Energy and base metals have been luring investors in the last few years, especially after oil prices reached a record high in July 2006. At peak, oil was seven times higher than in 1998, natural gas 4 times and gasoline 5 times. This impressive move in energy was imitated by base metals on the back of stronger demand for raw materials coming out of China and the result of under-investment in the mining sector over the last two decades. Nickel touched an historical high on 5 April 2007, while lead keeps posting new record highs nearly every day. During these years, agricultural commodities have often been overlooked as prices for wheat or corn were in downward trend between 1980 and 2001 because of large increases in production, essentially due to improvements in the yields and acreage from agricultural land.

But lately, investors have rediscovered agriculture commodities and realised their attractions, among them the fact that they are contra-cyclical and demand for them is overtaking production. They do not move in tandem with the business cycle, especially during recessions as grain prices tend to rise in real terms. Moreover, nature has not been as generous in the last few years. Cropland is shrinking due to soil erosion and desertification, and crop yields are threatened by rising temperatures and inadequate water supply. Rapid population growth threatens agricultural self-sufficiency in many emerging nations, where population is projected to increase substantially, resulting in a decline in grain land per capita.

Moreover, agricultural land is being diverted from its traditional uses: hundreds of thousands of hectares are every month converted into industrial and new housing complex as demand for houses follows the growth in world population. It took only 12 years, from 1987 to 1999, for world population to grow from five billion to six billion. This is the shortest time ever to add one billion people to the world’s population.

The relationship between the world’s growing population and the ability of governments to feed it at an acceptable level of nutrition is one of the most controversial current global issues. India and China both face this critical challenge. Despite their policy of containment, including the one child family policy in China, the populations of the two countries keep rising.

Shrinking agriculture acreage

From the beginning of agricultural production until the early eighties, increases in world food production have come largely from expanding agricultural land. Between 1960 and 1981, the area in wheat expanded from 202 million hectares to its historical peak of 238.9 million hectares. By 2007 it had fallen to 217 million hectares (see Figure 1). Meanwhile, with population expanding from 2.8 billion in 1960 to 6.2 billion in 2006, the cropland area per capita shrank from 0.072 to 0.034 hectare.

The world’s grain area is unlikely to expand much in the coming decades. Low grain prices in recent years led some farmers to pull back from marginal lands and abandon degraded fields. In addition, agriculture has lost millions of hectares of farmland to urban expansion. Where there is limited arable land, fast-growing populations can shrink cropland area per person to the point where countries can no longer feed themselves, driving governments that can afford it to import grain – the source of more than half the calories humans consume directly. But in countries that cannot import grain, people go hungry.

Countries such as Japan and Taiwan import more than 70% of the grain they consume. If we look only at Japan, the country imported 92% of its wheat last year. Emerging economies and traditional soft-commodity producers are now facing the same reality. Egypt for example imports over 40% of its grain to feed its 70 million citizens. With the water from the Nile River now fully used, and with Egypt’s population increasing by over 1 million annually, this share of imports will almost certainly climb.

A growing giant desperate for grains

History taught these countries that an economy is sustainable only if people are able to eat properly – a famine can easily de-stabilise an entire society and jeopardise the process of economic and political reform. Many still remember the famine which occurred in China during the Great Leap Forward (1959-1962) and killed approximately 30 million people. The industrialisation programme in that period caused a huge increase in the non-agricultural labour force. The number of people working in state and collective enterprises grew from 31 million in 1957 to 52 million in 1958 – a 20 million increase in a single year (Peng, 1987). These workers could no longer produce their own grain, but depended on the state distribution system. A failure in grain distribution between provinces contributed to the crisis.

Marshal Peng Dehuai, who commanded the Chinese troops in the Korean War and criticised Mao reforms, captured the situation well in a poem:

The millet is scattered over the ground.
The leaves of the sweet potato are withered.
The young and old have gone to smelt iron.
To harvest the grain there are only children and old women.
How shall we get through the next year?

The spectrum of food insufficiency is rising again over the modern Chinese society. China has been for decades a net exporter of corn, but from 1994 to 1996, it turned into an ‘accidental’ importer, helping corn prices to surge to new highs at the end of the period, above the 350 cents a bushel in Chicago.

Today, China is busy again seeking grain exporters to buy from as domestic corn usage increased 6 million tons in both 2005-06 and 2006-07 (compared with a domestic production and usage of both 143 million tons in 2006-07), driven essentially by an expanding meat production. China is the world’s largest pork producer and its consumption per capita is the second largest in the world, after Germany.

Partly given this extra demand, corn prices in Chicago jumped from 273 to 440 cents per bushel (Sep07 contract) between September 2006 and February 2007, before fading since then. These relatively high prices helped hog numbers falling earlier this year in China; as a result, hogs prices displayed more than 40% year-on-year increase in the first three weeks of May 2007 in most of the mainland cities.

The emergence of a new world

The area under irrigation has stagnated in the last 20 years and ground-water reserves are over-exploited. According to Lester Brown from the Earth Policy Institute, water reserves are falling as 15 countries containing half of the world’s people, a total of 3.26 billion, are over pumping aquifers. Depletion of aquifers threatens especially emerging countries with a sharp decline in grain production, at a time when water usage per capita is rising faster than ever. Incomes in these economies have appreciated, increasing the demand for all food products and water as hundreds of millions of people in these countries converge towards a more Western way of life. We can imagine that municipal water consumption per capita and per day in Bangkok (210 L) can only converge to the one from US resident (380 L).

Global warming and scarcity of water

To add to that bleak picture, agriculture is vulnerable to global warming because the world’s most widely consumed grains (corn, rice and wheat) are highly sensitive to higher temperatures. In several parts of the world, many crops are already being grown just under the maximum temperatures they can tolerate, a fact reflected by slowing yield increases in the recent years despite the use of heavy fertilisers (see Figure 2). The scale of agriculture’s vulnerability to global warming was highlighted at the end of 2006 when the Consultative Group on International Agricultural Research (CGIAR) issued a worrying estimate of the impact of climate change on wheat farmland. By 2050, the best wheat-growing land in the wide arc of fertile farmland stretching from Pakistan through Northern India and Nepal to Bangladesh should be a souvenir as the region will be submitted to too hot temperatures for the crop.

It is worth remembering that optimum growing conditions generally range from 20 to 35 degrees, and then fall sharply. Crop scientists say that grain yields fall about 10% for every 1-degree Celsius increase in temperatures above the mid-30s during key stages in the growing season, because the hotter temperature hampers photosynthesis.

Global land area affected by drought rose from 15% in 1970 to 30% in 2002 according to the United Nations. Three of the four warmest years on record came during the last four years – years of crop shortfalls.

Unusually dry and warm weather conditions this spring in Europe significantly reduced yield potential and drove the International Grain Council to lower its grain production forecast for 2007-08 to 1,666 million tonnes, not enough to match a forecast consumption now pegged at 1,680 million tonnes this year. The case for wheat is appealing. Even if world wheat production forecast for the 200708 season currently stands at 623 million tonnes (down 1 million from the previous estimate, but upfrom 590 million tonnes in 200607), world ending stocks of 113.4 million tonnes would be the lowest in 30 years. In days of usage, ending stocks of 66.3 days would be the lowest in modern history.

As a direct consequence of rising prices, political leaders are forced to interfere in trade grains to protect the integrity of their nation. In Ukraine, the government recently suspended wheat exports sales until stocks are fully replenished – in a way to keep food inflation in check until the parliamentary elections taking place at the end of September 2007. Fertile grounds in the Black Sea region – which in aggregate produce more and higher-protein wheat than the US – have suffered from a severe drought this year. Pakistan also announced it will not export wheat until local prices of grains fall, even though the country had a record wheat harvest of 23.5 million tons this year and had planned to export the grain for the first time since 2003.

Soil erosion and use of fertilisers

Soil erosion is another threat to modern agriculture. This gradual process occurs when the impact of water or wind detaches and removes soil particles, which results from the loss of the nutrient-rich upper layers of the soil and the reduced water-holding capacity of many eroded soils. Soil deterioration and low water quality due to erosion and surface runoff have become severe as lands in some parts of the world can no longer be cultivated and must be abandoned.

Some scientists say that topsoil is being lost at least 16 times faster than it can be replaced; it would take from 200 to 1,000 years to recreate 2.5cm of lost topsoil. The Food and Agriculture Organisation (FAO) estimates that the global loss of productive land through erosion is about 6 million hectares per year. Until recently, accelerated water erosion effect upon agricultural soils was mitigated in the Western world by the increased use of fertilisers. But as their price is going up, following the rally in energy prices since 2000 (nearly 95% of the nitrogenous fertilisers used in America are made out of natural gas), farmers will tend to use less. Moreover, crop response to nutrients follows the ‘law of diminishing returns’. The greatest increase in yield is from the first pound of nutrient added, and each additional pound of that nutrient gives a smaller yield increase until a maximum yield is reached. Adding more fertiliser beyond this point may actually cause yield to decline if soil erosion aggravates.

Grains for biofuels

Finally, the rise of the biofuels industry is a completely new factor of demand in the current uptrend cycle in grains prices. As a result of the rapid capacity expansion in the biofuels industry, the amount of grains and oilseeds used for ethanol and biodiesel production is increasing considerably. While corn production has been stagnating and slowly decreasing since 2004, even if it still remains at high historical levels, demand for ethanol has exploded. In 2000, 6.3% of the US corn output was used for fuel ethanol. This figure reached 11.7% three years later, and 20.1% in 2006. The bioethanol plants being constructed in the US presently would need 58m tonnes of corn to produce the required ethanol, a tonnage of corn that is equivalent to 69.5% of corn traded globally.

Iowa alone, which is currently contributing 35% of the US ethanol production and harvested 54.9 million bushels of corn in 2006, used more than 16 million tons of corn to produce nearly 1.7 billion gallons of ethanol in 2006 slightly more than Iowa’s total consumption of gasoline estimated at 1.6 billion gallons in 2006. But this is nothing compared with some forecasts for 2010 from US universities: the overall ethanol capacity in Iowa should reach that year 68.6 million tons as 33 new dry-grind plants have been announced with projected completion by the end of 2010. As distilleries compete with feeders for grain, it is highly likely that Iowa will become a corn importer within three years.

Conclusion

A critical situation is now being discoveredby the investment community in the agriculture segment. A combination of low historical valuations, low inventories and risks of supply shocks should fuel further price appreciation and appeal to many investors. There are a number of catalysts for change in this sector, which are set to act in tandem.

The key drivers – world-wide population growth, soil erosion, global warming, water scarcity, and demand from the biofuel market – could cause substantial price rises to staple food items in the coming years. And it goes without saying that investors with exposure to the agricultural sector are likely to achieve above average returns well into the next decade, when the agricultural industry will have its day in the sun.

Mehdi Chaouky is an analyst at Diapason Commodities Management