The soft commodities you should buy now

Rationing is something that we associate with the dark days of World War II. But it's still a reality for many parts of the developing world and the bad news is that the situation is likely to get worse in the near future.

Global food scarcity is such a problem that, as Javier Blas reports in the FT, Egypt has just widened its food rationing system for the first time in two decades. And Pakistan has re-introduced a system of ration cards that had not been needed since the mid-1980s. Meanwhile, Russia and China are trying to counter rising prices by putting price controls in place, while Argentina and Vietnam are imposing foreign sales taxes and export bans to protect their own supplies.

So why the sudden scramble for food? The problem is that global food supplies simply can't cope with the demands of a world population rising by 75 million people per year, containing more and more emerging-market consumers adopting increasingly Westernised, meat-heavy diets.

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On top of that are ill-advised biofuel targets imposed by the EU and US, which demand that foodstuffs such as grain be turned into energy-inefficient fuel making the planet hungrier rather than greener. It's no wonder JP Morgan reckons agriculture is "the most recession-proof of asset classes".

That doesn't mean you should just pile into any agricultural (or soft') commodity you can find. Corn and wheat in particular have garnered a lot of column inches and now look dangerously close to bubble territory. But there are plenty of other options such as pork and beef, which have barely moved that look ready to play catch up. Here's a look at the softs and how you can play them.

Soft commodities: grains

Demand from biofuels is a major driver of most agricultural prices, but none more so than corn. The US Department of Agriculture (USDA) expects ethanol production to soak up about 30% of world supplies in the next two years, nearly double the current level, as the US struggles to meet President Bush's demands for a fivefold increase in the use of renewable fuels by 2022.

Bill Nelson of AG Edwards reckons that planting of corn for ethanol alone will need to rise by 43% to 30 million acres by 2015. And even though the USDA reckons there could be a record crop of 30 billion bushels this year, Merrill Lynch commodities strategist Francisco Blanch sees lots of further upside. "High prices seem to be here for the long-run" due to "growing structural imbalances" too much demand hitting dwindling stocks.

This prospect has sent corn prices soaring to more than $5 a bushel from just $1.74 in 2005. That and biofuel subsidies has in turn attracted more farmers to plant more corn. But for every extra acre of corn planted, an acre of something else is being sacrificed. This is driving the prices of other grains wheat and soybeans higher too.

On Monday, the price of wheat rose by 25% in a single day as Kazakhstan, one of the world's largest grain exporters, announced a plan to impose export tariffs to curb sales. With countries such as Turkey, Iraq and China all trying to replenish inventories at a time when global grain stocks are nearing quarter-century lows, Gavin Maguire of Iowa Grain in Chicago said "buyers are panicking". At nearly $24 a bushel, the price of the spring wheat used to make bread is up fourfold in a year, while the more widely available soft wheat for biscuits has more than doubled.

Meanwhile, the price of soybeans a crucial component in animal feeds and cooking oils is up by more than 60% in the past year and soybean oil has jumped by 83%, according to Merrill Lynch. On the supply side, the USDA forecasts the smallest US soybean crop in four years, with stocks plunging from 574 million bushels to just 160 million. Even though emerging markets such as Brazil and Argentina are raising production, most of that is for domestic markets.

As a result, global demand coverage is expected to drop this year to a five-year low of 70 days as demand hits record levels, particularly from emerging markets such as China the China National Grain and Oil Information Centre (NGOIC) expects imports of soybeans to double this year in an attempt to control runaway domestic inflation and counteract the loss of up to 40% of the country's rapeseed crop due to poor weather.

It's little wonder that prices are soaring and many believe there is plenty of upside still to come. But when we see prices rising by 25% in a day, it makes us nervous. Wheat, corn and soybeans have some strong fundamental reasons for rising, which has fuelled the boom, but this could all change if biofuels targets are reconsidered, crop yields rise, or some of the planet's marginal land is brought into productive use. And, of course, with prices rising at the current rates, farmers will find ways to grow more of these crops, leading to an eventual supply glut. The good news is that there's a way to play the grains boom without buying any grains.

Soft commodities: meat

Crop farmers might have had a fine 2007, but their gain is the livestock farmers' loss. It takes around 7kg of corn to produce just one kilo of beef so rising grain prices make rearing animals an expensive business. For farmers who have a choice between using grains to feed costly cattle, or instead sell into market, the choice seems clear. Canadian farmer Hubert Preum tells The Globe and Mail how he got rid of half his pigs last year because the barley he also grows on his farm was too valuable to be used as feed. "Instead of feeding grain to our hogs we sold it into the malt market and made our money that way."

In the US too, extortionate animal feed costs mean that farmers are rearing fewer animals and slaughtering them younger The Times estimates that total meat production fell by around 1.7lb per person. Farmers rushing to dump their high maintenance animals has kept the price of meat down over the past 12 months.

However, if farmers are killing their livestock off young and favouring growing more crops over raising more animals, that adds up to two things: too much grain and not enough meat. By 2009, a pig and cattle shortfall looms as inventories come under pressure, which will probably happen just as grain prices start to drop off.

And while supply is under threat, demand just keeps increasing. Growth in meat consumption in developing countries has averaged 4.8% a year over the past decade against just 0.5% in developed countries, reports Credit Suisse First Boston. Chinese meat consumption per head has been rising at around 2kg per year for the past ten years and shows no signs of slowing. You can find out how to invest in cattle and pigs below.

Soft commodities: sugar

Corn isn't the only foodstuff used to make biofuels. Sugar actually produces a far more efficient form of ethanol, of which Brazil is the main producer. As Seekingalpha.com points out, sugar-based ethanol is "the only economical biofuel without subsidies". And despite punitive import tariffs imposed by the US to protect domestic corn-based ethanol producers, the Brazilian government has just launched a $10m campaign to expand its ethanol export industry, targeting the US, Canada, Europe and Asia. Currently most of its production goes to fuel domestic demand.

The prospect of rising demand for biofuel use, as well as a rush of speculators hoping for sugar to follow its peers in shooting higher, has been part of the reason why the price has jumped by 30% already this year. May white sugar futures recently hit an 18-month peak of 14 cents per pound on the Intercontinental Exchange (ICE). Sterling Smith of FuturesOne in Chicago still sees "plenty of upside" and expects the white sugar price to hit 16.50 cents by July.

However, the US Foreign Agricultural Service expects a bumper harvest for sugar this year, with high output from India to contribute to a massive surplus of around nine million tonnes. If they're right, sugar prices could take a fall. Others disagree sugar analyst Kingsman recently forecast that India's output will not be as strong as expected, which could see the world sugar surplus cut to just a million tonnes by 2009. Even so, it seems to us that the direction of sugar prices in 2008 will very much depend on how the weather affects harvests and that's not a bet we'd be happy to stake money on.

Soft commodities: palm oil

Palm oil has garnered a great deal of bad press in recent months, amid reports of rainforests in Indonesia being hacked down to make room for palm oil plantations. Its use as a biofuel is the aspect of the story that gets the most attention, but in fact, palm oil is much more important as a foodstuff. Although it's a minor cost when filling a Western shopping basket, it's a different story in the East where palm-based cooking oil is an important source of calories and represents a big cash outlay. The futures price for crude palm oil hit an all-time high on the Malaysian exchange last week, and prices are tipped to go further by analyst Isaac Chow of HLG Research.

Ongoing emerging market demand is part of the reason for that for example, when a Carrefour store in Chongquing in China announced a limited-time cooking-oil promotion in November, the resulting stampede left 31 people injured. But there are plenty of other factors at work. After a brutal winter that hurt production of rapeseed oil, a palm-oil substitute, China is joining Indonesia in limiting exports. Meanwhile, poor weather in Argentina and Brazil has hampered production of soybean oil, encouraging a switch into palm oil as a cheaper substitute.

Sounds good but the trouble is, everybody else knows it too. Palm oil has attracted a great deal of attention from investors Papua New Guinea's largest palm oil plantation, New Britain Palm Oil (NBPO), has more than doubled since listing in mid-December which makes us wary of recommending buying into the story right now.

Soft commodities: cotton

Cotton isn't used as a biofuel, and nor is it edible. But this fibre, popular for over five thousand years, could be the best way to play the biofuels boom. As Seekingalpha.com points out, the price "has done nothing since the commodities bull market began". But that could be about to change. On the demand side, increasingly wealthy consumers in China, India and Latin America have joined Western peers in boosting sales of cotton tee shirts and jeans. China seems to have noticed that cotton is still cheap and has been buying heavily the USDA expects cotton imports into China to rise by 12% in 2008/2009 and a futures market has been set up on the Zhengzhou Commodity Exchange. Volumes there at around 60,000-80,000 contracts per day now match those in New York.

The trouble is, with all those expensive grains around, no one wants to grow cotton. Cotton plantings at around 9.5 million acres are the lowest in 25 years, according to Reuters. Next year could see the lowest crop in ten years, at which point investors might start to wake up to cotton's potential. You can find out how to buy cotton below.

Exchange-traded commodities are an easy way in

The spot prices of all the commodities above (and more) can be tracked using exchange-traded commodities (ETCs) from ETF Securities. It's important to remember that commodities don't pay dividends, so unlike buying shares or property you are purely investing in the belief that prices will rise further. Individual commodities, even those with solid long-term fundamentals and clear rising trends, can also be very volatile, and a full-blown global recession could well hit demand, and therefore prices.

It's also clear that for many investors, soft commodities have become the new hot' story. Even allowing for supply and demand imbalances, some, such as wheat and corn, look as if they've entered bubble territory, driven by hedge funds and other investors looking for an alternative home for their money as equity and property prices fall back.

That's not to say that the boom won't continue in the long term demand from increasingly wealthy emerging market consumers isn't going to reverse anytime soon. But encouraged by high prices, supply may be able to catch up with demand more rapidly than many analysts are currently allowing for, which is why we'd be particularly cautious about buying into corn, wheat (see chart) or soybeans, which look vulnerable in the short term.

If you do think the grains story has further to run, we'd suggest buying a mixed basket' ETC, such as Grains (LSE:AIGG), which covers corn, wheat and soybeans. Given that these three crops compete for land and investment from farmers, there's every chance that if one crop is over-produced, it will result in a shortfall in the other, so that may help hedge against large falls.

However, we believe that a better way to play the grains boom now is through buying meat. You can track the price of pork and beef through the Lean Hogs (LSE:HOGS) and Live Cattle (LSE:CATL) ETCs respectively. Like many ETCs, these follow their respective Dow Jones sub-indices, which in turn track Chicago Mercantile Exchange futures contracts. This means they will not precisely track the "spot" or cash price for each commodity, but they are the closest a retail investor will get.

If you want to kill two birds with one stone, there is an iPath Exchange Traded Note (NYSE:COW) available, which is 67.9% invested in live cattle and 32.1% in lean hogs. In terms of stocks, you could consider Cresud (NADSDAQ:CRESY), which has beef cattle, grain and milk operations in Argentina; its p/e of more than 30 looks very punchy, but Larry Edelson of Real Wealth reckons the price could rise to $27 a share this year from the current $18.

Cotton, which has yet to take off (the price is down by just under 1% over the past six months, compared to a leap of more than 40% for corn), also looks like an attractive alternative to grains, having been squeezed out of production by farmers keen to chase the biofuels boom. You can track the spot price via the LSE:COTN ETC.

If you're feeling particularly daring, you could even short the grain stocks while going long meat. ETF Securities has launched various shorting ETCs that rise in value as the underlying commodity falls, and vice versa. You can go short individual grains, such as ETFS Short Wheat (LSE:SWEA), or a basket of soybeans, corn and wheat (ETFS Short Grains (LSE:SGRA)). But this is definitely only something you should do with money that you are prepared to lose in markets with volatile double-digit movements, it's easy to lose all your money very quickly by shorting.

Alternatively, if you'd prefer broader exposure to the agricultural sector as a whole, then Hugh Hendry's CF Eclectica Agricultural Fund (020-7556 8800) is worth investigating. While many of the larger agriculture stocks, such as farming machinery group John Deere (NYSE:DE) and pesticide and seed technology group Syngenta (VX:SYNN) have seen their share prices rocket, Hendry says he has uncovered more than 400 smaller, neglected stocks in the agricultural universe. As someone who was onto the agriculture boom long before the crowd, Hendry is worth following.