For a fistful from a thinning supply line

The prices of many agricultural commodities have been trending higher over the past few years, particularly staples such as wheat, corn and rice.

This trend has accelerated recently, so much so that rice prices have doubled in the last year, and wheat prices have more than trebled.

Unlike rises in the prices of other commodities such as gold or platinum, these increases have a direct and tangible effect on global consumers in the form of higher food prices.

Rising agricultural commodity prices have been putting upward pressure on inflation globally, but particularly in emerging markets where food has a high weighting in the consumer goods basket.

Some recent price moves have provoked tariff responses from governments keen to avoid unrest over the prices and availability of staple foods. This has tended to exacerbate moves in the market price; the price of spring wheat (the kind used to bake bread) jumped 25 per cent in one day in February after Kazakhstan announced it would act to curb exports.

Increases in the price of rice have caused four of the leading exporters (China, India, Egypt and Vietnam) to impose export controls to protect against inflation.

Poor weather has been a contributory factor but the underlying reasons for this sustained price strength appear to run deeper. Likewise, the impact of speculators and investors hedging against inflation seems to have only intensified recent price moves. What is clear is that there are long-term structural, fundamental factors that have been driving commodity price strength over the last few years.

Over the last decade, many densely populated developing countries such as China and India have enjoyed robust economic growth. Rising incomes and the emergence of a growing middle class have seen diets change to incorporate significant increases in protein-based foods, such as meat and dairy.

As economic growth and wealth continue to rise, we can expect this trend to intensify. The reason this change in diets is important is that it has a multiplier effect on the demand for grain. It takes approximately two kilos of grain to produce a kilo of poultry and a huge seven kilos of grain to produce one kilo of beef. Rising meat consumption therefore has a significant multiplier effect on grain consumption. This is one of the reasons that grain stocks have dwindled to record lows.

On the supply side, the agricultural land base is declining. Industrialisation and urbanisation in emerging economies, especially Asian rice-producing nations, are reducing arable land, while gains in yields have levelled off after a shift to more productive strains. Economic growth brings with it roads, railways, factories and housing - factors that have combined to more than halve the planet's arable farmland since 1950. In short, there is an increasingly pressured balance between growing demand and tight supply.

Something unusual

Within that declining arable land space, however, something unusual is happening. Farmers are switching to more profitable crops, contributing to scarcity in the crops they are giving up. For instance, rice and soybean prices have been driven up, at least partly, by growers moving into other crops such as corn. One might argue this is merely normal market economics at work. However, the reason has more to do with the headlong rush into biofuels by a number of governments.

The high oil price has encouraged governments to explore alternative fuels for their economic and environmental benefits. Ethanol and biodiesel can be made from a range of agricultural commodities: corn in the US and China; sugar cane in Brazil and India; and palm oil in Malaysia and Indonesia.

Biofuels are already having a critical impact by reducing the amount of food available for human and livestock consumption - demand for which, we know, is growing at pace. Intuitively, strong biofuel demand suggests greater convergence between food and energy commodities. Higher oil prices therefore raise expectations of agricultural prices, implying the ceiling is the energy equivalent oil price.

These changing demand and supply dynamics have shifted up the price ranges of a range of agricultural commodities. Although prices fell back in March, they remain at elevated levels compared to history and many analysts think that this was merely a correction within a longer term uptrend. While slowing global growth may prompt some easing in prices, tightness in supply and sustained emerging market demand is likely to support price strength in the long run. For instance, some analysts think that, despite being a leading exporter of corn, China could soon become a net importer, such is its voracious appetite for commodities.

High commodity prices should encourage farmers to bring what available land there is under production, and we are already seeing a supply side response in rice. In wheat, there is excess capacity in the Ukraine and Russia. However, prices are likely to remain volatile for the next year or two until the supply response takes full effect. In the longer term, with arable land likely to remain under pressure, farmers simply have to get more out of their existing land. This is why the demand for fertiliser has surged in the last few years, with emerging economies again acting as the main drivers.

Higher food and energy prices have been causing concern globally and, in the US, there are growing fears that the Fed is storing up inflation problems with its aggressive monetary policy. Meanwhile, euro zone and UK inflation is staying doggedly above the target rates of the respective central banks.

One reason the Fed is cutting so aggressively is because they partly strip out food and energy costs from their preferred measure of inflation on the assumption these are mean-reverting. If they are wrong and those suggesting we are seeing a structural shift up in agricultural prices are right, then food prices may continue to pressure inflation. If that is the case, the assumption the Fed can cut rates without fear would appear to be a dangerous one that runs the risk of letting higher inflation expectations become entrenched. Unlike wage inflation, central banks have less influence over food and energy inflation.

The great divide

Food price inflation is the dominant driver of consumer price inflation at the moment. However, food price inflation does not fully reflect the price movements in agricultural commodities. In the developing world, food has a much higher weighting in the consumer spending basket and many countries have a far greater reliance on one or two staple foodstuffs.

Lower processing and labour costs mean commodity prices have a more dominant role in driving food price inflation. This is why the Chinese government recently had to release part of its strategic pork reserve to reduce the rate of food price inflation in China. In the Philippines, fast food outlets have been urged to reduce the size of their rice portions.

In developed economies, food makes up a much smaller part of overall spending. In fact, UBS estimates that only around 20 per cent of spending on food in OECD (Organisation for Economic Co-operation and Development) countries is driven by agricultural commodities. This is because the main determinant of OECD food price inflation is labour costs.

Food production in developed economies is labour cost intensive in all of its various processing, packaging, transportation, distribution, retail and service phases. In this sense, trends in labour costs play a greater role than commodity prices in determining food price inflation. Given predictions of a weak labour market with low demand for lower income workers, UBS believes the outlook for food price inflation in the OECD is actually quite favourable even if agricultural commodity price inflation stays at the same high level.

Nevertheless, food price inflation can disproportionately influence consumer perceptions of overall inflation as it is a high frequency purchase. One key concern is that the mere expectation of rising inflation among consumers translates to higher wage demands and thus pushes up core inflation.

Although, private sector employees currently lack the bargaining power to push through these demands, we have recently seen unionised steel and textile workers in Germany looking for above inflation rises.

The long term positive outlook for commodities remains broadly intact on the basis that the structural drivers highlighted here will continue to create the conditions for scarcity. We may see further corrections, particularly given the involvement of speculative money.

However, much of the investment inflows into commodities have actually come from passive index funds, which are treating commodities like an asset class in the same way as equities or real estate.

There are a number of companies not just in the agricultural space, but in equipment, chemicals, food production and retailing, and real estate sectors who are benefiting from these structural trends in commodity prices. Fundamental investors have been playing these themes for some time and bottom-up stock selection can reveal the most compelling opportunities.

- The writer is director of sales (Middle East) at Fidelity International.