In the past, soft commodities such as corn, wheat, palm oil and sugar cane did not get a fund manager’s pulse racing. Today, the investment community has developed quite a taste for grains on the back of the biofuels craze and a burgeoning middle class in countries such as China and India who have a bigger appetite for beef, chicken and pork.

Historically, soft commodity prices often behaved erratically due to variable weather conditions. This past year has been no exception with a severe prolonged drought in Australia and disappointing harvests in the US taking their toll. However, markets have recently defied trends and price increases are occurring simultaneously across the soft commodity spectrum. For example, according to industry figures, average US dollar spot prices for corn were up 86% in the first quarter of 2007 compared with a year earlier, while palm oil rose 41%. Meanwhile US raw milk rose 22.5%, soybean oil jumped 32%, with cocoa and coffee showing respective hikes of 16% and 23.5%.

Nudgem Richyal, manager of the Baring Latin America Fund, explains: “It seems clear that the commodity cycle has finally turned. We have seen strong performance from the energy sector, and history shows that soft commodities, such as soybeans, wheat, sugar and oats, tend to be the next area to see inflows of capital in each commodity cycle.

“Also, against the backdrop of concern about global warming, demand for soft commodities such as biofuels has grown exponentially. This has created a source of demand that simply was not present to the same extent in previous cycles, and is acting as a further positive support for commodity prices.”

As Jeffrey Currie, global head of commodities at Goldman Sachs puts it: “A combination of food, feed and fuel demand is driving structural increases in agricultural commodity prices. Food is a stable source of demand, while feed is one reasoncountries such as Brazil, Russia, India and China (BRIC) are getting wealthier and wanting to eat more protein. In the past, increase in demand for grains has been met by yield expansion but today it requires acreage expansion. This is much more costly than just tweaking yields with technology. These factors combined will continue to put upward pressure on long-dated agricultural prices.”

Although production is being increased, it still lags behind demand mainly because inventories, especially in wheat and corn, are at their lowest levels for 25 years. Figures from the International Grains
Council reveal that despite an expected 6.2% hike in global grain production to a record 1.666bn tonnes in 2007-08, it will not match global consumption, which is forecast to rise to 1.680bn tonnes, up 3.1% on the previous year. If this trend continues, Goldman Sachs predicts that in five years’ time, corn could trade at $5 (€3.8) a bushel, compared with about $3.50 this year, while wheat could rise from $4.50 to $6 a bushel.

 

While there is no doubt that a wealthier BRIC contingent is getting more play, most of the buzz in soft commodities is around biofuels. There are two main types; biodiesel, that requires an oil feedstock such as canola, palm oil or animal fat, and ethanol, which is derived from sugar or starch-based plants like corn or cane and which is a petrol substitute.

In the past two years, environmental issues and relatively high oil prices have forced many countries across the globe to explore their renewable energy options. Research from Goldman Sachs notes that if government policies are adopted in full, global demand for biofuels could jump from 10bn gallons (37.9bn litres) a year to 25bn gallons by 2010.

Brazil, the world’s largest sugar producer, has been a pioneer and started over 10 years ago to convert sugar to ethanol. More recently, the US and EU have jumped on the biofuels bandwagon. The EU recently called for biofuels to replace 10% of petrol by 2020, while several states in the US, which is the world’s largest producer of corn, have already passed legislation requiring that the ethanol content of gasoline increases to 10% over the next few years, with long-term targets closer to 20%.

The US has wasted no time getting into gear, and last year the country overtook Brazil as the world’s biggest ethanol producer as its output jumped by 22% to 4.89bn gallons. Current production capacity is up an additional 20% and rising fast. In total, there are 120 ethanol plants with 75 more slated for construction. According to research from Threadneedle, the UK-based fund management group, ethanol
consumed about 20% of the US corn harvest and this figure could increase to nearer 40% by 2009.

Not surprisingly, US farmers are rubbing their hands in glee as they are reaping bountiful revenues on the back of rising corn prices and ethanol sales. But the euphoria could be tempered if a recent report from United Nations - Energy, a consortium of 20 UN agencies and programmes, is taken on board. Although it is unlikely that the issues highlighted will immediately stem ethanol production, they could provide food for thought. The UN consortium is calling on governments and farmers to think twice about the impact ethanol processes and production has on the environment and poorer communities.

The main concern is that the benefits of using ethanol, which can help reduce global warming, may in the end be offset by the creation of other serious environmental problems and increased food prices. Planting and cultivating corn, for example, is an expensive exercise in terms of fertilising, harvesting, processing and transportation. Also, as the report noted the use of large-scale mono-cropping could lead to significant biodiversity loss, soil erosion and nutrient leaching.

The report also highlighted the dangers posed to rainforests, particularly in South-east Asia, where countries such as Malaysia, one of the major planters and producers of palm, continue to clear their primary forests to make room for the crop to boost supplies. Prices soared by over 60% in 2006, and so far this year they are up by 17.6%.

 

Last, but certainly not least, are fears over the ramifications of diverting food crops to fuel. As Petra Lottig, head of commodities and investor products of Deutsche Bank, notes: “We are definitely seeing a trend where countries are increasingly growing crops such as corn for ethanol at the expense of other commodities. This is leading to a situation where planting more corn equals fewer soybeans and this is putting upward pressure on the prices of both.”

Alistair Lowe, head of global asset allocation for State Street Global Advisors in the US, adds: “When farmers in the Upper Midwest in the US are faced with a choice of whether to grow corn, wheat or soybeans, they will chose the one that will attract the best price. At the moment this is corn because of the ethanol story but this obviously comes at the expense of growing another crop.”

Biofuels, albeit a major factor, is not solely responsible driving prices higher. Roland Kitson, sales and marketing director of Close Fund Management in the UK points out: “The problem is being exacerbated by the rise of the middle classes in developing countries across Asia and South America, demanding more sophisticated foods and meat. However, producing meat from grains is an inefficient process as it takes about nine kilos of grain to produce one kilo of beef and 4.5 kilos to produce one kilo of pork.”

Although it is hard to predict how quickly eating habits will change, a recent report by Barings notes that the behaviour of the US population between 1909 and 2004 may provide some insight as Asian countries move up the GDP curve.

During that 95-year time-frame, meat consumption in the country jumped 90% as per capita GDP rose from $5,000 to $20,000. The latest estimate for China is $7,198 per capita GDP based on 2005 figures, which means that the population has a long way to go before it develops a US-type appetite for meat.

Barings’ research also reveals that the average person in China and Taiwan consumes 2,500 calories a day, but in Taiwan this includes nine times more animal protein. Chinese consumption of beef and chicken, on the other hand, is growing by 20% every year. At the moment, China, which is the world’s largest wheat producer, is meeting the demand by increasing its own production. However, longer term, it may experience shortages as wheat stocks have already dropped dramatically to 35m tonnes in 2006 from 103m in 2000 as farmers have used farmland for industrial and urban purposes.

Coffee and cocoa, which have not been caught up in the biofuels or emerging market demand stories, have benefited from short-term supply and demand imbalances.

A growing taste for dark chocolate due to a raft of stories promoting its health benefits has pushed cocoa prices to eight-year highs. In the US, sales jumped by 49% to $1.88bn between 2003 and 2006.

Meanwhile, coffee prices hit a four-year record on the back of growing popularity for takeaway coffee. Industry studies show that over the past decade, the takeaway market in the US has trebled from $30bn to $90bn, while the thirst of the consumer shows no sign of abating.

Although inventory building has been hampered by adverse weather conditions in key West African producers, analysts believe stocks will be replenished and that by 2008, prices should drop by about 12%. The caveat, of course is the arrival of another El Niño global weather phenomenon or a return to civil war in Ivory Coast.

Topics