What Rising Food Prices Mean for Investors

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This article has been adapted from our sister site across the pond, Fool U.K.

As global food prices hit an all-time high, many investors will be licking their lips at the prospects. But is there a danger of biting off more than you can chew?

I asked Hugo Rogers, manager at the specialist Thames River Water & Agriculture Absolute Return Fund, what rising food prices mean for investors.

Food fight
Agriculture is a growth area. Food supply simply isn't meeting demand, and this problem cannot be addressed overnight, Rogers says. This makes now a good time to invest.

Food stockpiles have been falling for some years. In February 2008, world grain inventories dipped below 70 days of supply. Prices soared; people rioted. The unrest spread to countries such as Bangladesh, Cameroon, Egypt, Haiti, India, Mozambique, Senegal, Somalia, and Yemen. But it was followed by two good harvests and stable food prices. Prices fell; investors lost money.

The 2010 harvest was pretty respectable, Rogers says, but grain inventories have once again dipped below 70 days of supply, as producers struggle to keep up with demand. "Unless we see a massive harvest," he says, "inventories will remain low."

Water, water … not everywhere
Water is an even bigger worry. "Water tables are sinking all over the world, especially in India and China," Rogers says. "China has 20% of the global population, but just 7% of its water. The U.S. Midwest is the most productive land in the world, but it relies on the Ogallala Aquifer, a huge, shallow underground water table that is depleting five times faster than it is replenishing. It is difficult to know how much water is left there. So we also need high water prices to stimulate supply and alleviate shortage."

A sustained period of higher prices is needed to boost investment in food and water production and infrastructure, and if it happens, it should reward investors. But this isn't a one-way bet. You can expect plenty of volatility. "If we have a particularly good harvest, it could knock prices," Rogers says. "There has been a lot of speculative interest in agriculture, and this could quickly reverse."

Where's the beef?
So why are food prices so high? Rising demand is one reason. People in emerging markets are shifting to protein-based diets, which places more pressure on producers -- it takes 7 kg of grain to produce just 1 kg of beef, for example. Another problem is that more productive land is being set aside for biofuel, he says.

Supply is also a problem. "Improvements in agricultural yield have fallen dramatically since the Green Revolution in the 1960s, where new technology led to dramatic yield increases," Rogers says. "At its peak, yields were increasing by 20% a year. They have now fallen to as low as 1% a year. Even with [genetic modification], we're not getting much more in terms of output per hectare."

Climate change is adding to the uncertainty and volatility. "We have seen a massive increase in the frequency and strength of extreme weather patterns," he says. "The current La Nina is the strongest since records began. It follows an extremely strong El Nino two years ago."

Rotten infrastructure
This doesn't mean we're running out of food, though. "The U.S. has the highest global yields per hectare," Rogers says. "If you lifted yields in Latin America, Europe, Asia, and Africa to U.S. levels, you could feed three times the world population."

In Brazil, 30% of grain never makes it to market. In India, 40% of vegetables rot. This is down to poor infrastructure, transportation, and central logistics. "Food prices have been falling for the last 20 years, and this has deterred investment in infrastructure, logistics, transportation and water-saving technology," Rogers says. "This is now beginning to reverse. Fresh investment can do a lot to lift productivity, particularly in Eastern Europe and Latin America."

A fund for all seasons?
Investing in agriculture is risky, because the fundamentals can change with the weather. One bad harvest, and prices soar. A good harvest, and they can crash back to earth.

Rogers says a long-only strategy is therefore dangerous: "This sector is uniquely susceptible to weather, political interference, and natural disasters. That's why we have absolute return targets. When agricultural prices collapse, which they will do at some point, we still want to make money for investors."

Thames River Water and Agriculture Absolute Return was launched in March 2009 and is domiciled in Ireland. As a unit trust, it has a 5% initial and 1.75% annual charge. Last year, it returned 10%, roughly in line with its sector and benchmark.

It's gonna rain
So what does the future hold? Grain inventories have once again fallen to a critical level, Rogers says. El Nino could hit soya bean production in Latin America. Heavy rainfall in Southeast Asia and Australia has pushed up the price of crude palm oil, rice, and wheat. "We can expect further price peaks throughout the year," he says. "Things are going to get worse before they get better. Our fund is still long."

At some point, this trend will reverse. With prices high, farmers are planting as much as they can, Rogers says: "Farmers have more money. There has been a wave of mechanization. Yet we believe that in the long run, both supply and demand are favorable for positive returns."

Golden grains
Agriculture is different from other commodities in one key respect: Rising food prices can lead to "demand destruction," which could mean people starve. They can also bring down governments.

ETFs have been blamed for encouraging speculation in food prices, but Rogers says the problem has been overstated. "Grain isn't like gold," he says. "You can't just take it off the market. It needs to be consumed. It also needs to be stored, which adds up to 12% to the cost. With an ETF, you are paying a very significant storage premium, so it is expensive. There is also the big risk of investing after the cycle has peaked."

Agriculture could add some beef to your portfolio, but be warned: Your investment fortunes can change with the seasons.

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