Grain prices could be heading higher – permanently

Cotton hit a 15-year high yesterday; it's the latest in a line of 'soft' commodities to hit fresh highs.

Commodity prices are generally volatile. And softs are, if anything, even more unpredictable than their 'hard' peers. There's the weather for one thing: too hot, too cold, too wet all can take their toll on the supply side.

And when it comes to random events, the weather is the least of your worries. A plague of locusts threatened Australia's harvest earlier this year. How do you plan for that?

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And while the likes of copper or oil have fairly long production cycles it takes a while to find and establish a mine if you want to produce more copper the supply of softs can be ramped up comparatively quickly. Corn prices are high? So plant more corn. Problem solved.

So you might be tempted to dismiss the latest spike in the softs complex. But what if there's more to it than that?

Why changing demand for grain matters

Dylan Grice at Socit Gnrale has just put out a very interesting piece of research on soft commodities more specifically, the grain markets.

As Grice points out, "real commodity prices should decline over time". Why? Because improved technology better farm machinery, smarter seismic exploration tools, etc. reduces the production costs per unit. So you get the same amount of commodity for a fraction of the effort.

Sure, you might get a price spike every so often if there's a supply 'bottleneck'. But that should simply encourage the production of new supply, which will bring the price back down in time.

However, not every commodity 'shock' is temporary, argues Grice. Look at the 1973 oil crisis. The Opec oil cartel embargoed supply during the Yom Kippur war, causing a spike in oil prices. But even when the embargo ended, although oil prices fell back, they remained permanently higher than before.

Why? Because US domestic oil production peaked in 1970. This "pushed the US dependency ratio (imports as a % of consumption) from 20% to 40% in barely three years." In other words, America needed to import a lot more oil on a permanent basis. And this shift means that real oil prices have never actually returned to their pre-1973 levels, even during commodity bear markets such as 1997, and the 2008/09 crash.

All very interesting. But why does it matter today? Because, says Grice, the same thing a permanent shift in demand could be happening to the grains market right now. China's population is a lot bigger than its productive land and water resources can handle. So the more industrialised it becomes, the more food it needs to import. And indeed, China has gone from being a net exporter of grains as recently as the late 1990s, to importing more than 10% of its needs, according to the US Department of Agriculture.

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Invest in companies serving agriculture

What does that mean? Well, if we're looking at a permanent shift on a par with the oil market, it basically means you should be looking to invest in companies that service the agriculture sector. That's everything from fertiliser stocks (along the same lines as BHP Billiton bid target, Potash Corporation) to producers of genetically modified crops.

Now before we tell you to pile in, a word of caution. The case for a long-term bull market in agriculture seems to be so widely accepted that it's a good idea to look for arguments against it. My colleague Merryn Somerset Webb has tackled some of these points on our blog in the past: How high grain prices could hurt the investment case for agriculture. A reversal of demand for biofuels in the US, or a stalling in the trajectory of the global population (as people get richer, they have fewer children) could make the case for agriculture a lot less compelling.

On top of that, a recent book by ecologist Simon Fairlie counters the idea that a meat-rich diet is necessarily a lot more resource-intensive than a vegetarian one. More on that in the next issue of MoneyWeek magazine, out on Friday.

And I'd add that agriculture is one of the most distorted markets in the world. It's a forlorn hope, but if the politics, protectionism and rampant subsidising of the sector were ever tackled, I suspect we'd find it much easier to feed all those mouths.

Two ways to play agriculture

But for now, agriculture looks like a sector you should have at least some exposure to. As we've noted before, if you're happy to take a bet on soft commodity prices themselves, you can use spread betting (there's a comparison table of brokers here) but bear in mind that this is highly risky and that losses can mount rapidly if your bet goes against you. Also, it's not a way to get long-term exposure to the sector it's basically for taking short-term punts.

If you want to invest for the longer term, one way to play both agriculture and urbanisation in general is to invest in water. We covered how to do this a couple of weeks ago in MoneyWeek magazine. Subscribers can read the piece here: Put your money in water and watch it grow if you're not already a subscriber, then you can read the article and subscribe to MoneyWeek magazine.

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