations.

Climate Change And Global Warming

Scientists are now more than 99% certain that mean temperatures will continue to rise around the globe. Global warming could have both good (increased yields in colder environments) and bad (decreased yields in warmer environments, increased insect outbreaks, soil erosion, diminished water supply) impacts on agriculture. However, a report by the Intergovernmental Panel for Climate Change (IPCC) suggests that losses to crop and livestock from extreme climate events (heat stress, droughts and floods) may outweigh gains from moderate temperature increases, at least in the short run. Even if positive in the long run, it will take time to adapt to the changes and to prosper from them.


The agriculture sector is going through a period not previously experienced. Even if supply can keep up with demand, low inventories mean world environmental events will now have a greater impact. Additionally, with both oil and food price inflation, the debate surrounding food or fuel will continue until prices stabilise. The world has been blessed with stable or falling raw agriculture prices over the past 30 years but with falling yields and increasing costs, this situation was destined to end.

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