Why you can't afford to ignore soft commodities

The future is an impossible place. Every year the world's financial pundits have a go at forecasting it and pretty much every year they are wrong. Indeed, if they had any sense they'd have given up long ago. Still, they haven't, and no one appears to mind much if they keep getting it wrong the financial commentary market seems to be a remarkably forgiving place. With this in mind, we've asked some of our writers and some of our favourite analysts to tell us what they think might happen during 2006...

Everyone knows that energy and metals prices hit new highs in 2005, but not many noticed that many soft' or agricultural commodities were on the up too.

Feeder cattle futures hit a lifetime high; lean hog futures climbed to an eight-year high; sugar climbed to its highest since 1995; and coffee futures hit a six-year high. Yet many soft commodities are still priced "so far below their all-time highs it's hard to see them falling", commodities guru Jim Rogers told MoneyWeek in November.

So why should they keep rising? First, because of "the record-breaking hurricane season", Agbeli Ameko of First Enercast Financial told Investors.com. The immediate effect was to push up oil prices, but other commodities will be affected over a longer time frame, as many crops were destroyed. Forecasts for the Florida orange crop have fallen from 190 million boxes before the hurricanes to 162 million boxes and that's before taking into account the forecast harsh US winter. That's why orange juice futures climbed above $1.30 in December to their highest levels since 1996, not that they're forecast to keep rising (new trees take time to grow). Overall, says Rogers, orange juice is a "better safe haven" than gold.

But this is only part of the story. The more fundamental force behind climbing prices is China, which is demanding ever more food. The middle class is forecast to grow by 140% by 2010 to 155 million double the whole population of the UK. And as the middle class grows it is demanding higher protein food. This in turn affects the worldwide market for soft commodities; to produce one kilogram of beef takes seven kilograms of grain. But thanks to the droughts that increasingly pervade vast swathes of China, it can't grow enough food to meet its own domestic demand.

And according to Stephen Wrobel of Diapason Commodities Management, speaking at our Roundtable last month, that isn't going to change any time soon. Whether you put it down to global warming or misuse of land, says Wrobel, many countries are finding that the amount of farmland available to them is shrinking. The average farmland per capita in China in 2004 was only 0.1 hectare, even less than half the world average. No wonder supply can't keep up with demand.

Other factors pushing soft prices upwards are the green lobby, and high oil prices. As legislation is forced through to lower carbon emissions, and oil remains at near-record prices, many countries and firms are looking for fuel alternatives. As most soft commodities can be made into fuel, they benefit. The most attractive is sugar, which can be made into ethanol, a green alternative to petrol, which is gaining popularity. It not only comes with tax breaks in some US states, but in Brazil it fuels one car in three. Indeed, sugar is Barclay Capital's favourite soft for 2006, reports The Times, as "it still has the best and most persuasive underlying story among the soft commodities".

Unfortunately, there is at present no fund that is a pure soft commodity play. Spread betting is one option, or Goldman Sachs offer certificates that allow you to track the three main components of its commodities index precious metals, base metals and soft commodities. But if you want to invest in equities, UK-listed plantation and cattle firm MP Evans might be one to look at. Alternatively, US-listed Bunge is a global agribusiness that, in its own words, captures "value wherever it appears on the food production chain," and its story justifies its p/e ratio of 16.