A sector that shows all the signs of being below its long-term equilibrium is agricultural commodities. The strong dollar, weak demand from China, and increased yields due to favorable weather conditions brought prices of agricultural commodities to their multiyear lows.
As agricultural commodities are not correlated to the general economy, it is a good way to de-risk a portfolio while having the additional plus of a potential rebound in prices, which also adds flavor to it. This report will explain why we are at or close to the bottom in agricultural commodity prices and elaborate on three interesting investment opportunities to seize the rebound.
Agricultural commodities and related investments have not been very rewarding for investors in the last 5 years as their prices slipped alongside energy and metals. The slow but steady decline in prices was mostly influenced by lower input costs as energy prices and fertilizer prices fell, and by favorable harvests in major producers that created persistently large inventories and ample supplies. As the US is the leading global exporter of agricultural commodities, a look at the climate situation will give indications on where the current agricultural market stands.
Figure 2. Palmer Drought Severity Index (PDSI)
The Palmer Drought Severity Index measures the impact of drought on farming in the US. It is clear how various climate events like “El Nino” have a cyclical effect on climate which consequentially affects farming. The last 4 years have been favorable as there has been no severe drought which has allowed farms, combined with low interest rates and investments, to produce large amounts of food.
Figure 3. Cereal production, utilization and stocks. Source: Food and Agricultural Organization of the United Nations
The last three years have been characterized with oversupply and increasing inventories. Figures 2 and 3 show how climate has a severe effect on crop production and that it had a positive influence in the last few years. With more food produced food prices fall, as food prices fall farmers postpone the usage of fertilizers because it is not profitable to invest in fertilizers as the marginal increase in crop yields would not cover the cost of fertilization. So the vicious circle evolves and puts downward pressure on anything related to agricultural commodities.
Predicting agricultural commodity prices is literally like predicting the weather: impossible in the long term. But the weather is the most important factor as good weather results in excess crops, while poor weather and low crop yields boost prices. Before looking at investment opportunities that are profitable at these depressed price levels, let us take a look at the outlook for agricultural commodities. According to the Food and Agriculture Organization of the United Nations prospects for 2016 look very stable for food as good weather in the main producing countries aided the planting season.
In the longer term ( OECD outlook to 2024), food prices are going to be volatile as they are influenced by weather but secular trends show that demand for animal protein is going to drive food markets as global food demand rises, especially in developing countries, where continued but slowing population growth, rising per capita incomes, and urbanization all increase demand for food. But the growth in demand is expected to be well covered by growth in supply, so prices are not expected to grow in real terms.
Low oil prices further put downward pressure on prices especially through their impact on energy and fertilizer costs, and as low oil prices make ethanol less attractive, it should have a negative impact on food prices. So if there will be further long-term downward pressure on food prices, how can food be a good investment? Because currently everything that lowers food prices is happening: the climate has been beneficial for the last 4 years bringing inventories to historical highs, low oil prices lowered input costs and demand for ethanol, so the expectation is that food prices will stay stable if the circumstances do not change. Which is exactly where the opportunity lies.
As the FAO expects that “over the decade, at least one severe shock to world markets is likely,” this is the time to position yourself in food as any shock could have tremendous influence, especially now that low prices make farmers reluctant to invest more than the minimum necessary.
Prices of cereals are expected to be in check as inventories have risen, but global production is expected to be slightly short of projected demand as low prices already lower production which means we are currently at the bottom of the cycle. Production of wheat is also expected to decline, but the markets should still be well supplied due to high inventories. Prices, as above, are expected to be stable. An equal situation is applicable to coarse grains.
The situation with rice is a bit different as the market seems to be tightening, so rice prices seem to have bottomed. With edible oils, the situation looks like the 2016/2017 season will be a good one as supply cannot match the increased demand. Prices have already shot up in 2016.
Prices of meat and dairy have also been depressed, so that demand is expected to pick up and stabilize the market.
Sugar is the perfect example of the cyclicality in agricultural commodities as low prices lower production and soon create a supply deficit. The European Union forecasts a supply deficit between 6.7% and 11.4% for 2016 which immediately increased sugar prices by 40% in the last 9 months.
The deficit phase of the world sugar production cycle is expected to continue as it will take a while for new investments to add production, and as demand growth is faster than the global increase in population due to increased demand from developing countries.
Coffee is different from the above mentioned commodities as it is produced in different areas. The price of coffee is also not far from 10-year lows so that any shock to the industry, like the 2013 drought, could push prices up.
Fertilizers have declined almost 70% since their 2012 peak which is logical given the decline in food prices.
As already mentioned, lower food prices postpone the usage of fertilizers but crop yields can be sustained for a year or two without normal fertilizer application, so demand is expected to increase in combination with agricultural price increases. The 2012 high prices have spurred significant investments in new production facilities which also increased downward pressure. With large amounts of supply, production costs are essential in order to find low risk, high reward investments in the fertilizer industry.
The majority of agricultural commodities are still in a slump but the sugar case shows exactly what is bound to happen as commodities move away from their bottoms due to lower investments in new arable areas and lower usage of fertilizers. As soon as food prices shoot up, fertilizer prices are also bound to follow and thus investing at this moment provides investors with limited risk as supply has stopped growing and demand is steadily growing alongside global demographic growth. Any climate shock would only increase the speed of the upward trend. Let us focus now on investment opportunities.
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