Update: Read Where to make a fortune in soft commodities for more expert advice on how to invest in soft commodities.
In December most City analysts were assuring us that oil prices wouldn't be anything to worry about in 2006. The bull run was to be firmly left behind in 2005 and oil would soon fall back to the $40 range, a level at which it could safely be ignored as being both no threat to anyone's inflation or interest rate forecasts and of no investment interest.
It's early days yet, but so far it isn't working out quite like that and I don't think it will. Oil prices are not falling but rising. And with supply still tight and Asia's economies still booming it rather looks as though oil will turn out to be as good an investment in 2006 as it was in 2005.
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However it may not turn out to be the best investment in the commodities sector. I have no doubt that we are still near the start of a long term bull market in commodities but within that there will be leaders and laggards. Last year the leaders were oil (+41%) natural gas (+58%) and the industrial metals (zinc jumped 50% for example) and the laggards were agricultural commodities (or softs'). Soybean and wheat prices rose 10% each while coffee and cattle prices managed only 3%.
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Yet the driving forces behind the softs' market are much the same as those for hard commodities strong demand from China, India and the like combined with limited supply so there is every chance that we will see them moving into prime position this year.
Emerging economies may need copper, lead and zinc to build their infrastructures but they also need food to feed the newly-urban populations using them. And they need it in increasing variety and quality.
The first thing that people do as their disposable income increases is improve their diet: they stop eating plain rice and vegetables and chuck in a little chicken in the beginning. Then as things get better they up the amount of chicken or pork, then as they move into towns and become the part of the urbanised middle class they add more processed and convenience foods into the mix.
All this has huge implications for soft commodity demand, particularly given that according to the United Nations the urban population of China will more than double to over 800m by 2020.
Consider grain consumption. Today, according to the Earth Policy Institute, the Chinese consume under 300kg of grain each a year. The Americans get through well over 900kg each thanks to their meat, milk and egg-rich diet (chickens and cows eat a great deal of corn and soya).
Then look at the amount of meat the two nations eat. The Americans devour 276kg of it each every year. If the Chinese were to do the same, their total meat consumption would go up from 64m tonnes a year to 181m tonnes. That's the equivalent of four fifths of current global meat consumption.
Something similar can be said of pretty much any commodity you can think of from coffee (the Germans consume 50 times more per head than the Chinese) to sugar and orange juice. These enormous discrepancies can't possibly last just as there's no reason why owning two SUVs each should be a privilege exclusive to Americans, there's no reason why they should be the only ones that get to have fried chicken for supper every night either.
Another thing that investors need to bear in mind is that food isn't just food any more. It's also an oil substitute. Farmers grow soy, sugar, corn, palm oil and even coconuts, not just for eating but as the basis for bio-ethanol and bio-deisel too.
And as governments come under increasing pressure to cut carbon emissions we are going to see demand for these fuels rise exponentially. Already 30 countries around the world including Brazil ("the Saudi of ethanol" thanks to its huge levels of sugar production, say analysts at ABN Amro), India and Australia produce biofuels.
Even in the US ethanol makes up about 3% of transport fuel; and in Switzerland you can buy Greenlife diesel made from diesel and rapeseed oil at ordinary petrol stations. Add all this to the rising demand for foodstuffs in the emerging world and you can see why it might be time for soft prices to start moving.
Now we get to the tricky bit of the story how to invest. Irritatingly there are no easily accessible funds devoted to the sub-sector which means that investors must either spread bet or invest in individual equities. I wouldn't recommend the former (soft prices are very volatile) but there are a few opportunities in the latter category.
One might be to take a look at the few remaining plantation companies listed in the UK. At the start of the twentieth century there were scores of these based in the UK but devoted to exploiting the resources of the Empire and supplying the globe with everything from rubber to tea. But as the century moved on and the colonies became independent their numbers dwindled (nationalization of their assets and various other political difficulties made it hard to stay in business).
Now only a handful remain, most of which have long been seen as enchanting but essentially useless memorabilia of a long lost age. However I think it is time to see them as rather more than that - they may now be one of the few moneymaking plays on agricultural commodities in the market. My favourite, MP Evans (MPE), operates palm oil plantations and cattle ranches and appears to have a sensible long term strategy while its shares trade on a p/e of 17 times and offer a yield of over 3%.
First published in The Sunday Times, 08/01/2006
