COMMODITIES OPPORTUNITY REPORT - Daniels TradingCommodities Opportunity Report: The Global Food...

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COMMODITIES OPPORTUNITY REPORT: The Global Food Crisis

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TABLE OF CONTENTS

SECTION

Introduction

Gold vs. Grain: Where is the Money Flowing?

Inflexibility of Agriculture

Population Growth

A Growing Middle Class

Instability in Supply and Demand

Rising Demand for Biofuels

The Implications of Massive Water Shortages

Land Erosion and Urbanization Affecting Arable Acres

Expectations for the Future

End Notes

Commodities Opportunity Report: The Global Food Crisis | 2

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COMMODITIES OPPORTUNITY REPORT:

INTRODUCTIONRecent spikes in food prices and concerns about the ongoing supply have spurred some investors to make serious investigations of agricultural commodities. This paper hopes to offer a basic understanding of the causes and implications of the global food crisis, particularly as this pertains to the commodities market.

GOLD VS. GRAIN: WHERE IS THE MONEY FLOWING?In the past year, precious metals have emerged as the darling of the commodities market. Unrest roiling through the Middle East and North Africa drove many investors away from oil, and mounting debt problems are still sweeping through Europe. In comparison, gold has seemed the reliable fallback. In the past year, prices for gold have risen roughly one-third and silver prices have more than doubled.

The sharp rise in precious metals, however, should not discourage the exploration of other markets. Despite the growing popularity of gold and other precious metals for hedging investments, the metals market is still dwarfed by agricultural commodities. According to the June 2011 monthly volumes reports from CME Group1, the parent company of New York and Chicago Mercantile Exchanges, those markets

The Global Food Crisis

saw a peak of nearly 450,000 metals contracts daily in late 2010. Those same exchanges saw roughly 1.2 million agricultural contracts in early 2011.2

Like the precious metals that have drawn such interest for hedging, agricultural commodities are in the midst of their own price spike. Since last year, some key products have risen dramatically in prices, with corn more than doubling and some of the smallest increases reaching around 35 percent.

According the Food and Agriculture Organization of the United Nations Food Commodity Price Indices3, costs for agricultural produces like sugars, oils and fats have spiked even higher. Over the past five years, the FAO’s Food Price Index notes the world has seen sharply increasing aggregated food prices, with the index at times reaching more than double the average of the prior decade-and-a-half. In particular, prices saw a major spike beginning in 2007 and dropping sharply back down in 2008. Costs rose in fits and starts until half-way through 2010, when prices rose above their 2008 peak and have largely remained there to this point.

Despite the growing popularity of gold and other precious metals for hedging investments, the metals market is still dwarfed by agricultural commodities.

LOW SINCE AUGUST 2010 HIGH SINCE AUGUST 2010

Corn Futures US $3.75 per bushel US $8.00 per bushel

Soybean Futures US $9.50 per bushel US $14.50 per bushel

Wheat Futures US $4.50 per bushel US $8.75 per bushel

Rice Futures US $9.50 per 100 pounds US $17.00 per 100 pounds

Live Cattle US $0.90 per pound US $1.22 per pound

Lean Hogs US $0.66 per pound US $1.05 per pound2

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These types of sharp price jumps are not entirely without historical precedent, according to an Organisation for Economic Co-operation and Development4 report released in the wake of the 2008 spike, having occurred multiple times in every major food category each decade going back to the 1970s, when the IMF Food Index more than doubled over the course of one year. Despite the long-standing volatility of the agriculture industry, the market’s capacity to predict these rapid shifts has improved little over the years, even as understanding of the underlying causes has grown. The current food crisis finds its roots in a broad range of factors including population growth, unstable production and increasing use of crops for non-food purposes, among others, the interaction of which makes it almost impossible to predict anything other than general trends. Looking to historical examples, this suggests current high food prices could linger and even increase over coming years, but ultimately expect to follow a familiar pattern of sharp decline and eventual spikes.

INFLEXIBILITY OF AGRICULTUREWhile oil tanker crashes may slow the supply of oil, the overall production of oil can ramp up or down with relative ease. However, the fixed nature of planting and harvesting makes the agriculture industry ill able to afford the slightest setback with today’s demand. As noted in recent report, commissioned by the G20 and coordinated by the FAO and the OECD,5

understanding why agricultural commodities are so susceptible to price spikes, both large and small, depends largely upon understanding what distinguishes them from other markets. First and foremost, the type of commodity in question differs from other common goods because of the level of necessity involved. Demand can only reach a certain minimum threshold, at which point the determining factor becomes the ability to pay for the goods. Supply is similarly distinct, in that producers can increase output only on a cyclical basis, with a time-frame linked to a crop’s growing season, and are subject to dramatic environmental shocks.

POPULATION GROWTHGiven the crucial role most agricultural commodities play in providing food for the global population, the number of people being fed clearly holds relevance to prices. The world has seen a dramatic rise in population over the past 60 years. In 2004, the United Nations Department of Economic and Social Affairs6 estimated the global population in 1950 at around 2.5 billion people. In May 2011, the UN released new estimates putting the current population at around 7 billion, a 280 percent increase in the span of 60 years, well above prior projections.

Although the total world population is increasing, the rate of this growth has gotten steadily slower since the 1990s and is projected to decline further as standards of living

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improve among developing economies. However, those same projections expect to see the world population hit 9.3 billion by 2050 and 10.1 billion by 2100.6 China and India alone, the world’s first and second most populous nations, have grown from around 667 million and 434 million, respectively, in 1960 to 1.33 billion and 1.15 billion in 2009, according to data from The World Bank.7

A recent report from the FAO8 on meeting future food needs notes that world cereal production has roughly doubled since 1970, though global crop yield growth rates have largely declined over the last fifty years, just like the population growth rate. Estimates suggest the global crop yield growth rate could decline further over the next 40 years, reaching as low as 0.9 percent between 2030 and 2050. Though population and crop growth both look to decline, the increasing demand for limited arable land and water are likely to continue to push up prices as populations increase.

A GROWING MIDDLE CLASSWhile crop yield growth rates and population growth rates decline, economic conditions have improved substantially for many in the developing world, and as a result there is a steadily growing middle class with far greater purchasing power in regards to food. According to the World Health Organization9 report on food consumption patterns, the average person increased caloric intake from 2,358 kilocalories between 1964 and 1966 to 2,803 kilocalories between 1997 and 1999, an 18.9 percent increase. Projections even suggest that growth could continue in coming years, with estimates reaching 3,050 kilocalories by 2030. This increase signifies that there are more and more people across the world that can afford to consume greater quantities of higher quality food, and most likely the demand to maintain this affluent lifestyle will greatly impact food supply and prices. The greatest jump in caloric intake was seen in East Asia, where consumption rose by nearly 50 percent. East Asia, and particularly China, has been the site of two other major shifts: the development of a larger middle class and the growing demand for diversified diets.

Between 1969 and 1971, cereals accounted for more than 60 percent of dietary energy in the developing world. By 2030, that proportion is expected to drop to 50 percent. Already in East Asia, meat consumption rose from 8.7 kilograms per year between 1964 and 1966 to 37.7 kilograms per year between 1997 and 1999, an increase of 433 percent. Raising livestock exerts substantial upward pressure on food prices, as they use land that can sometimes be devoted to crops and require feed of their own. While the WHO notes the global demand for cereals per person, including as animal feed, has declined

since the 1980s, the overall demand for cereal-based feeds has grown by more than 4 percent in East Asia and Sub-Saharan Africa as well as more than 2 percent everywhere else in the developing world, according to the FAO.10

The nations that have seen an increase in the proportion of calories coming from meat are also the nations seeing a rise in total caloric intake. This should generally lead to steady or rising demand for the cereals for human consumption, pushing up prices for these commodities. In turn, the livestock that provides meat for the growing middle class must also be fed, generally on a cereals or cereal by-products that have already risen in cost. The G205 report notes that beef prices have actually become substantially more stable over the past few decades, suggesting that growing demand for diversified diets might have more to do with consistent upward pressure on prices, rather than with increased volatility.

INSTABILITY IN SUPPLY AND DEMANDWhen Europeans first landed on the southeastern coast of Australia in the late 1700s, they were greeted by a temperate climate much like those enjoyed throughout their native land. With consistent winter rainfalls and moderate temperatures, the region proved extremely well-suited to many European crops and livestock. Consequently, Australia has emerged as one of

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the world’s largest exporters of wheat. Since those early days of colonization, however, Australians have come to realize that the continent actually follows a more erratic weather pattern, with long periods of drought. The G20 report notes that severe conditions in Australia contributed strongly to the price spikes in 2007 and 2008, after the country experienced its driest and hottest winter on record, according to the Australian Bureau of Meteorology.11 In particular, the G20 food price index for wheat spiked from roughly 200 in the summer of 2007 to nearly 500 in early 2008. Rice saw an even more dramatic price spike, jumping from an index of nearly 400 in early 2008 to more than 950 that summer.5

These kinds of environmental shocks are hardly limited to Australia, but come and go relatively unpredictably around the globe. At present, one of the largest crop producers in the U.S., Texas, is experiencing its worst drought in more than a century, crippling the agricultural industry. More dramatic environmental crises such as hurricanes and floods, or the massive wildfire that swept through Russia in the summer of 2010, can also devastate crops. These disasters need not necessarily be weather-related, either, with infestations of apple moths in California and disease-carrying grasshoppers infecting rice crops in Thailand.

The OECD4 labels environmental impacts as a temporary factor in crop prices, in so much as they are likely to subside at some point before reemerging. Over the years, however, they have had a secondary effect on the market, beyond the obvious increase in prices. In times of surplus, governments are able to put crops aside in the hopes of softening price spikes during shortages. The FAO3 tracks the amount a food purchased for emergency stores and, while levels have recovered from the recent low during 2008, they currently remain nearly 15 percent below levels from the early part of last decade. The ratio of stocks to worldwide usage, meanwhile, has fallen from 29.9 percent to 21.3 percent, dramatically limiting countries’ ability to use these reserves to control commodity prices. With production not expected to outpace demand, the OECD4 has labeled this issue a permanent concern.

While one of these issues is perceived as ultimately temporary and the other likely to linger indefinitely, both environmental

shocks and low reserve stocks exert inconsistent pressure on food prices, contributing to extreme price volatility. Many policy proposals addressing the issue have emphasized as much. One increasingly popular approach for addressing this increased volatility is advocating the use of weather-indexed derivatives or insurance. The G205 report notes that the difficulty in assessing these risks, as well as the tendency for crop damages to be grouped closely together, makes the task of limiting volatility extremely hard and thus a growing international concern.

RISING DEMAND FOR BIOFUELSAs global demand for energy—particularly the need for liquid fuels for vehicles, generators, and other equipment—has grown, many countries have turned to plant-based fuels as a potential source for renewable energy. Though more environmentally impactful than many reformers would prefer, these biofuels at least offer a reliable source of energy potentially capable of outlasting existing oil reserves.

According to the G20 report,5 biodiesel production grew more than ten-fold over the last decade and bio-ethanol production quadrupled. The OECD4 now notes that cereals devoted to this purpose could double between 2007 and 2017. Already, biofuel production accounts for 4 percent of all sugar beets, 9 percent of all vegetable oil and coarse grains, and 20 percent of all sugar cane produced.4 This increased demand could see prices increase as much as 8 percent for wheat, 13 percent for coarse grains and 35 percent for vegetable oil.4 Unlike weather-variables, this increased demand does create a lasting upward pressure on food prices, and a recent report from The Guardian12 suggests a secret World Bank report places the lion’s share of price spikes at the feet of increased biofuel

As global demand for energy has grown, many countries have turned to plant-based fuels as a potential source for renewable energy.

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demand. Increased demand from the biofuels sector ostensibly accounted for 75 percent of a 140 percent price increase in the foods being tracked. High energy and fertilizer prices meanwhile combined for only 15 percent.

The greatest problem with this market, however, is not just its reliance on potential food crops, but the distortion of the market by government incentives. Many countries, notably the U.S., have imposed minimum biofuel blends for gasoline, further exacerbating the already inflexible demand for agricultural products and pushing price spikes ever higher when they occur. In addition, subsidies for biofuels based on domestic crops, such as corn in the U.S., encourage further inefficiency. The use of non-food or non-critical crops such as grasses or sugar could limit biofuel’s impact on price volatility. Though the original report suggests ending these policies—or at least indexing requirements on commodities prices—so as to limit the impact on the food market, these proposals were ultimately not adopted by the G20. Any such effort would likely cause an eventual decline in prices for corn and other heavily subsidized biofuel crops.

THE IMPLICATIONS OF MASSIVE WATER SHORTAGESThe agriculture industry relies on a wide range of circumstances to be successful, from fertile soil to abundant

sunlight to effective farming methods. One of the most hotly contested resources, however, is the increasingly limited global water supply. The FAO8 reports that global water supplies are actually more than sufficient. These resources, however, are not ideally distributed, with the vast majority of untapped water reserves located in Central and South America and the Caribbean. Despite holding more than 13,000 cubic kilometers of untapped renewable water resources, many of these countries lack basic infrastructure or the appropriate climate needed to take advantage of them.

Meanwhile, researchers at the Centre for Environmental Systems Research13 at the University of Kassel in Germany estimate that a total of 2.1 billion people rely on water resources under severe strain. Most of the Middle East and North Africa, as well as huge swaths of India and Pakistan, rely on water systems with a withdrawal-to-availability ratio of higher than 0.8, and even most of Europe falls into the “mid stress” range.

The FAO8 suggests that, while agricultural output could be positively affected by global warming in the near term, the increased pressure rising temperatures could put on water supplies could prove catastrophic in the long term. In particular, major producing regions that already face some strain, like India and Europe, could see a dramatic reduction in output, which would likely send prices skyrocketing. At present, the

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strain on these systems serves more to increase year-to-year volatility, as farmers lack the resources to cope with especially hot summers.

LAND EROSION AND URBANIZATION

DISCLAIMER

AFFECTING ARABLE ACRES

scarce, particularly for small scale farmers in developing nations. A 2008 report from the International Fund for Agricultural Development 14 suggests that between 5 and 10 million hectares of land becomes unusable because of soil and environmental degradation each year. Meanwhile, the Population Reference Bureau 15 estimated in 2007 that the majority of world population has already moved into urban areas. While this ongoing population shift from rural farms to

it has also increased demand for non-agricultural uses of land.

The FAO 8 estimates that developing nations will add a net total of 120 million hectares of agricultural land, but farms in developed countries are actually expected to contract by as much as 50 million hectares. The majority of available land for agricultural expansion is located Latin America and Sub-

majority of remaining available land actually lies in industrial countries, where it is expected to be put toward other uses.

These factors touch only a small fraction of the potential

largest have nonetheless been addressed. Others include the growing connection between oil prices and food prices, as well

EXPECTATIONS FOR THE FUTUREWith the dramatic consequences posed by rising food prices, governments and organizations around the world have taken up the call to help address the issue. Policy options for such a broad-reaching problem remain limited, however. Likely the most crucial driving factor behind the current crisis is the world’s steady and substantial population growth, which continues to put strain on food production centers, fresh water and numerous other resources. So long as this global population continues to expand, agricultural commodities should see upward pressure on prices.

Growing non-food demand for agricultural products also seems unlikely to reverse course. As environmental policies become stricter, demand for petroleum replacements should grow, particularly with higher demand for consumer products from the developing world. Combined with increasing need for animal feed, the strongest “permanent” pressures seem to point toward a slow, but steady upward trend in commodity prices. This should make commodities a reliable long-term investment despite substantial volatility over the shorter-term.

supply and demand within the agriculture industry inclines the market toward rapid and dramatic price spikes. Though this volatility always leaves open the potential for relatively quick drops, the strong long-term supports help control the potential losses. The variety and complexity of factors playing into the volatility of agricultural commodities make predicting

expect existing trends to continue over the short-term, making successful investment less a matter of e�ective prognostication and more about careful monitoring of market trends.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. THE RISK OF LOSS IN TRADING FUTURES CONTRACTS OR COMMODITY OPTIONS CAN BE SUBSTANTIAL, AND THEREFORE INVESTORS SHOULD UNDERSTAND THE RISKS INVOLVED IN TAKING LEVERAGED POSITIONS AND MUST ASSUME RESPONSIBILITY FOR THE RISKS ASSOCIATED WITH SUCH INVESTMENTS AND FOR THEIR RESULTS.

YOU SHOULD CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR CIRCUM-STANCES AND FINANCIAL RESOURCES. YOU SHOULD READ THE “RISK DISCLOSURE” ACCESSED BY THE LINK BELOW. DANIELS TRADING IS NOT AFFILIATED WITH NOR DOES IT ENDORSE ANY TRADING SYSTEM, NEWSLETTER OR OTHER SIMILAR SERVICE. DANIELS TRADING DOES NOT GUARANTEE OR VERIFY ANY PERFORMANCE CLAIMS MADE BY SUCH SYSTEMS OR SERVICES.

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CME Group Metals Products website. Available at: http://www.cmegroup.com/trading/metals/. Accessed August 5, 2011. CME Group Agricultural Commodities Products. Available at: http://www.cmegroup.com/trading/agricultural/. Accessed August 5, 2011.

Food and Agriculture Organization of the United Nations. FAO Food Index website. Available at: http://www.fao.org/worldfoodsituation/en/. Accessed August 5, 2011.

Organisation for Economic Co-operation and Development. Rising Food Prices: Causes and Consequences. Washington, DC: Organisation for Economic Co-operation and Development; 2008

Organisation for Economic Co-operation and Development. Price Volatility in Food and Agricultural Markets: Policy Responses. Washington, DC: Organisation for Economic Co-operation and Development; 2011.

United Nations Department of Economic and Social Affairs. World Population to 2300. New York, NY: United Nations; 2004.

The World Bank. World Development Indicators. Available at: http://data.worldbank.org/data-catalog/world-development-indicators?cid=GPD_WDI. Accessed August 5, 2011.

Food and Agriculture Organization of the United Nations. How to Feed the World in 2050. Available at: http://www.fao.org/fileadmin/templates/wsfs/docs/expert_paper/How_to_Feed_the_World_in_2050.pdf. Accessed August 5, 2011.

World Health Organization. Global and regional food consumption patterns and trends. Available at: http://www.who.int/nutrition/topics/3_foodconsumption/en/index.html. Accessed August 5, 2011.

Food and Agriculture Organization of the United Nations. Feed Commodity Demand and Supply. Available at: http://www.fao.org/wairdocs/lead/x6123e/x6123e05.htm. Accessed August 5, 2011.

Australian Government Bureau of Meteorology. Drought intensifies over eastern and southern Australia as spring rains fail. Available at: http://www.bom.gov.au/announcements/media_releases/climate/drought/20061103.shtml. Accessed August 5, 2011.

Chakrabortty A. Secret report: biofuel caused food crisis. The Guardian. July 3, 2011.

Alcamo, J. Global estimates of water withdrawals and availability under current and future “business-as-usual” conditions. Hydrological Sciences. June 2003; 48(3): 339-348.

International Fund for Agricultural Development. Improving access to land and tenure security. Rome, Italy; Palombi e Lanci. 2008.

Population Reference Bureau. Urban Population to Become the New Majority Worldwide. Available at: http://www.prb.org/Articles/2007/UrbanPopToBecomeMajority.aspx. Accessed August 5, 2011.

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