Sowing the seeds of commodities growth

Tim Hornibrook examines the factors that will lead to rising demand for agricultural commodities over the next few decades.

Jacques Diouf, director general of the Food and Agriculture Organization of the United Nations (FAO), said in 2006: “We not only need to grow an extra 1 billion tonnes of cereals a year by 2050 … but [must] do so from a diminishing resource base of land and water in many of the world’s regions, and in an environment increasingly threatened by global warming and climate change.”

In the following two years after Diouf made this statement, the price rises in agricultural commodities brought increased attention to the market dynamics and the drivers of demand and supply for these commodities.

Food, feed and fuel

Agricultural commodities have three main uses that we call the three ‘f’s – food, feed and fuel – and there has been an increase in demand for all three.

This is being driven by global population growth (demand for food), economic growth in emerging markets (demand for feed) and biofuel policies that are being implemented by governments across the globe (demand for fuel).

Population growth is a basic factor that drives an increase in the consumption of agricultural products, as the growing global population is the core base of demand growth for food.

The global population has grown substantially during the past few decades, and from its current base of 6.1 billion people is projected to rise to 8.3 billion by 2030 and 9.1 billion by 2050 – resulting in an additional 79 million mouths to feed each year.

Further, in the coming years, population growth is expected to be concentrated in developing and emerging economies, meaning some countries that have previously been self-sufficient will need to start importing foods.

Although the rate of growth is slowly decelerating, the absolute annual increases are undeniably large. Growth in food demand is reflected in the growth in demand for wheat, which is one of the primary food grains.

Human consumption accounts for approximately 70 per cent of total wheat consumption and, according to the USDA, during the past 20 years worldwide wheat consumption has been growing, on average, at 1 per cent per annum.

Economic growth in the emerging markets is another source of growth in the demand for agricultural products, as rising per capita incomes and urbanisation are resulting in greater consumption of food, as well as a shift in the dietary patterns in these countries.

Rising gross domestic product (GDP) per capita and incomes are important drivers of demand growth for agricultural products. As GDP and incomes grow people consume more, but more importantly consumers trade up to higher value foods, such as meat and dairy, as they become wealthier.

This change in dietary habits is most pronounced in emerging economies, which is significant because these economies are expected to experience the strongest economic growth.

Urbanisation is also closely linked to economic growth and rising incomes.

The factors that underpin urbanisation include the search for employment or higher paying employment, access to better health and education services, and greater entertainment and lifestyle options.

Urbanisation often leads to a higher per capita income and an increase in living standards which, in turn, results in urban populations consuming a higher number of calories per capita than their rural counterparts and, generally, demanding better quality and a greater variety of food products.

In addition to the demand for agricultural commodities being driven by the demand for food and feed, the search for alternative, renewable sources of energy has introduced a third competing use in biofuels.

The increase in the use of biofuels has resulted from a number of government policies around the world setting targets for the use of renewable fuels.

Although only 4 per cent of global grain and oilseeds were used in the production of biofuels in 2007 and 2008, the recent growth in biofuel production is providing an additional and relatively new driver on the demand side for agricultural commodities.

The issue of supply

While increasing supply is driving commodity prices higher, increasing supply is also becoming more of an issue.

The amount of high quality arable land available is under pressure due to urbanisation, land degradation and climate change and, as a result, the global harvested area for key agricultural crops has increased only modestly during recent years.

At the same time, growth in global crop yields is decreasing and the ability to increase yields is being affected by factors like climate change and water scarcity.

There is no short-term solution to overcoming this shifting dynamic.

After the GFC

Despite these collective challenges, the prices of many commodities have now stabilised above historical levels, and the case for investing in agricultural assets has become a more attractive option for investors looking at alternative investments.

This is particularly the case following the global financial crisis.

In an Australian context, the returns from agribusiness have historically been negatively correlated to the returns of other asset classes and industries.

This is because agricultural assets are real assets.

They are tangible and provide a hedge against inflation, and they are less affected by economic slowdowns.

With the modern investment portfolio significantly weighted towards equities, or other assets highly correlated with equities, many investors suffered significant losses through 2008 and much of 2009.

However, while the share market may have taken a turn for the worst during those periods, this didn’t affect the value of a farm – or the value of meat or crops – in the same way.

As a result, many savvy advisers and institutions have been looking for ways to access diversified sources of returns.

Agricultural investments can provide significant diversification benefits, resulting in an increase in portfolio return or reduction of overall portfolio risk.

Not to mention tax efficiencies in some instances and the potential for long-term returns.

For us, the agricultural thematic has a long way to go and its benefits are just beginning to be understood. The significant potential of this asset class into the future is hard to truly comprehend, as we continue to move towards the 2050 milestone highlighted in Mr Diouf’s statement five years ago.

Tim Hornibrook is co-head of Macquarie Agricultural Funds Management.