By Ian Fraser
Published: Fund AIM (Alternatives Intelligence Magazine)
Date: 4 June 2007
IN Australia, the threat of global warming finally hit the political mainstream in April, when it was cited as the cause for a severe drought in the Murray-Darling Basin that is causing some landowners to allow irrigated farmland to return to desert. Meanwhile in mainland China, consumers who until the 1990s lived in rural areas and subsisted on locally produced rice, noodles and vegetables are moving to the cities and eating more poultry and meat. The repercussions for future demand for animal feedstuffs are huge: it takes 7kg of feed to produce 1kg of beef.
Professor Bill McKelvey, head of the Scottish Agricultural College, believes these changes are going to put pressure on humanity’s ability to feed itself in coming years. But he adds that the most pressing immediate threat to future food supplies is coming from the push to supplement fossil fuels with biofuels. At a recent talk, McKelvey said the increasing use of corn for ethanol production is already tightening world grain stocks, which have dropped from 100 to 40 days supply in six years. And he said the European Commission’s target of 5.75% of biofuel incorporation into fuels by 2010 is causing scores of new rape-seed-derived biodiesel and sugar/grain-derived ethanol plants to sprout across the EU.
The biofuel revolution is also underway in the US, where it has prompted farmers to reconsider what to grow. According to a recent “plantings” report from the Department of Agriculture, US farmers are planning to devote 15 per cent more acreage to corn this year, with an equivalent drop in soybean acreage. Sudakshina Unnikrishnan, commodities analyst at Barclays Capital, says: “The US government’s decision to phase out the fuel additive MTBE is driving demand for ethanol.” Also across South-East Asia there is a drive to replace crops such as rubber and cocoa with palm oil trees, which are increasingly also being used to produce biofuels.
Why should this interest to investors? Put simply, some these global trends are expected by some to spark and give impetus to a soft commodities boom that is likely to bear many of the hallmarks of the minerals and energy-based commodities booms that have so enriched investors over the past four years. Nudgem Richyal, manager of the $340m Baring Latin America Fund, strongly believes that the commodity cycle has turned. “We have seen strong performance from the energy sector and history shows that soft commodities – such as soybeans, wheat, sugar and oats – tend to be the next area to see inflows of capital in each commodity cycle.”
Another reason for investing in softs now is that, thanks to futures contracts that are the sector’s universal currency, they provide a good hedge against inflation. Also whereas natural disasters such as Hurricane Katrina or the Asian Tsunami can knock equities they tend to have a more positive effect on commodities. Ewen Cameron Watt, head of research at BlackRock Merrill Lynch Investment Management, believes that agricultural commodities will be one of the major investment themes over the rest of this year.
He said: “The growth of hard commodities, such as metals and oil, was a major theme of 2006. However, soft commodities, such as arable crops, have been less widely followed. This will be driven by demand from countries such as China and India, while there is also an increasing global demand for traditional soft commodities in the use of alternative energy production – such as ethanol and biofuels.”
And according to Jim Rogers, the New York-based commodities bull and the author of the best-selling book Investment Biker, the commodity bull market may have another 15 years to run. He says: “Wheat, soya, corn, orange juice are all far below their all-time highs. In bull markets everything eventually makes an all-time high and invariably it’s multiples of the previous peak. There’ll be some huge moves in agriculture.”
Until fairly recently, it was not easy to gain exposure to soft commodities without massive exposure to risk. A cursory viewing of the 1983 hit comedy Trading Places makes clear the potential risks of direct investment in commodity futures. In that film, the patrician brothers Mortimer and Randolph Duke are financially ruined when their bet on the future of the frozen concentrated orange juice (FCOJ) market turns sour. The traditional alternative means of access was simply to put money into listed companies whose principal activity is dependent on soft commodity futures, such as Tait & Lyle, Nestle, Kellogg, Herschey’s, Kraft and Unilever.
However Nik Bienkowski, head of listings and research at Jersey-based commodities asset manager ETF Securities, says there are a number of problems associated with direct investment in commodity-linked corporates. He says: “Such companies are few and far between, and none of them are directly correlated to the commodities markets.” He says this is because a number of other factors – including management skill, packaging costs, transportation costs, marketing prowess etc – can all have just as much of a bearing on these corporate’s share price performance as the underlying commodities markets.
Over the past 12 months, a number of alternative avenues have opened up for institutional and retail investors seeking to hitch their wagons onto the soft commodities bandwagon before it leaves the station. One is through the use of tax-efficient exchange traded funds (ETFs). Some of the recently launched ones permit investors to buy into either baskets of agricultural products or individual commodities but without any of the risks and costsÂ associatedÂ with directly managing their own commodity futures positions.
Bienkowski’s company offers 31 commodities ETFs or to be more precise exchange traded commodities (ETCs). These all track the Dow Jones/AIG commodities indices. He says: “Our products represent futures, but with an added layer of security and regulation on top.” Each of ETF Securities’ funds, which are available through regulated brokers or approved market makers, is a dedicated tracker following either individual commodities or baskets of commodities.
Bienkowski, who worked for Macquarie Bank and actuarial consultants Towers Perrin before co-founding Jersey-headquartered ETF Securities with Graham Tuckwell of Gold Bullion Securities last year, says business is booming. “We have brokenn through that barrier [of being an unknown quantity] this year. We’re gaining in both liquidity and traction.” ETF Securities’ assets under management have risen from US$200m to $600m since the start of the year.
The Australian-born Bienkowski, is perhaps unsurprisingly, a strong advocate of the group’s products. “There are a number of advantages. The funds are accessible and simple. At 0.49% per annum, the fees are low. And the funds give you direct exposure to commodities.” He says ETF Securities plans to offer investors the ability to short all the group’s funds through an immiment tie-up with IG Index.
There are alternatives to the ETF/ETC route. Tracker fund CF Bespoke Investment Funds Dow Jones AIG Total Return Commodity Index offers exposure to both hard and soft commodities, while an index fund run by Diapason is more reflective of the agriculture index. On March 17 Barclays launched its Six-Year Agricultural Commodities Plan, which aims to give investors 110% of the rise in the GCSI Agricultural Excess Return index over a six-year period. Goldman Sachs has also launched two soft-commodity structured products. Both are classified as certificates, and have a six-year life. These are tied to the GSCI Agricultural Excess Return and GSCI Livestock Excess indices.
Another way to get into softs is to spread bet on a wide range of softs, including cocoa, coffee, sugar, soya or rice, through firms such as IG Index or City Index.
However it is not all going to be plain sailing. Bears of soft commodities warn that the elasticity of supply is going to prevent sort of exponential growth seen in more “traditional” commodities markets such as oil and steel. It can take at least a decade to create a new copper mine, oil refinery or steel mill. However a farmer can plant fields with different crops at short notice. “The lead times for production to increase a very much shorter,” says Barcap’s Unnikrishnan. “That makes supply much more elastic.”
However Rogers argues certain traded soft commodities do suffer from inelastic supply, particularly where trees are involved. He points out that it takes five to seven years for a coffee tree to mature. “So if a farmer decides to go into the coffee business today it might take him seven years before he comes to market.”
Investors must also be aware that any significant fall in the oil price could impact the dynamics of the soft commodities market. The use of palm and vegetable oils to make fuel would become uneconomic were the price of fossil fuels falls to fall. Ralph Sims, researcher at the International Energy Agency, estimates this would happen if world oil prices fell below about $50 a barrel.
Another risk is volatility. BarCap’s Unnikrishnan says that the increasing preponderance of speculative investors in markets that were traditionally the stamping ground of the likes of food producers such as Archer Daniels Midland, Cargill and Louis Dreyfus is increased unpredictability. Traditionally commodities companies accounted for nearly 100 per cent of the long positions in these markets but speculative investors today account for 25 per cent to 30 per cent of that.
Unnikrishnan says: “These are already rather volatile markets, with strong reactions to weather conditions and crop reports, and the influx of money from non-commercial participants is only going to add a further dimension of volatility to what we already had,” she said.
This article was published in Fund AIM – Alternatives Intelligence Magazine Volume 1 No. 3 – May/June 2007