Skye Macpherson argues that rising living standards in the emerging world are leading to higher food demand.
Turmoil in global financial markets has dominated headlines and investor sentiment since early 2008.
Quietly in the background there have been some significant shifts occurring in our global population and the food self-sufficiency of China; both stand to have a resounding impact on agriculture.
The first development was China’s demand for soft commodities growing beyond the country’s ability to produce them.
This resulted in China becoming an active participant in world trade of basic foods like corn, wheat and pork.
The second development saw the number of people living in urban centres shifting to more than 50 per cent of the world’s population.
The urbanisation occurring in emerging economies has resulted in people shifting to cities for work, and buying rather than growing their food.
The United Nations forecast that around 70 million people would urbanise on an annual basis out to 2050. With higher incomes off a low base, these people cannot only afford to consume more food, but also consume grain-intensive protein.
The key driver of agricultural commodity demand going forward is the growing wealth in developing economies as urbanisation continues.
Have we reached an inflection point for global agriculture?
In September 2009, the Food and Agriculture Organisation (FAO) produced a report titled ‘How to Feed the World in 2050’, a summary of the key findings following a three-day Meeting of Experts.
They used the UN population forecasts of 9.1 billion people in 2050 (a 34 per cent increase from today) and the UN urbanisation forecasts of 70 per cent of the world’s population living in urban areas in 2050 (compared to just over 50 per cent today) in their assumptions.
Their key finding was that in order to feed this larger and wealthier global population, global food production needs to grow by 70 per cent from 2009 levels.
In order to achieve this, roughly US$83 billion is required to be invested on an annual basis into research and development, infrastructure, environmental services and sustainable resource management.
Improving productivity is one of the most effective ways we can improve agricultural output, given our limited land and water resource base.
The FAO estimates roughly 80 per cent of the growth in output can be achieved through higher yields and more intensive cropping.
However, this requires investment to reverse the actual trend of declining yield improvement. In 1960, yield gains achieved in cereals were 3.2 per cent compared to 1.5 per cent in 2000.
An environment of falling real grain prices did not encourage investment in agriculture.
Since 2007, the pricing environment for soft commodities has changed. Prices have moved to a higher level which has created the incentive for private companies to invest in agriculture.
Why have soft commodities prices risen?
After several decades of soft commodity prices moving largely sideways, 2007 saw a significant rally.
Despite significant volatility in soft commodity prices since then due to financial market turmoil, it might surprise people that many soft commodity prices remain at least twice the 10-year historic average price.
The reason that prices rallied and have stayed at these higher levels is because of inventories.
Globally we have been consuming more than the world has been able to produce in eight out of the last 12 years (despite producing some of the largest grain crops on record over the past seven years).
This has left global grain inventories, relative to global consumption, at historically low levels.
When inventories fall to these critical levels, prices tend to move higher in order to encourage new marginal production.
Interestingly, if you go back to the early 2000s and study why hard commodities like copper, nickel, coal and iron ore prices rallied and the final pricing outcome, the story is remarkably similar.
The prices of hard commodities rose due to low inventories and increased to the point that would incentivise mining companies to invest and grow their production.
China is becoming an important player in global soft commodities.
Food security is important to the Chinese government to ensure that food remains plentiful and affordable to maintain social harmony. In recent years, China’s self-sufficiency has seemingly come to an end.
China has become an importer of soy, corn, wheat, pork and milk powder. Each year the number of tonnes imported increases.
The amount imported relative to domestic consumption is quite small, but relative to the global trade of these commodities, it is meaningful. For example, China currently accounts for 60 per cent of the seaborne soy trade.
Chinese buying has also been opportunistic, preferring to buy on pricing dips. As a result, Chinese behaviour has been providing a level of support to many soft commodity prices.
This also helps explain why prices have remained much higher than their historical averages.
These higher prices directly benefit farmer incomes.
Despite input costs also rising, many farmers around the world are making historically high margins.
This means two things for the industry.
Firstly, farmers are highly incentivised to maximise their yield per acre and expand production where possible.
It also means they have the balance sheet to invest in their business in order to apply the optimal amount of fertilizer, buy the best quality seeds, upgrade their equipment, and expand their business by buying nearby properties to achieve greater economies of scale.
In such a buoyant rural environment, many parts of the agricultural value chain (input providers, farmers, handlers/traders) are generating decent margins and profits.
While higher crop prices are incentivising farmers to maximise their yields, generally the increase in global acreage has been quite marginal in recent years.
While developed markets like the US have limited additional land available for cropping, developing markets still lack the appropriate infrastructure to tap new areas.
Simply put, the improvement in grain prices to date is not enough to justify the incremental costs from producing and transporting crops from more remote areas.
The farmer must be certain that these higher prices are sustainable, given the investment required to establish new farmland and time required to optimise the yield.
Agriculture is a volume-driven secular story
Few can argue against the need to increase agricultural output in the future to meet growing demand. The question for investors is how to get exposure to this growth.
The most liquid way is via agricultural equities.
Further, given the inherent risks of investing in agriculture (namely weather), being diversified by geography, by commodity, and by sector (fertilizer, farming, agricultural equipment and traders) helps to minimise volatility.
Skye Macpherson is a portfolio manager, global resources at Colonial First State Global Asset Management.
