Where to invest now? Agriculture or stocks?

The markets are in a turmoil, Wall Street is a roller-coaster, gold hits over $1,700/oz as Asians flee to a known safe haven, Europe (according to one Irish politician) is "run by a bunch of mad people in Brussels" and the Swiss are concerned because their currency is another safe place to be, so making their watches unaffordable. Where do we go next?


Even agricultural commodities, historically more stable and rising for the last few years, have shown uncertainty and a drop off in investment values from the peak at the start of the year (Chart 1, a comparison of the S&P 500 with RJA-Agri, is discussed later in this piece).

Disclaimer: we economists are story-tellers, and we can tailor a story to suit your needs just like the augurs of old, looking at signs and portents and building the story to make folk feel happier.  Of course the real answer is,  nobody knows and we don't even know what we don't know.

But disclaimers and caveats aside here we go anyway following a tried and trusted method which is looking at the individual parts of the puzzle and seeing if we recognize a pattern - not so different from the ancient Chinese seers who shake the sticks or divine the I Ching from the patterns on a turtle shell.  We'll also ask, what can change things as we see them? Looking for the counter-argument or the absence of information is always helpful dealing with uncertainty.

First the fundamentals:  stocks of food commodities are tight, so tight that it will not take much to push prices up yet again. The weather in key North American production areas for corn and wheat has been record hot and the USDA has just adjusted its area estimates down. Rice crops are good, but for the international market a lot will depend on policy in Thailand (see our previous post on August 1st and this piece in Agrimoney).  So the supply side of the equation does seem to imply upward price pressure.

What can turn the pressure down?  Black Sea Grain reports that grain crops in the Ukraine will be larger and this is confirmed by USDA estimates.  This goes some way to compensating for any short-term decline in the USA. In the longer term, the supply side will react (our markets are at least free to do so) in a conventional way: more resources will be drawn into production and prices will react accordingly. Let's look at this in more detail.

There is huge interest in investment in agricultural land.  Every day emails come in to our FoodWorks office  bearing news of this scheme or that scheme, from wheat farms for sale in Australia to more exotic jatropha (bio-fuel) projects in Indonesia.  An excellent Bloomberg article describes the returns people have been expecting on agricultural land (16% annually!) to get an idea of how resources get pulled into production.

Two things: investors have to understand that unimproved land without the water supply, fertilizer, seeds, farm access roads, labour and machinery needed to grow crops is also unproductive land. Equally energy costs are pushing up inputs (fertilizer prices that have soared with the price of crude oil) and the wise investor should see if the gross margin he makes on the crop can really be achieved - it's NOT the farm-gate price that motivates the farmer, any more than it is the price at the check-out that bothers your grocer, it's the difference between production costs and the sales price that counts and that is not as clearly seen as the pure price level . We'll be looking at farm gross margins and profitability in a later post.

If investment does go into productive land, and we hope it will do via improved technology and market infrastructure, the supply may just turn around and go up, crashing prices.  Managing farm returns to make a long-term sustainable profit within the agricultural cycle is actually something that requires years of experience and we wonder if the hedge funds or their agents have it? We're not being patronising - after 30+ years in this business, we've probably LOST more money than we've made in risk-based agriculture (by which is meant agriculture in emerging countries).  So we understand just how difficult this industry can be.

The other side of the market equation is demand.  In this case we can point to consumption increases from China and India and other emerging economies where a middle class requires more sophisticated products and a wider mix of foods. In these countries the high rate of economic growth implies a rapid growth of the middle class and a consequent rise in demand (indeed this is implicit in GDP growth) for processed foods. As people get richer they substitute basic staples (cereals and starches) for dairy, meat and fish. As we shall see, the issue is not simply the absolute number of people on the planet needing to be fed, but the increase in the number of people who can pay, and pay well, for their food.

For fish the market situation is clear: world fish stocks are declining and farmed fishery (aquaculture) is struggling to keep up with demand (check out our page on Fishery for more detail). With regard to staples, livestock consume large amounts of animal feed to produce our desired dairy and meat products and the conversion rate from cereal grain to meat is pretty poor.  So there is considerable upward pressure on demand (and price) for the raw materials of animal feed as the rich world requires more milk, meat, cheese and eggs.

But that can go the other way just as rapidly.  As the world struggles with what seems to be an impending economic implosion (read new recession), inevitably consumers will restrict their demand for these expensive products or (where they can) revert to traditional diets. Here's news that Tyson Foods, the largest meat company in the US, has just reported third quarter profits down by 21%: Tysons warn of "sluggish demand for chicken, pork and beef as consumers face higher gasoline prices. The company has focused on streamlining operations as a weak economy dampens consumer demand and as feed costs continue to soar, forcing Tyson to also raise its prices." (quote from Market Watch)

Result: more corn and other feed ingredients left in inventory and a downward pressure on prices. Of course it isn't that simple. Newly urbanised populations in emerging markets have less opportunity to escape the mega-city cash economy and young people (the majority of the expanding population world-wide require energy foods based on carbohydrates and sugar, but the principle of saving on the food budget is there.

We've made the point before: the world's food markets are currently finely balanced and which way this goes is not at all certain. 

Let's consider a couple of other frequently discussed elements: Demand for bio-fuel is consistently cited as a reason for high food prices.  We think it's more complicated than that.  Sugar cane and palm oil are both major sources of bio-fuel.  Neither is grown on land that is primarily suited for food crops.  Oil palm plantations in particular are grown on former forest areas in tropical countries. In the case of Malaysia, many of these plantations have been in place for probably 60 years; in Indonesia there is much new planting and to the extent that it depletes rainforest that is environmentally of concern, but does not immediately impact food crops, although here is an impact (so far unquantified) via climate change.

Climate change may indeed affect e.g., Sub-Saharan Africa, reducing food supplies, but this sector of demand is not what drives the current high market prices. As our recent post on Somalia indicates, population growth is occurring in those countries which are (a) very low incomes - so they cannot afford to buy on the international market - to use economist's jargon, this segment represents "notional" demand based e.g., on FAO or WFP benchmarks for what people should eat rather than what they can afford and do eat (or not in the case of Somalia) - "effective" demand, and (b) in many cases the poorer countries are largely agricultural and grow their own foodstuffs; China, India and Indonesia are by-and-large self-sufficient in rice.

So the driver for commercialised agricultural produce is NOT the 3 billion people at or below the poverty line (it is estimated that 3.4 billion persons live on less than $2.5/day), but as we have said the new middle class in countries like China and India that might just withdraw their demand for commercialised agribusiness products if another recession hits. One more point to remember: currency changes impact the food markets; a weaker US dollar makes US-produced food attractive to international buyers (especially given the rapid drop against the Chinese RMB) but it makes input costs (especially energy) higher reducing farm margins.

To return to bio-fuels argument for a moment.  In the USA, the expansion of the corn area has been driven by the ethanol subsidy. But to the extent that corn is grown with wheat and soyabeans as a rotation crop, we suggest that by adding to farmers' overall revenues it has actually enabled food production e.g., through the acquisition of new machinery. In general we believe that a search for renewable energy is the right (only) way to go and that the impact on the food security situation needs considering and analysing unemotionally and in depth. Overall, so long a bio-fuel competes with crude oil we think this will support agricultural investment.

So much for the fundamentals of supply and demand.  The truly shocking fact is that with the world's population hitting 7 billion, only a relatively small proportion can actually afford marketed food, i.e., the agriculture and food-based industries reflected e.g., in the exchange traded funds.  But this proportion is growing rapidly at a rate exceeding population growth and, recessions aside, can be expected to continue to grow - The World Bank estimates that the global middle class is likely to grow from 430 million in 2000 to 1.15 billion in 2030!

In this case, investing in industries that feed those with money to buy food seems like a safe enough bet. Of course what happens to the rest of the world, the majority who are poor, is critically important but a subject for another day. Let's now turn investment and the actuality of how the markets have behaved.

Take a look at the chart at the head of this article (Chart 1).  It compares the Rogers International Commodity Index for Agriculture (22 ag commodities) with the S&P 500 index of stocks (the black line is the RJA, the red line the S&P 500) since 2008 (as the peak ag prices started to decline).  Without getting too technical (and we are not technical specialists) it is clear that agricultural investments have done better than stocks.  The peaks are higher and the valleys less deep, the recovery more intense.

It is however true that since January the RJA has been going down or sideways but  it is also true that as the current decline has set in, agricultural investment has held up better than stocks (see Chart 2). So not only is there less long run volatility in agricultural investment, but the data shows the returns are indeed also better.

Another interesting point from the data  is the volume of contracts trade in the market. Look at the red and green bar chart. Note the greatly increased volume of trades since January, creeping up since the previous September. Volume is an indicator of where people are putting their money and the build up of interest in agriculture is significant.

What's do we conclude? From our perspective agriculture is a long-term safer bet than stocks because despite it's dependence on biology and the environment and the obvious fact that it has large cycles, the fundamentals are more understandable than stocks and the market is overall less inclined to panic. We also think that investment in emerging markets is the way to go; first such markets often offer lower production costs and second, we think this is a way that the problem of the lower income demand for food can be satisfied. But we hasten to add: agriculture has VERY nasty ways of catching one out and the supply-demand equation is a lot more complicated than many expect.  So be careful and be prepared for the unexpected!

"Amazing Thailand" - new rice policy will damage the market and Thai rice farmers

While the weather still keeps us on our toes in North America, let's take the opportunity to look at the rice industry.  Above all we need to understand the serious downside impact the ridiculous policy proposals of the incoming populist Pheu Thai government]will have on international supplies.

Rice represents 23 percent of the world's supply of major cereals and is the preferred staple food of much of Africa and most of Asia - in other words the regions of the world where the population is growing the fastest (a recurring theme in this Bulletin).  Although many Asian do consume wheat or corn products, in almost all these countries the word "rice" is synonymous with eating - the Thai will say, "gin khao mai?"  - "eaten rice?"when she asks if you've eaten a meal and it is an equally common greeting.  The Japanese word for cooked rice "Gohan" is synonymous with "meal".

Seventy-eight percent of the world's supply of rice is produced in China, the Indian sub-continent, the Mekong Sub-Region and Indonesia, while demand is similarly concentrated - 67 percent is consumed in China, the Indian SC and Indonesia.  Partly because of the deep-seated cultural importance of the crop Asian countries want to be self-sufficient and largely they are. Indonesia has been an exception switching from being an exporter to an importer depending on the harvested volume. The operations of the Indonesian government's procurement agency BULOG are important to watch.

This means that the international trade in rice is very "thin", i.e., the volume is a small proportion of the overall amount of rice in the market.   Exports represent just 7 percent of the total supply, and about half of that comes from just two countries, Thailand and Vietnam (Cambodia and Laos also contribute, but much of their rice is actually taken through the two main Mekong countries).

The small volume of internationally trade rice (relative to the overall supply) means that prices can swing rather dramatically depending on the volume available for export and the fact that there are few sources with a surplus to buy. For example, when BULOG enters the market on the buy side, rice process can jump by $100/ton.  Similarly a reduction of supply will raise prices dramatically.

So what happens in Thailand and Vietnam is critically important to those who DO import rice - many African countries and Europe. Countries like Ghana, Senegal and Tanzania (which actually do grow their own rice) have relied on cheap Thai and Vietnamese to meet growing demand.

Let's review the situation in Vietnam first: there are two main rice growing areas, in the north the Red River Delta (surrounding Hanoi) and in the south, the Mekong (Viet. Cuu Long) Delta are both intensively cultivated.  From being just self-sufficient in the early 1990s, Vietnam has raised production to the extent that it now exports the world's second largest volume of rice (6.4 million tons) and competes equally on quality with Thai white rice.

The issues for Vietnam are (a) paddy land is being lost to industrialisation, (b) industrial pollution is damaging yields that have hitherto been driving the production increase, and (c) the water in the Red River and the Mekong is being limited by dams built upstream by other riparian countries.  Vietnamese experts say they expect that rice exports will peak at around 7 million tons and may well come down.

And now for "Amazing Thailand" (those familiar with Thai tourist advertising will get the allusion).  Thailand has dominated the international rice trade both in terms of volume of exports (up to 10 million tons at the peak) and quality.  Thai "fragrant" or "jasmine" (Th. khao hom dork mali) is a premium product that sells for over $1,200/ton in e.g., Hong Kong.  The issue for this variety is that it grows only on  dry land in the North-east so overall production is limited. But Thai white rice is grown extensively throughout the central areas of the country  supported by an extensive and relatively well-managed irrigation system. Weather, soil, water, experienced and hard-working farmers, available seed, technical expertise and a sophisticated export trade.

What could possibly go wrong?

The answer is (as is often the case in developing countries - Thailand is "emerging"  - but one wonders what it will emerge as?) GOVERNMENT.

Of course all governments interfere in agriculture and the Thai government is no exception.  However the proposal of the incoming (elected by a huge majority) Pheu Thai government to establish a monopolistic farm-gate price for white rice of 15,000 Baht (about $517) per ton and more for fragrant/jasmine rice amounts to sheer unadulterated lunacy.

The current price paid to farmers by hundreds of millers is roughly half that amount; production costs amount to (at a guess) $400/acre, with a yield of, say 2.5 tons/acre and a farm sale price of the current $241/ton, the farmer gets a gross margin of roughly $200/acre.  About 60 percent of farmers have holdings of  less than 10 acres. But even at this level, with three crops a year under irrigation the farmer's gross income is around $6,000/year.  Although not large by western standards this is considerably more than the minimum wage.

So the average Thai rice farmer is not poor (by world standards). But of course he would like to be richer and the rural population voted almost exclusively for the Pheu Thai party and for a government-subsidised farm gate price about double what he or she gets now. Nice if you can get it, but unfortunately one of the basic rules of economics (not a subject well understood in Thailand, at least not in official circles) is "there is no free lunch".

At the subsidised price for paddy rice, millers and exporters estimate (see article in The Nation newspaper) that the F.O.B price would have to rise to over $800/ton - when Vietnam is exporting comfortably at $545.

The Thai government (we should say, the Royal Thai Government - RTG - to be correct) proposes to use its food security warehouses to buy all the paddy. It will become (that lovely word) a monopsonist - the sole buyer of farmer's paddy.  This will be milled on consignment and then packaged and sold ONLY from the government warehouses, it is said on "government-to-government" arrangements.  Official stocks are forecast to rise to well over 6 million tons for the current 3 million.

They could be even higher, because rice will flood into Thailand from, you guessed it, Vietnam, Laos and Cambodia. Hey folks, it's called arbitrage - absent effective border controls (and I can assure you they ARE absent) a commodity will simply follow the money.

So now we have the very real prospect because of this daft politician's promise, made for no other reason than to get elected, that not only will Thai rice - hitherto available competitively for export at a reasonable price relative to other cereals - back up in government warehouses, but export availability will be reduced in Vietnam and other neighboring countries.

One wonders what the WTO will make of this flagrant abuse of anything resembling free trade, and one is SURE that the prospect of "government-to-government" deals without the benefit of the current competition between dealers, will lead to rampant corruption.

In the end who will be the loser?  Unfortunately the very person the policy is intended to benefit, the Thai rice farmer, who will have priced himself out of the market. And the consumer, now without a supply of reasonably-priced rice. With rice removed from the thinly traded export market, prices will sky-rocket.

What could change the situation?  An outbreak of common-sense in Thailand is never a likely prospect. But India is set to lift a ban on rice exports and this may relieve pressure on the international price.  So then the RTG will be the proud owner of millions of tones of rice that it has bought for considerably more than the world price; you can keep  rice, but not forever:)

As we who live in Thailand  say, "TIT" - This is Thailand, and as the Thais say, "mai pen rai" - Never mind!