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Why your next dinner needs a huge capital investment

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American Countryside in Summer Time

We noticed an interesting piece in the Financial Times this week which highlighted the many dynamics, variables and challenges in the farming of corn. Reporting on the fall in corn prices, which followed a statement made by the US Department of Agriculture on the record 42 million acres of corn planted in the last week alone, the story highlighted a crucial point:

“The blistering pace of planting shows how new technology, from global positioning systems and huge 48-row planters to self-driving tractors, has transformed farming from a small family business to an industry requiring huge capital investments. The largest corn planters could cost nearly $350,000 per unit.”

And “huge capital investment” is what financial markets do best.

We’ve highlighted this before; as the United Nations’ Food and Agriculture Organization (FAO) put it in a report titled The State of Food Insecurity in the World:

“Producer margins will likely need to move higher in order to support investment in equipment and technology. Freely-operating cash and futures markets are an important precursor, as they help facilitate returns to encourage and sustain investments.”

Let’s remember what is at stake here: the hard number is 7 billion mouths to feed and industrial-scale farming of some soft commodities is essential to sustain that number.  Quite simply, without financial markets there would be no “huge” or “sustained” investment in agriculture (or any other commodity market) and without investment, we suspect there would not be as much corn.

A 1,700-year-old method for getting food to hungry people

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The FT Global Commodities Summit was held in Switzerland last month, a gathering of 300 senior executives and traders to debate the key issues facing the commodities industry. The keynote speaker was Greg Page, CEO of Cargill, the world’s largest agricultural trading house. He gave a wide-ranging speech in which he urged the commodity trading world to be accountable for the environmental, economic and social effects of their decisions. He had no hesitation in calling the work of getting crops and raw materials where they are needed not just a business but an “obligation.”

Page addressed trading’s role in this process, by quoting 4th century writer Libanius’ Orations III. From Page’s speech:

“‘God did not bestow all products on all parts of the earth, but distributed his gifts over the different regions, to the end that men might cultivate a social relationship because one would have need of the help of another. And so he called commerce in to being, that all men might be able to have common enjoyment of the fruits of earth, no matter where produced’…. in my experience, Libanius was right. Trading, or exchanging goods, has long underpinned human progress, and the interdependence that comes from trading creates the real capacity to raise living standards.”

Page discussed just how necessary this interdependence is to progress, and to feeding the eventual global population of 9 billion (a topic we have touched on previously). And it’s something everyone involved in agriculture, from growing to transporting to risk management, has reason to be proud of:

“We should not ignore or underestimate the significant value we bring to people’s lives every day through  moving food and crops from places of surplus to areas of deficit, or providing safe and efficient storage, minimising waste, maximising productivity, or supporting farmers with crop inputs, pre-financing or access to markets, managing risks or trading coal, electricity, natural gas, petroleum, iron ore and basic metals.”

Page sees efficient markets as not just a business, but as the only viable solution for sustaining the population of the world we live in ‒ and we have to agree.

Swiss commodities report as reliable as clockwork

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The Swiss government’s departments of Foreign Affairs (FDFA), Finance (FDF) and Economic Affairs, Education and Research (EAER) published a fascinating report recently on the commodities sector.

While the report underscores the significance of the commodities industry for Switzerland – we are talking about an industry that contributes some 3.5% to the country’s GDP after all – it also discusses the role of the financial sector for commodities. As the report explains:

“….commodity traders are dependent upon the financial industry for the securing of risks. Traders, by the nature of their activities, are constantly exposed to the risk of a collapse in prices; they seek to secure themselves against price fluctuations with the help of financial derivatives. This practice, known as hedging, has a stabilising effect on prices. In the agricultural commodities sector, for example, derivatives have been used for hedging purposes for over 150 years… Financial investors thus make an important contribution to the liquidity of commodity derivative markets and also assure the ability of commodity traders to find a counterparty when needed.”

The report also goes on to discuss “regulatory issues: commodity trading and the financial industry” and makes some cogent points on the real price drivers in the market  Here’s their take on what is often termed as “financial speculation”:

“…. while financial investors can certainly contribute in the short term to the creation of financial bubbles, no convincing empirical evidence has yet been presented to show that financial investors have a lasting influence on commodity prices. Rather, according to most studies, it is real economic factors, including rising demand from emerging markets and a slow response on the supply side, that are the main causes over the middle to long term.”

Finally, a section from the report’s conclusion addresses wider misperceptions about the impact of the financial sector on commodities:

“The commodities industry…has developed into an important sector …. making an increasingly significant contribution to value added, job creation, and tax revenues… Commodity trading conducted in a well-organised manner contributes globally to the efficient and sustainable allocation of natural resources.”

As the German speakers of the world would say, Genau das wollten wir hoeren! (Exactly what we want to hear!)

A competition with no winners

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It hasn’t gone unnoticed that the Financial Times’ fund management supplement – the aptly named FTfm – has given significant air-time to the topic of food price speculation.

Last week’s piece, entitled “Food price speculation taken off the menu” was a rather balanced story on the effect the food price speculation argument is having on the exchange-traded fund market.

While reporting on the increasing number of European banks either scaling back or exiting funds tracking agricultural prices, largely as a result of a targeted campaign by the international charity Oxfam, the story stated:

“A question emerges in the frenzy of Oxfam’s campaign, however. Does investment in ETFs or standard open-ended funds offering exposure to commodities actually push up food prices?”

At last, a refreshingly balanced piece that asks that all-important, yet often overlooked question and addresses both sides of the argument!

Unfortunately, it was soon followed by another article in the print edition (“Trio up for dangerous product award”, March 11) describing a newly-launched contest to find Europe’s most dangerous financial product for investors. As the article notes, “Four categories were identified as posing the greatest risk: food-speculation funds and funds involved in the extraction of uranium, silver and oil shale.”

It seems clear that the aim of the “competition” is more political than financial in nature. Which leads us to ask: does this contest merit such visibility and space in one of the world’s most important newspapers? Both add a lot of credibility to an awards program that is designed largely to stir up publicity.

Particularly given the fact that an overwhelming body of research exists on this subject… and that research contradicts the oft-voiced but shakily grounded assertions about commodity and food speculation. As the March 3 FT story notes, quoting from a research report published by Deutsche Bank:

“‘Little empirical evidence’ supports the idea that the growth of agricultural-based financial products provokes price increases or volatility in the food market…. ‘The vast majority of studies agree that the fundamental cause of rising food prices is sharply rising demand that is not yet matched by supply. Demand is surging because of population and income growth in developing countries while production is limited by water scarcity, climate change, lack of infrastructure and harvest waste.’”

To that end, as mentioned in last week’s story, Deutsche Bank predicts that more than $80 billion must be invested in the agricultural sector each year to increase farming productivity and meet increasing demand for food.

As we’ve said before, when there is a need for increased investment that is where the financial sector comes into play. Sustained investment and reduced price volatility is essential – not just nice, but by broad consensus essential – to meeting the increasing demand for food the world over. Again, as we’ve said before: we have the capability and the capacity to meet these needs; but we must allow financial markets play their crucial role.

After all, $80 billion isn’t exactly pocket change. Might we be so bold as to suggest a competition for ideas as to where this $80 billion could possibly come from without financial sector involvement?

Markets for the nine billion

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Every year, the United Nations’ Food and Agriculture Organization (FAO) puts out a report called The State of Food Insecurity in the World. We came across this year’s report when it was referenced in a J.P. Morgan Global Commodities Research note. Both the FAO report and the note make for interesting reading — especially for those interested in the role that markets can and do play in feeding the world. Among other facts, the research note mentions:

“In a 2012 report, the FAO estimated that 868 million people in the world were undernourished between 2010 and 2012, or about 12.5% of the global population. As the US Census Bureau projects the world population to surpass 9.0 billion in 2042, human civilization faces the challenge of feeding an additional two billion people in less than three decades.”

As the report highlights, the challenge of feeding more than nine billion people will require more efficient distribution, storage, and risk management of food supplies. The FAO is straightforward in prescribing increased investment in agriculture: “this will sustainably increase yields, reduce input costs, increase productivity and reduce food losses and waste.”

And when there is a need for increased investment, the financial markets come in to play. From the FAO: “Producer margins will likely need to move higher in order to support investment in equipment and technology. Freely-operating cash and futures markets are an important precursor, as they help facilitate returns to encourage and sustain investments.” [emphasis ours]

So the availability of free markets actually creates the conditions for sustained investment in agriculture that the world will need.  The J.P. Morgan note expands on why this is the case:

“…Futures markets have at least two important roles in providing enhanced food security. First, futures markets provide reliable and fair benchmark prices, whereby various physical basis markets can equilibrate to move supplies to where they are most needed and to discourage thoughtless waste. This service is of the utmost value to society generally, as it resolves imbalances dispassionately and efficiently. Second, futures markets also provide the significant benefit of reducing food price volatility from where it otherwise would be in a resource-constrained world.”

Nine billion mouths to feed. It will only be accomplished with sustained investment and reduced price volatility. We have the capability and the capacity to achieve these goals; but only if we let financial markets play their crucial role.

Climate shocks cause price shocks

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Since humans became farmers about 10,000 years ago, they have been weather dependent – harvests rely upon a good equilibrium between rain and sun. Then as now, unpredictable climate shocks significantly affect the main cereals (wheat, corn, rice, soja), fruits and vegetables and, indirectly, cattle and sheep.

One of these climate shocks has just been experienced: 2012 was a terrible year for farmers in North America, with summer droughts followed by autumn floods. Harvests were low, and the economic fundamentals of agricultural markets are subject to potential spikes and volatility because of this shock.

But don’t take our word for it.

An article in the January 4 edition of The Telegraph (UK) discusses how the managing director of Waitrose, a major UK supermarket chain, expects prices could spike by 5 percent due to substandard crop yields and the attendant supply shortage.

The article goes on to say that this kind of shock may be, as the saying goes, “the new normal.” Quoting the UK government’s chief scientist Sir John Beddington: “There is going to be another billion people on the planet in 13 years’ time. There is already a billion people in poverty. That is going to increase demand for food. We have got climate change. We have got major changes in weather patterns, so supply is going to be extremely fragile, reserves are way down…. and we are going to have these [price] shocks.”

Fundamentals – including demographic changes and weather patterns that affect the supply and demand of commodities – are the key drivers of commodity price changes.

We believe it’s important to understand and know the facts about commodity price changes and volatility. That’s why we developed CommodityFACT.org. We hope also to address misperceptions about commodities markets, and to explain the wider role of commodity investing. We do this by bringing together facts, data and research from government, academia, independent organizations and the media.

We invite you to join us as we continue to highlight articles like this, along with relevant papers and studies, to make sure all sides of the discussion on commodity prices and investing are heard.