The best way to play agricultural commodities

The world's population is rapidly growing in both size and prosperity. And so demand for raw materials – for food and clothing – will keep rising. But with soft commodity prices so vulnerable to changes in the weather, how can you profit? John Stepek explains.

By John Stepek

published 5 July 2010

in Features

How happy would you be to stake a chunk of your pension money on what the weather will be like next Wednesday?

I'd hope your answer is "not at all." Because of course, this is a gamble. No one knows what the weather will be like next Wednesday. If you want to take a punt on it, by all means do, but it's not an investment fit for your long-term savings.

What's my point? Well, as several hedge funds discovered last week to their cost, playing the soft commodities market is basically just betting on the weather.

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I'll explain in more detail below. But suffice to say, the price of raw materials such as grain or coffee or cotton is always going to be dictated by weather cycles more than anything else. So even although demand for agricultural commodities as a group will keep rising, betting directly on the price of various softs is just too risky for the average investor.

It's a shame. Because this is a fantastic long-term investment theme, which incorporates everything from the rise of the East to the fact that water is set to become more important than oil in the decades ahead. The good news is that there are more effective ways to invest in the softs sector...

Markets could relax a bit this week

The fear of a double-dip recession seems to have accelerated suddenly. Less than a month ago, the idea seemed unthinkable to most analysts. Yet now it's all over the front pages of the business sections.

As the saying goes, if it's 'in the press, it's in the price'. So I wouldn't be surprised if markets relax a bit this week. After all, in terms of economic data, it's set to be a relatively quiet week news-wise. And after last week's plunge in stock markets, we're probably due a bit of a rally. However, it won't be long before fear starts to spike again. There are too many nasty little surprises that can still be sprung on the market. We'll discuss all this more in the next issue of MoneyWeek magazine, out on Friday (if you're not already a subscriber, subscribe to MoneyWeek magazine).

Why corn was where the market action was last week

But let's leave equities aside for the moment. Some of the most interesting action in the markets last week happened away from stocks. One asset in particular - corn - saw its biggest spike since 1988, according Rowena Mason in this morning's Telegraph.

As I noted in the Saturday round-up email, agricultural analysts have been talking of a grain glut this year. Bumper harvests in recent years mean the sector has gone from fear of food riots to concerns about the ability of farmers to sell their crops at a profit.

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Hmm. Too much supply, not enough demand - time to short-sell corn. It's a logical step, and many punters took it. But they reckoned without the weather.

A damp May in the US corn belt saw a million fewer acres seeded than the US Department of Agriculture (USDA) had expected. On top of that, stockpiles are being used up at a much faster rate than at this time last year. Meanwhile, hot weather in Russia looks like it might leave a dent in what had been expected to be a healthy wheat harvest too.

The result? A massive short-squeeze (where investors who are short rush to cover their positions before they lose even more money), which drove the corn price up by 10% on Friday. There's a suggestion that this could even have been partly behind the fall in gold and oil, as investors sold positions in metals and energy to cover their soft shorts.

By the way, some of you might be thinking: "serves the short-sellers, speculators and hedge funds right." And they'd probably agree with you. After all, you make a bad bet, you pay the price. This is the flipside of the "evil short-sellers" nonsense that springs up every time a European politician wants to whine about their banks or governments being picked on. Short-selling is risky. And when a hedge fund gets it wrong - as they did on this occasion - none of them come running to you, the taxpayer, asking you for a bail-out. Unlike banks, or indeed governments.

How to play the softs market

Anyway, back to the main story. The point is that the global weather system can wreak havoc on expectations for the softs market. You can go from feast to famine and back again remarkably quickly. So betting on the likes of corn or cotton directly is very risky and almost pointless for anyone but the most knowledgeable day-traders - or farmers.

At the same time, there is unquestionably going to be long-term, rising demand for more raw materials. We all need to eat. We all need clothes. And the richer we get as a world, we demand more, and better quality, of each. And supply will be squeezed too. Because the richer and larger our population gets, the more space we all take up, the more water we use, and the more competition there is for resources in general.

This trend will continue almost regardless of the threat of a double-dip. And the best way to play it is via "picks and shovels" plays. In other words, you want to buy the companies that will enable us to make the best use of the resources we have, rather than buying the commodities direct. My colleague James McKeigue looks at some potential beneficiaries here: Harvest profits from agricultural growth.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.