Investment Essentials: Food and Water

We don’t often think of these crucial components of life as giving rise to investment opportunities, but after a moment’s reflection, it’s obvious that they do. Here are a few of our thoughts on these key topics.

Agriculture

Over the past thirty years, agriculture has not been a hotbed of investment activity. Happily, for world-wide hunger…unhappily, for the obesity epidemic…food prices on world markets have fallen by three-quarters in real terms. The corresponding decline in farming revenue has been a hot political topic in both the United States and Europe. This past year’s action in agricultural markets is, thus, very unusual. Wheat prices have doubled and almost every other agricultural commodity achieved record highs during the past year.

In the US, there were a number of weather-related and other, one-time, events which have pushed prices up. But commodities analysts do not expect prices to rapidly revert as they have in the past. There are two explanations offered for this secular bullish view of agricultural prices: growing wealth in emerging economies and political forces.

The primary reason for the possible continuation of agricultural inflation (“agflation”) are the long-run changes in diet that accompany the growing wealth of emerging economies — e.g., the Chinese consumer whose consumption of meat has grown 150% since the mid-1980s. Demand for protein in turn pushes up demand for grain and other cereals – it takes 8 pounds of grain to produce one pound of beef.

But the rise in US prices, particularly corn, is also the self-inflicted result of our ethanol subsidies and speculation regarding alternative fuel. In 2007 biofuels consumed a third of our (record) corn production. Demand for biofuel not only affects the market for corn directly, but also indirectly as farmers switch to corn from other crops. The 30 million tons of corn going to ethanol in 2007 amounts to half the decline in the world’s overall food grain stocks.

In the longer run, new farmland could be put into production and new, more productive technology could be employed.  These are the now familiar rescues to the Malthusian threat.*  But much of the new available land is in remote parts of the world, requiring big investments in roads and other infrastructure.  Precious forests could also be in danger.  And some of the new land — dry, marginal areas of Africa, Brazil, and Central Asia—could be vulnerable to damage from global warming.  According to some reports, global warming could cut world farm output by as much as one-sixth by 2020.

We hesitate to be alarmist about this. Malthus has been proven wrong many times over. It is risky to predict long-run trends in farming—technology in particular always turns out unexpectedly—but most forecasters conclude from these demand and supply currents that, at least, prices will stay high or go higher for as much as a decade. Because supplies will not match increases in demand, the International Food Policy Research Institute believes, cereal prices will rise by between 10% and 20% by 2015. The UN’s Food and Agriculture Organization’s forecast for 2016-17 is slightly higher. This year’s agflation seems unlikely to be, as many past rises have been, simply the upward side of a spike with a downward side quickly to follow. We believe that we are at a new level.

Water

There are two challenges facing the world’s water consumers. First, population growth in dry areas has expanded rapidly. In the US, the population of the seven states that depend on the Colorado river grew by 10% between 2000 and 2006, compared with only 5.6% in the rest of America. And much of the growth is in the driest parts of even those states.

Second, much of the world’s population does not have access to clean water and getting more water to them will be hard. China has over 20% of the world’s total population and just 7% of the fresh water on earth. The United Nations has identified China as one of the 13 countries with the lowest water per capita in the world. It is estimated that half of China’s population consumes contaminated drinking water on a daily basis and less than 15% of China’s population has safe drinking water from a tap.

Part of the answer lies in redistribution. Even in California, by far the most populous state in the West, four times as much water is used by farming as is used by household consumers. Some of California’s irrigated crops make sense, others certainly do not. Redistributing water resources away from inefficient farming to consumers seems probable and desirable over the long run, but overcoming the political barriers to such change has proven very difficult in the past.

Investment Implications

While we enjoy the intellectual stimulation of our research into macroeconomic dynamics, our primary task is to develop investment strategy and execute investment implementation for our clients. For example, we currently provide modest exposure to food, agricultural commodities, and water indirectly through broad-based equity and commodities vehicles, owning food exposure through big agribusiness in large cap domestic stocks such as Archer Daniels Midland and directly through a commodities asset class allocation. And a number of water utilities are part of the small cap exposures, including Aqua America (WTR) and American States Water (AWR).

We are unlikely to add concentrated investments to client portfolios which are essentially speculations on the spot price of food and water. Even our commodities strategy, for example, is expected to generate an attractive return even if the commodities’ spot prices remain exactly the same.

We look forward to continuing to share our research into these and other powerful macroeconomic trends and will continue to look for ways to bring their positive impacts to the benefit of our clients’ portfolios.

Jason Thomas, PhD
Chief Investment Officer, San Francisco