Those with the stomach for it should go long on food demand
WELSH lamb-farmers have every reason to celebrate as they edge closer to signing a lucrative export deal with China. The deal is just another of many signs that emerging markets’ growing demand for hard commodities like steel and oil is leading to a boost in demand for soft commodities like wheat and cocoa. As infrastructure projects boost productivity and provide jobs, the resulting wealth is feeding consumer-led demand for more and better food.
But traders looking to capitalise on the trend should beware of taking punts on soft goods – although the overall trend is upwards, short-term fluctuations are highly dependent on something that not even the most seasoned investors can predict: the weather.
There have been dramatic price movements in soft commodities this year, with the price of your favourite latte in danger of spiking on the back of jumps in coffee and sugar. Coffee spiked to over $160 per tonne, close to its early-2008 highs, while sugar shot up to 30 cents per pound in February – its highest level for around thirty years. But these sweeping moves highlight that trading on soft commodities in the short- to medium-term is not for the casual investor or the faint of heart. Particularly because, as IG Index’s David Jones points out, “by the time a major move in a market is hitting the mainstream press, the move is over. All cocoa has done since it hit the news is go down”.
This means that if you come to a soft commodities market late and want to trade, you are better off going short than trying to catch the tail-end of a spike. Prices often rally upwards dramatically and then correct downwards, sometimes by as much as 40 per cent in a few days. They are also increasingly following oil prices because many nitrate fertilisers used by modern farmers are oil-based.
GROWING POPULATION
But with the world’s population growing in number and wealth, most analysts are bullish
about soft commodities over the long-term. With interest rates so low, contracts for
difference traders can afford to hang on for these longer-term gains, so long as the near-term lurches don’t scare you off.
With meat consumption in markets such as Brazil and China on the rise – not least Welsh lamb – the grains required to feed the requisite animals are likely to be in high demand. For example it takes 9.4 kilos of grain to feed enough pigs to produce one kilo of pork, and 25 kilos of grain to feed enough cows for a kilo of beef. Patrick Armstrong of Armstrong Investment Managers emphasises that this “multiplier effect” will combine with dietary changes to drive up demand for meat: “In 1961, Chinese meat consumption was 3.8kg per person per year. In 2008, it was 60kg,” he says.
WATCH THE SUPPLY SIDE
But even with this growing demand, it is important to keep an eye on the supply side of the equation. There is continuing uncertainty as to the pace of infrastructure development, mechanisation, the use of GM crops and other factors such as a move towards or away from biofuels. Investors should look at the underlying drivers of production before choosing where to put their money.
For example, while the excessive sugar and coffee rallies seem to have lost momentum, Barclays Capital’s Sudakshina Unnikrishnan says the rise in the cocoa price is due to more sustainable factors: “The cocoa story is still moderately bullish on the strength of longer-term bullish factors, especially given the infrastructural deficiencies in the Cote d’Ivoire. There is a lot of under-investment there because there isn’t a stable political system: cocoa trees peak after 30 years of production and the bulk of these trees were planted in the 1970s and are in decline.”
Aside from investigating supply, contracts for difference traders investing in soft commodities should also take account of the contango effect. This refers to the negative effect on profits from rolling futures contracts: because when you come to renew your contract, the price of a good has gone up, you have to buy at this raised price and don’t see the full advantage of the rally. One way of mitigating this effect is to make sure your contracts are a little longer-term than normal: rather than trading contracts that are on a monthly basis, buy quarterly contracts.
Even taking account of this effect, however, rising soft commodity prices should easily justify a well-placed investment. For any investor with faith in emerging market development, betting on demand for food makes sense.