Deutsche bullish on agricultural commodities

Deutsche Bank outlines the sectors and themes that investors can pursue to take advantage of predicted long-term increases in food prices.
China's National Development and Reform Commission announced yesterday it expects the countryÆs consumer price inflation to hover around 4%, compared to 4.7% in 2007, while GDP growth will remain in double digits at 11%, compared to an estimated 11.5% in 2007. Deutsche BankÆs latest research report says that while subprime-related losses are expected to hinder growth in G3 in 2008, the contagion risk to China will be relatively limited.

This all sounds fine, except for the problem of food-related inflation.

Although party leaders have declared fighting overheating as their first priority, Amanda Lee, commodities trading strategist at Deutsche Bank, says ChinaÆs food-driven inflation is not going to ease any time soon. Lee believes food supply-demand dynamics will remain stretched by rising Chinese consumption and falling farm production. This, coupled with global demand for biofuel production, is going to extend price rallies in the agricultural commodities sector beyond 2009.

ôWe donÆt have enough to eat, to feed and to drive,ö says Lee. But China's problem could be a boon for investors, and Lee is extremely bullish about the sector for 2008.

According to IMF data, ChinaÆs urbanisation ratio has close to doubled in the past 20 years û from 24% in 1986 to 43% today. This has resulted in a 30% drop in the countryÆs arable farmland since 1978. Farm labour has also been falling rapidly û 13 million Chinese citizens have been moving into urban settlements every year for the past two decades, a population equivalent to the Czech Republic.

China, as the worldÆs second largest agricultural producer after the US, is now fast shifting its role from exporter to net importer in areas such as corn. This shift will impact global agricultural prices, but thus far, China has shown little to no improvement in its overall farming productivity to amend the situation. Over the next 12 to 18 months, Lee says, China will become a net importer and trigger a strong turnaround in food prices.

This country is not alone. Its neighbour, India, currently the worldÆs third largest agricultural producer, reported its first trade deficit in wheat last year. Land and water constraints, coupled with weather uncertainties are pushing the worldÆs inventory for grains to a multi-decade low. The US Department of Agriculture reports corn reserves will last for just 43 days, compared to over 160 days in the mid-1980s; wheat reserves have also shrunk from 140 days to 67 days.

If feeding the worldÆs two largest populations, which combined equal 2.4 billion people, is not perturbing enough, consider that as disposable incomes in these countries rise, so do the dietary habits change. ChinaÆs meat consumption per capital was 4kg in 2006. This year it was close to 12kg per capita. ôAs they get richer, they can certainly afford to be more æmeatyÆ,ö says Lee.

At current levels, Chinese meat consumption is still only 60% of the world average, Lee says. She says that 10kg of grains is still required to produce every kilogram of beef, reinforcing the demand on the agricultural food chain. The overall increased demand has driven up prices for grains, such as rice, wheat, and corn, contributing a large part to food inflation.

Moreover, the crusade to develop cleaner energy, in particular, biofuel in sugar-derived ethanol and biodiesel, is also contributing to this price rally. USDA data suggests in 2007, 60% of all corn and 50% of soybean consumption was dedicated to ethanol and biofuel production. Recent headlines with triple-digit oil prices will likely shift more responsible investments to biofuels, which will only make food more expensive.

LeeÆs maximum bullish outlook on agricultural commodities forecasts corn prices to gain by 34% from $4.67 to $6.27; 43% for wheat from $9.32; soybeans 69% from $12.49 to $21.10. Sugar could gain by 165% from $0.11 to $0.3, while cotton will see a record rally that is likely to extend to February 2012 from $0.69 to $1.4 or 165%.

She favours long positions for corn, cotton, soybeans, wheat and farmland Reits. Other possible plays include machinery, fertilizer, water resources and GM crop technology providers. Agricultural exporters such as Brazil and Argentina are possible country themes. Meanwhile, she is short on food and beverages, which are likely to see their margins squeezed this year.

Headlines touting oil over $100/barrel and gold over $1,000 could, however, disappear from the media this year: ôThey are at risk of being driven by an overshooting US dollar,ö Lee says. She expects oil prices to ease back to $85 per barrel as geopolitical issues and production bottlenecks, and refinery constraints ease in 2008.

Meanwhile, Lee casts a grim eye on the performance of industrial metals. Given the traditional high correlation between industrial metals and S&P500 performance, prices in this sector are ôlikely to sufferö in the present downturn. Performance in this sector will remain "disappointing" until the US equity market recovers, she says.
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