DUBAI, 4 July 2005 — The three-year running bull market in commodities has attracted a great deal of attention from hedge fund managers seeking a reliable source of non-correlated investment returns, but much of that interest has focused on traditional “hard” commodities such as oil and gold, while “soft” commodities have lagged. The longer term outlook for these agricultural products, however, is looking altogether rosier.
The Goldman Sachs Commodity Index rose 128 percent between Jan. 1, 2002 and March 31, 2005, comfortably outperforming global stocks and bonds, as growing demand for energy and a rush to the relative safety of gold forced prices higher. However, Goldman Sachs’ agricultural sub-index rose a more modest 24 percent in the same period, thanks in part to huge subsidies within developed nations in Europe and the US which help keep food prices lower.
That, some argue, is all about to change, as there is growing evidence of a mismatch between long-term supply and long-term demand that must ultimately lead to a hike in food costs.
Demand Pressure
Population growth, increasing global wealth and the continued industrialization of emerging economies such as China and India are all putting demand pressure on agricultural prices and these are only likely to increase over time.
In China, for example, urbanization is forcing a shift in diet away from traditional starch based foods towards higher protein meals. BNP Paribas estimates that the average Chinese person currently consumes about 2,800 kilocalories per day, but projects that this figure will rise to about 3,100 over time as consumers use their new wealth to eat better. Wealth will also drive demand for niche and luxury products.
Global population, currently a little over 6 billion, is projected to rise to 9.1 billion by 2050, which is also likely to place pressure on demand.
Supply Constraints
At the same time, there is severe pressure on global food supplies. World fish stocks are under immense pressure, with fresh quotas expected from regulators such as the European Commission to protect fragile marine eco-systems.
Industrialization and urbanization are also cutting into available arable land in countries like the US and China, though there is still ample available farm land in countries like Argentina and Brazil.
Approximately 40 percent of the world’s food comes from the 5 percent of agricultural land that is irrigated, and there are signs that the water to sustain these properties is running out. Sandra Postel, director of the Massachussets-based Global Water Project, claims water is being pumped out of the ground for agricultural purposes faster than it can be replenished, particularly in the US, China, India, North Africa and the Arabian Peninsula.
Furthermore, about two-thirds of the world’s agricultural land is degraded to some degree, according to Stanley Wood at the International Food Policy Research Institute, and about a fifth of irrigate land suffers from salinization, which makes it less productive.
The examples are endless, but the underlying message is always the same, there is a great deal of pressure on agricultural production and there are no quick fixes to relieve it.
The Issue Is Now
While all of this may seem like a distant concern, recent figures show that the gap between supply and demand is closing rapidly. In 2002/2003, global food production was around 1,344 million metric tons according to Goldman Sachs, which consumption was about 1,411 million metric tons — in other words, the world ate more food than it produced. Compare that to the 1960s, when food production was approximately twice global consumption.
Simultaneously, there is growing political pressure on the leaders of developed nations to reduce farm subsidies, which smaller, developing nations claim create trade imbalances. While it seems unlikely that European Commission will relent and revoke its Common Agricultural Policy soon, there are already indications that they will reduce them, which will benefit prices.
Old News?
It should be noted, however, that predictions of a boom in commodity prices on the back of population growth have backfired in the past.
Most notably, Paul Ehrlich, the author of “The Population Bomb” who argued that a population explosion would drive commodity prices through the roof in the 1980s, famously lost his bet with economist Julian Simon that a basket of commodities would increase in value over a ten-year period. Simon, who was ultimately proved correct, had countered that technology and social developments, coupled with shifts in demand and commodity usage, would help to keep prices low.
That could prove to be the case in agricultural markets where, for example, genetically modified crops may increase yields. However, there is only so much advantage that can be acquired from technology and consumers have, thus far, shown strong resistance to so-called “Frankenstein” GM foods. Unlike hard commodities there are also limited opportunities for swapping between commodities, with all sorts of cultural and social constraints.
Whatever the case, there will also be a considerable lag between any global initiatives to boost agricultural productivity and a real increase in output, possibly several years which means that, in medium term at least, it seems reasonable to expect that prices will rise.
Commodities and Hedge Funds
That should be good news for hedge fund managers. Commodities, and particularly soft commodities, offer significant diversification potential within an investment portfolio because their returns present low, or some cases negative, correlation to traditional bond and equity markets.
Historically, commodities have provided a good hedge against inflation. That, coupled with their excellent return potential and strong diversification benefits, are increasingly making them a must have in any well-diversified portfolio.
(Antoine Massad is head of Middle East and Asia at Man Investments. He is based in Dubai.)
