Should you put your money in soft commodities?

Oil and metals hit new highs this week, grabbing the headlines once again. But...

Oil and metals hit new highs this week, grabbing the headlines once again. But there is another group of commodities that has hit investors' radar screens. Agricultural, or soft', commodities, such as soybeans, orange juice and coffee, have seen their prices creeping up too.

Fund managers seeking high returns are now looking to softs, which has led to the hope that softs will emerge from their decade-long doldrums, says Carl Mortished in The Times.

Softs certainly haven't been the place to be in recent years: the sector has experienced its "booms and busts", with coffee prices falling by 58% between 1998 and 2001 and cocoa prices weak in recent times after reaching a peak in the mid-1980s. This has had little to do with the state of the global economy, however soft commodity prices have historically been governed by factors such as disease, drought and frost.

But now, the same forces that are driving oil and metals mainly demand from China are beginning to drive the prices of softs such as wheat and soya. China's not the only country going through a massive industrialisation programme. And as emerging countries get wealthier, they consume more.

This is creating new markets for products such as coffee and confectionery, and increasing demand for the raw materials. It is a trend that's set to continue: the UN estimates that net imports of food by the developing nations as a whole will increase fivefold to £28.8bn by 2030, says Investment Adviser.

But grain and sugar are not only used as foodstuffs. Philip Gilbert, co-founder of alternative investment provider Bespoke, says that the "major factor" driving demand for sugar is its use as a fuel to power converted cars. This has led to the price of sugar futures rising 15% so far this year after jumping 62% in 2005.

China was quick to recognise its population's increasing demand for food: in 2004, it began to subsidise its grain growers for the first time. The subsidies are funded by price controls in the oil industry: the government now plans to impose a special tax on companies selling locally produced crude for more than $40 a barrel, says Lex in the Financial Times.

The government has "set the hurdle low" $26 below the current spot price for Brent crude. At that price, it would collect nearly $1.25 a barrel, adding up to an extra 12.5bn yuan ($1.56bn) in direct subsidies to around 600 million grain growers.

But can the bull market continue? Doubters should look at the "stark wake-up call" on climate change issued by Sir David King, Britain's chief scientist, last week. Climate change could have "devastating consequences", such as famine and drought, for hundreds of millions of people, says Andrew Grice in The Independent.

A three-degree rise in global temperatures could put 400 million more people at risk of hunger and cause cereal crop yields to fall by between 20 million and 400 million tons. With snow melting earlier in the year, water sources would be dry before crops finished growing in areas such as the Sierra Nevada and northern India. The result could be cereal crops being lost and crop yields falling for the first time since the agricultural revolution in Europe, Russia and America. This makes the supercycle' in oil and metals a drop in the ocean.

Risky ways to play the sector

Investing in soft commodities is not easy as private investors are poorly served by funds in this area. Barclays is the first high-street financial institution to market a product to private investors, says Patrick Hosking in The Times. An unlisted structural product, the Six-Year Agricultural Commodities Plan, will give investors 110% of the rise in the Goldman Sachs Commodity Agricultural Excess Return index over a six-year period. But the benefits "end there".

Rather than a "total return" index, Barclays has chosen an "excess return" index, reflecting the returns made on top of cash returns. The problem is the vast bulk of returns comes from the cash component of commodity investment, which is used as collateral and earns risk-free interest. Soft commodities will have to deliver "spectacular" price rises to give a decent return. Avoid.

Goldman Sachs has also launched two soft-commodity structured products, says Investment Adviser. Both products, classified as certificates, will have a six-year life, but they are also "tied" to the GSCI Agricultural Excess Return and GSCI Livestock Excess indices, so share the problems of the Barclays fund. Another way into softs is to spread bet on a wide range of softs, including cocoa, coffee, sugar, soya or rice, through firms such as IG Index or City Index. But this is a risky option.

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