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Markets: Food for Thought
John R. Stephenson: June 25, 2007
By John R. Stephenson

Want to know where the next great investment idea is coming from? Likely, the answer is staring you in the face at dinner. That's because food inflation is here to stay and is a big contributor to the increase we've seen in the long-bond yields over the last month. A misguided energy policy, an emerging middle class in Asia and disappointing harvests have all contributed to soaring grain prices, which has a direct bearing on the price of meat.

With soaring oil prices, an unstable Middle East and Al Gore beating the environmental war drum, it was inevitable that even the most ardent conservatives would become environmentalists. Big oil never had a better friend in the White House than George Bush, but even he felt the need to discuss "the serious challenges of global climate change" in his most recent state-of-the-union address. As a result, America now has an aggressive target of reducing gasoline consumption some 20% by 2017. To dial-in on this reduction, America will have to become increasingly dependent on corn-based ethanol. This is certainly welcome news for the American corn farmer.

But in the rush to go green, one key question has remained unanswered — is it even economical? For some, the answer is a clear no . Some economists who have studied the economics of ethanol have come away disappointed. The reason is that the energy inputs required to produce ethanol are greater than the energy that can be produced from ethanol. According to a 2005 study conducted by Cornell and the University of California, Berkley, it took 29% more fossil fuel to turn corn into ethanol than the fuel produced.

With hundreds of ethanol plants either in the planning or developmental stage, a full-out bull market based on a misguided government policy has begun. For bureaucrats, the environmental mandates might make perfect sense, but for ethanol producers the outlook is less clear. One of the issues facing ethanol producers is the high cost of both producing ethanol and transporting it. With corn prices on the rise, cost pressure coming from the trucking industry (facing higher oil prices) the squeeze is on for ethanol producers.

Figure 1: Corn Prices Rise in the U.S.

Source: Bloomberg

While the newly minted demand for ethanol is part of the reason for rising food prices, the most significant reason for food inflation is the rise of the middle class in Asia. With fifty million people a year in China and India entering the ranks of the middle class, the demand for protein and dairy products in their diets has exploded. No longer satisfied with simple starches, meat is the new, new thing in the diets of the newly affluent. This, in turn, has created enormous demand for agricultural feedstocks (grains) because of the very high protein conversion factors necessary to convert grain into meat and dairy products.

According to the U.S. Department of Agriculture, the growth in the consumption of feed grains has grown faster than the growth in consumption of oil. Not only is this true in America, but virtually every country is starting to experience a significant increase in food inflation. With an exceptionally poor harvest in the U.S. this past year; we had the lowest carryover of feedstocks in fifteen years.

Figure 2: Meat and Poultry Prices Soar in China

Source: Bloomberg

While the U.S. economy may be chugging along, Asia is on fire. As more and more of their citizens enter the middle class, their diets change to a high protein diet popular in the West. Look for no end in site to the upward price pressure on grains and meats as this phenomenon is linked to the very strong economic growth in the developing world.

Similar to the story for base metals and energy, we can now add food and the agricultural business to the list of commodities whose fundamentals are being driven increasingly by circumstances in China, rather than the U.S.

The best way for investors to participate in the bull market in agriculture is not to put a down payment on farm land in Iowa but rather to invest in the suppliers to the global agricultural business. Companies that supply farm equipment, fertilizer and genetically modified seed companies to the global marketplace are the likely winners in this evolving phenomenon. Banks and financial institutions that are headquartered in the Midwestern United States (41% of all U.S. corn is produced in this region) and who don't have massive derivative exposures or shaky real estate loans in their portfolios are also likely winners in what is expected to be great food for thought.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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