How to profit from rising food prices

You may not have noticed, but the cost of the humble onion has risen sharply. Here in the UK, a kilo of onions now costs around 77p - a 15-year high. Now this might not be that big a deal for the British consumer, but for low-income consumers in India, where the onion is a staple, the situation is far more serious. As the International Herald Tribune recently pointed out, a popular saying in the country is that 'you will never starve because you can always afford a roti... and an onion'. That makes rising onion prices a very visible sign of inflation in the country - the issue has even toppled Indian governments in the past, contributing to the downfall of ruling parties in 1980 and 1998.

But it's not just onions that are surging in price - far from it. The price of all foodstuffs is heading higher. Here in the UK, food price inflation is running at its highest in ten years, according to the Alliance Trust Research Centre, with the price of fish up 12.6% and vegetables up 10.2% over the past year. This is bad enough for consumers in the developed world - no one in the UK or the US will starve because of rising food prices, but the rise in inflationary pressures means that central banks are more likely to have to raise interest rates. That'll put a further squeeze on consumer incomes, even as their weekly shopping bill is cutting into their pay packets.

Meanwhile, as India's onion problem shows, the consequences for developing markets are more serious. For example, earlier this year a 60% leap in tortilla prices provoked rioting in Mexico, forcing the government to intervene to try to stabilise the market.

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The bad news is that this isn't just a blip. As Bedlam Asset Management (BAM) points out, 'the price of most staple foodstuffs has fallen by 80% over 30 years' in real terms. This means that even if prices were to double in the next five to ten years, as BAM expects, they would still only be 'back to half their historic average'.

Donald Coxe of fund management group BMO says: 'For the most part of the past quarter century, food prices have been benign... that has begun to change.' BAM's research suggests that between 2005 and 2007, the price of rice has risen by 50%, wheat by 33% and cattle by more than 40%.

Food prices: what's driving them?

So why is this happening? After all, as The Economist points out, bringing previously marginal land into productive use normally solves demand for food. This time, however, we have a heady cocktail of sharply rising demand from emerging-market consumers coupled with climatic changes, resulting in what Jim Rogers says is the lowest global inventory of food since 1972. Add to that the demands of a rapidly expanding biofuels industry and suddenly you have a serious squeeze. Investment bank Goldman Sachs says the world is entering a period of 'sustained inflation in agricultural products'.

Food prices: The growing hunger in Asia

In agriculture, the three economic giants are the US, China and India. Yet in America, despite 26 years of favourable growing conditions in the mid-west, the supply of feed grains is at near-record lows. That is in large part because consumers from a host of emerging markets are now joining Western countries at the table. BAM says: 'From 1,600 calories a day... 20 years ago, three-quarters of the world's population now has enough money to eat just like us; and they are.' It is this demand from India and China's growing middle classes in particular that is driving much higher levels of global food consumption and pushing up prices worldwide.

As people get richer, they tend to switch away from a predominantly vegetable-based diet to one that includes meat. Lots of it. JP Morgan reckons consumption per head in China could rise by more than 50% from 1997 to 2020, reinforcing warnings given a decade ago by Lester Brown in his 1995 book Who Will Feed China? The most protein-efficient meat is poultry; according to Coxe, 'a bushel of corn produces 19.6 pounds of retail chicken, but just 13 pounds of pork and a mere 5.6 pounds of beef'. The trouble is, demand for beef and pork has been strengthened by fears about poultry following avian bird flu outbreaks, which have hit Asia hardest. Today's emerging market preference for red meat is driving up the corn price, already under pressure from biofuel demand (see below).

It's a similar story in India. A 13.7% annual rise in white-collar salaries (the highest rate in Asia, says the International Herald Tribune), is creating huge demand for everything from houses to beer. Despite being the second largest wheat producer on the planet at around 70m tons, India is now a net importer; local prices have risen by 12% in the past year. Domestic supplies simply can't keep pace with a triple whammy of higher southern region consumption, rapid population growth and rising incomes.

Growing, urbanising populations also have another effect - reducing the amount of land available for arable use. 'Every year for the past decade, China has lost fertile land equivalent to the area of Scotland,' says BAM. To feed its population, it 'actually needs to add a land area equivalent to Scotland every year'. India and other industrialising nations are no different.

Of course, Malthusian predictions of a global food supply crunch are not new and nor is the emerging markets story. But an added development in recent years that has further upset the balance of supply and demand is what Goldman Sachs dubs 'ethanol euphoria'.

Food prices: the biofuel bubble

The surging price of oil, up from just $20 a barrel a few years ago to more than $60, has understandably created huge interest in finding alternative sources of power to cut dependence on the black stuff. The International Energy Agency estimates that demand for crops for biofuels is set to soar from 41.5m tons of oil equivalent in 2010 to 92.4m by 2030.

Thanks largely to George Bush's cleaner energy initiative, which aims for a fivefold increase in use of renewable fuels by 2020, the biofuel of the moment is ethanol. Carmakers in Detroit have agreed that half their vehicles will be designed to run on a petrol-ethanol mix of 85:15 by 2012. Unfortunately, the preferred method of ethanol production in the US is corn-based, even though this is a costly and inefficient way to produce fuel. Brazilian sugarcane-based ethanol is far more efficient, but the political reality is that the votes of corn farmers hold more sway with US politicians than environmental concerns. A fifth of the US corn crop is already given over to ethanol production, with some analysts suggesting this will rise to 25%.

It's not just the US. Europe wants biofuels to meet 10% of energy demand by 2020. Hans-Willem Windhorst of Germany's University of Vecta says to hit this target, 25% of all European arable land will have to be turned over to ethanol production. Unsurprisingly, this biofuel mania 'is creating unintended consequences throughout the global food chain', says Bloomberg. Land that was used for soybeans, for example, is now being diverted to corn for ethanol, sending soybean prices rocketing. Meanwhile, rapeseed crops being grown in the EU to feed biomass plants are taking up land once used for wheat and barley, resulting in rising hamburger and beer prices.

The huge diversion of corn in particular, notes The Sunday Times, is directly affecting meat prices. 'Livestock producers are having to bid against the ethanol industry to get supplies of corn,' notes the US Department for Agriculture. As a result, global output of beef, pork and chicken is expected to fall by up to $2bn a year, thanks to the rising cost of feeding livestock. But worse still, is that the drive for 'green' fuels - which are after all, meant to offset climate change - is set to make the problem worse, according to a new UN report. As Metro reports, 'soaring demand for palm oil, an ingredient in biodiesel, has already led to tropical forests being cleared in South East Asia'. In fact, Indonesia, a key palm oil producer, actually has the worst carbon emissions per head due to cutting down forests to make room for production.

Food prices: changing weather patterns

This brings us to another key reason behind rising food prices - climate change. Whatever your take on the causes of climate change, it is hard to deny that some parts of the world are experiencing freakish and troublesome weather conditions. Even Bank of England governor Mervyn King recently blamed rising UK inflation on 'a rise in food prices caused by a weather-induced global reduction in supply'.

In Australia, the prime minister, John Howard, last month warned that the drought facing the country, which scientists are calling a 'one-in-a-thousand-years' event, was an 'unprecedentedly dangerous situation'. In fact, if it doesn't start raining within the next few weeks, the government will be forced to turn off water supplies to the 50,000 farmers whose livelihoods depend directly on irrigation. A ban could see food prices triple, says food growers' group Ausveg, while Treasurer Peter Costello said the 400%-500% rise in banana prices seen after Cyclone Larry could be repeated, 'in relation to stone fruit, horticulture, all of these things', he said. Already rice production has collapsed, from 1.6m tons to 106,000 in 2006/07; cotton has tumbled to 250,000 tons, from 597,000 the year before; and wine grapes have produced their smallest harvest since 2000.

So why is this happening? Water has warmed up in the Pacific Ocean, moving moisture away from Australia and towards South America. But as Dr David Jones, head of climate analysis at Australia's Bureau of Meteorology, tells the Herald Sun, 'this isn't simply due to El Nino. We've never seen a drought event like the current one on our records. This is starting to go beyond anything we've seen in the past and there are other things going on. It clearly raises the issues of climate change.'

But at least Australia can afford to buy imports. In Guatemala, where nearly half of children are malnourished, more and more people are going hungry. Farmers lost their crops to Hurricane Stan in 2005, while drought is threatening crops this year. 'The weather affecting crops is increasingly unpredictable due to climate change,' Ian Herret, head of the UN Food and Agriculture Organisation in Guatemala told Reuters, adding that 'hundreds of thousands' could starve this year if rising prices combine with drought.

So what can we do about it?

Although drastic, these problems are not insurmountable, says BAM. New technology, such as genetic modification, could increase crop yields, while land could be used more productively. Meanwhile, the inefficient use of biofuels will likely stop once politicians realise that voters care more about eating cheaply than driving green cars. In the meantime, 'investors should expect much higher food prices and shortages, for these structural imbalances are a new long-term trend'. And if global warming turns out to be as bad as scientists suggest, 'they will accelerate'. That means there are profits to be made: we look at some of the best ways to gain exposure to rising food prices in the box on pages 20 and 21.

How to gain from booming food prices

Investors looking to get exposure to food prices can now invest directly in agricultural commodities. There are several exchange-traded commodities listed on the London Stock Exchange tracking softs including corn (CORN), wheat (WEAT), soybeans (SOYB), sugar (SUGA), and cotton (COTN). There are also ETCs available on livestock, such as lean hogs (HOGS) and live cattle (CATL). You can find out more at www.etfsecurities.com. Like the underlying product, these can be fairly volatile, so it might be a better idea to get more diverse exposure by going for a more general agricultural tracker based on a basket of goods. The Grains ETC (AIGG) tracks the price of soybeans, corn and wheat, while the Agriculture ETC (AIGA) tracks the Dow Jones Agricultural sub index, a wider basket of grains. If the idea of being directly exposed to the underlying commodities doesn't appeal, you can also invest in companies that stand to benefit from rising prices. Food producers might at first seem an odd choice, given that input costs are expected to rise. However, Goldman Sachs tips Danone (DA), Numico (NUM) and Nestl (NESN) on the basis that they are the best-placed companies in the sector to pass on rising costs to the consumer, due to dominant market positions and fast-growing sales. To us, Nestl looks best value of the three, on a p/e of 20 (against 23 for Danone, and 32 for Numico), not cheap but not bad given that earnings are expected to grow 12% this year. It also offers the best yield, at 2.15%, against 1.4% and 0.5% for its respective peers and is also the biggest producer of baby food in the US, after the recent acquisition of Gerber.

Agricultural businesses are also worth a look. Swiss-based firm Syngenta (VX: SYNN), is a crop-disease-protection company, producing herbicides and insecticides as well as seeds for crops. Patrick Lambert of Swiss broker Cheuvreux tells BusinessWeek that the stock could hit $54 a share in the next 12 months (from the current price of $37) because of rising demand from corn farmers in the US - corn acreage is expected to rise by 8% this year. The shares trade on a forward p/e of 17.5, with a PEG ratio of below one, which makes them look much more attractive than US rival Monsanto (US: MON), whose shares look pricey on a forward p/e of 34.8. Another option is agribusiness Bunge (NYSE:BG), which specialises in the storing and processing of soft commodities, including soybeans, and the supply of fertilisers to Brazilian farmers.

A less-direct play on food shortages is US-based DuPont (US:DD), which supplies its chemical, biotechnology and pharmaceutical products to industries as diverse as textiles, construction and agriculture. Crucially, it is also involved in the area of hybrid seeds, which will become far more important as countries look to boost crop yields due to populations increasing and cultivated land decreasing. Donald Coxe of BMO reckons that 'Africa can probably only expand food output significantly by planting GM grains that protect against pests'.

As for livestock, one option is Australian Agricultural Company (ASX:AAC), the world's largest beef producer. There are some risks. There is only a 50% chance of average rainfall across Australia over the next three months and the drought has seen farmers rush to sell their cattle before the winter kicks in, hurting prices. 'We are now getting perilously close to winter conditions and lack of feed that would sustain cattle through winter,' said Richard Norton of AWB on Bloomberg.

However, the country is the third-largest beef producer in the world, and has taken full advantage of its proximity to Asia to ride strong demand from the region as the US suffers a ban over mad cow disease. Beef exports to Japan have risen by 100% to 400,000 tonnes over the past three years. 'There will be a lot of money to be made when it does rain,' says Norton. 'It's a matter of how long people can hang on and how long they can sustain the input costs to keep cattle alive until it does rain.' Meanwhile, Bedlam Asset Management reckons holding AAC 'can be justified on either the value of its herd' or its land bank, which is 'the size of Ireland'.