How high grain prices could hurt the investment case for agriculture

Most people agree that global demand for food looks set to soar. But one thing could derail the investment story for agriculture, says Merryn Somerset Webb - bio-fuels. Here's how.

We often write about agricultural commodities at Moneyweek but we rarely suggest - these days at a least - that you invest directly into the softs themselves. Why?

With the supply / demand equation as finely balanced as it is today, there isn't much of a safety margin in the market and prices are just too volatile. Right now there is a shortage of wheat in Europe, thanks to the droughts and fires in Russia.

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That should keep prices high for much of the rest of the year. That means bumper profits this year for the US farmers who have had a good harvest. It also means, as agribusiness consultant Emma Cardy-Brown points out, that beef and other protein prices will tumble over the short term, as producers who can no longer afford feed send their animals to early slaughter in an effort to improve their short term cash flows. They'll then go up again fast as the supply of beef coming through will be cut.

It's all a bit much for the average investor to have to keep thinking about. So we generally suggest that you buy in via equipment and fertilizer makers - the firms that make money from the ways farmers try to beef up their yields (Forget grain - buy tractors instead).

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However even here long-term success is not a given. That's because an ongoing rise in the consumption of grains is not certain. Sure, barring any particularly nasty disasters, the global population will keep rising and demanding more and more food. But over the last few years demand hasn't been just about food, it's been about energy too.

There has been much debate about the impact that bio-fuel production has had on food prices across the globe. It's clear that, while it doesn't have the huge effect some claim for it (it wasn't just bio-fuel demand that led prices up between 2006 and 2008 for example), it does have some effect. How can it not, given that it uses up one third of the US corn crop, to take just one example?

Critics of this position argue that bio-fuel production has risen in the last two years but that food prices (until very recently) have not. But the equation isn't so simple - don't forget that the other factors driving demand up from 2006-2008 disappeared in 2008 and 2009 too. Consumption demand growth fell off as global recession kicked in; most of the market's speculators threw in the towel; the dollar soared; and the oil price fell.

The truth is surely that demand for grains and for oilseeds has been much raised by the government-supported rise of the bio-fuels industry. And that may not last. First oil prices might fall. That would cut the price of ethanol and hence the incentive to produce it, which would release more corn for consumption.

And second, very high prices might lead governments - in the US and Europe - to review their commitment to the bio-fuel industry. The subsidies paid out are expensive in themselves in a time of austerity, but if populations start blaming them for food inflation too, it is hard to see governments standing too firm. That, says Cardy-Brown, would put us pretty firmly into a "surplus supply situation." Lower demand and lower prices.

For now it seems reasonable to expect the volatility in food prices to be ongoing (and on an upward trend) and that makes us reasonably happy investors in the market. But if prices rise too far and if headlines about the prices of or the shortages of grains become commonplace, investors might be wise to move on.

Back in February, Obama appeared very keen on bio fuels, outlining a plan for an aid programme for "folks delivering biomass for the collection, harvest, storage, and transportation of biomass to eligible biomass conversion facilities." He might stick to his guns on this one. But if I were he, it wouldn't take much in the way of food riots from my financially-stretched electorate to change my mind.

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