Highly Leveraged Agriculture Will Keep Food Prices Volatile And High

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With food prices remaining stubbornly high near record levels, price swings and volatility have come to constitute a new normal in the commodities complex.  While pass-through to consumers is slow, this will put renewed pressure on producers, leveraged in terms of efficiency, and and will put the world’s poor at risk as small disruptions, such as bad weather, can throw off crop counts and send prices even higher.

Speaking at the Bloomberg Link Inflation Conference, portfolio managers Lincoln Ellis of Linn Group and Jennifer Fan of Arrowhawk Capital, along with MIT Professor Roberto Rigobon, made the case for a new normal in the commodities complex, particularly as it relates to food and agricultural products.

Global food prices surged toward the end of 2010, pushing 44 million people into poverty, according to the World Bank.  Prices have remained stubbornly high through 2011, as the UN’s FAO Price Index shows.  Released Thursday, the latest data show the index just shy of the all-time high mark hit back in February, 26% above its measure a year ago. (Read On The Verge Of A Global Food Crisis).

As the global population continues to grow, farmers and ranchers will face heightened pressure and relentless volatility as they produce food to feed the world.  Fan explained that “agriculture as it is today is in a highly leveraged state” as “we grow more food to feed more people on an increasingly shrinking acreage.”  As genetically modified seeds and fertilizers allow farmers to grow an increasing number of plants per acre, concentration increases the risk of disruption.

Volatility is here to stay, all three experts agree, because a simple weather event can cause substantial damage.  Fan cited the case of strong rains in the port of Santos in Brazil, causing sugar shipments to be delayed and sending sugar to multi-month highs in July.

The price of sugar illustrates how volatility has played out in global food markets.  The FAO’s sugar index jumped from 263 to 420 from August 2010 to January 2011, up 60% in a few months.  It fell to 312 by May and then jumped right back to 400 by July, down 26% then up 28% in a few months.  A true roller coaster ride.

Professor Rigobon furthered the point, noting volatility was a consequence of a “de-synchronization between the forces of supply and demand.”  As the global economy struggles to grow, and supply shocks hit prices, demand will be highly responsive too. (Read Why World Food Prices Will Keep Climbing).

Interestingly, though, price volatility isn’t really being passed on to consumers, Rigobon explained.  “Pass through has been extraordinarily slow,” noted the economist, who added “while the price of coffee may shoot up to infinity, a can of coffee in your supermarket of choice costs 2 to 5 cents more.”  But Rigobon accepts pass through is much quicker in developing countries, where food consumes  a greater, and very substantial, portion of disposable income.  “In Brazil,” he said, “the price of bread fluctuates much quicker than in the U.S.”

Ellis complements Rigobon‘s argument explaining that in a two-speed world, where dynamics for advanced and developing economies differ drastically, “we are seeing huge amounts of inflation being passed on to consumers in the emerging world.”  The key is wage growth.  With wages in advanced economies stagnating, retailers can’t afford the luxury to play with the price of inelastic goods like food, while in regions of fast wage growth, retailers adjust prices much more readily, as opposed to digesting the hit via lower margins. (Read China As America’s Banker, America As China’s Farmer: Malthus Was Right).

Along with price volatility, the global economy will have to get used to higher prices.  “There are long-term structural dynamics that will continue to support prices going forward, explained Ellis, “we are at a time in the commodities complex where it won’t necessarily be the case that high prices cure high prices.”

Ellis told investors they would be “well positioned by having exposure to this space,” and suggested buying seed companies and larger agro-business companies.

By 2050, the world will need 70% more food, the World Bank believes.  With almost 1 billion undernourished people in the world, land degradation, and climate change, fundamentals appear to be in place to support food prices for the long run.  That’s bullish for producers.

Source: Forbes Online>>

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