The best way to play agricultural commodities

By MoneyWeek Editor John Stepek Jul 05, 2010

John Stepek

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How happy would you be to stake a chunk of your pension money on what the weather will be like next Wednesday?

I'd hope your answer is "not at all." Because of course, this is a gamble. No one knows what the weather will be like next Wednesday. If you want to take a punt on it, by all means do, but it's not an investment fit for your long-term savings.

What's my point? Well, as several hedge funds discovered last week to their cost, playing the soft commodities market is basically just betting on the weather.

I'll explain in more detail below. But suffice to say, the price of raw materials such as grain or coffee or cotton is always going to be dictated by weather cycles more than anything else. So even although demand for agricultural commodities as a group will keep rising, betting directly on the price of various softs is just too risky for the average investor.

It's a shame. Because this is a fantastic long-term investment theme, which incorporates everything from the rise of the East to the fact that water is set to become more important than oil in the decades ahead. The good news is that there are more effective ways to invest in the softs sector...

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Markets could relax a bit this week

The fear of a double-dip recession seems to have accelerated suddenly. Less than a month ago, the idea seemed unthinkable to most analysts. Yet now it's all over the front pages of the business sections.

As the saying goes, if it's 'in the press, it's in the price'. So I wouldn't be surprised if markets relax a bit this week. After all, in terms of economic data, it's set to be a relatively quiet week news-wise. And after last week's plunge in stock markets, we're probably due a bit of a rally. However, it won't be long before fear starts to spike again. There are too many nasty little surprises that can still be sprung on the market. We'll discuss all this more in the next issue of MoneyWeek magazine, out on Friday (if you're not already a subscriber, claim your first three issues free here).

Why corn was where the market action was last week

But let's leave equities aside for the moment. Some of the most interesting action in the markets last week happened away from stocks. One asset in particular - corn - saw its biggest spike since 1988, according Rowena Mason in this morning's Telegraph.

As I noted in the Saturday round-up email, agricultural analysts have been talking of a grain glut this year. Bumper harvests in recent years mean the sector has gone from fear of food riots to concerns about the ability of farmers to sell their crops at a profit.

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Hmm. Too much supply, not enough demand - time to short-sell corn. It's a logical step, and many punters took it. But they reckoned without the weather.

A damp May in the US corn belt saw a million fewer acres seeded than the US Department of Agriculture (USDA) had expected. On top of that, stockpiles are being used up at a much faster rate than at this time last year. Meanwhile, hot weather in Russia looks like it might leave a dent in what had been expected to be a healthy wheat harvest too.

The result? A massive short-squeeze (where investors who are short rush to cover their positions before they lose even more money), which drove the corn price up by 10% on Friday. There's a suggestion that this could even have been partly behind the fall in gold and oil, as investors sold positions in metals and energy to cover their soft shorts.

By the way, some of you might be thinking: "serves the short-sellers, speculators and hedge funds right." And they'd probably agree with you. After all, you make a bad bet, you pay the price. This is the flipside of the "evil short-sellers" nonsense that springs up every time a European politician wants to whine about their banks or governments being picked on. Short-selling is risky. And when a hedge fund gets it wrong - as they did on this occasion - none of them come running to you, the taxpayer, asking you for a bail-out. Unlike banks, or indeed governments.

How to play the softs market

Anyway, back to the main story. The point is that the global weather system can wreak havoc on expectations for the softs market. You can go from feast to famine and back again remarkably quickly. So betting on the likes of corn or cotton directly is very risky and almost pointless for anyone but the most knowledgeable day-traders - or farmers.

At the same time, there is unquestionably going to be long-term, rising demand for more raw materials. We all need to eat. We all need clothes. And the richer we get as a world, we demand more, and better quality, of each. And supply will be squeezed too. Because the richer and larger our population gets, the more space we all take up, the more water we use, and the more competition there is for resources in general.

This trend will continue almost regardless of the threat of a double-dip. And the best way to play it is via "picks and shovels" plays. In other words, you want to buy the companies that will enable us to make the best use of the resources we have, rather than buying the commodities direct. My colleague James McKeigue looks at some potential beneficiaries here: Harvest profits from agricultural growth.

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Published in Commodities | More articles by John Stepek

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  • 1. Jim Dale - British Weather Services

    (05 July 2010, 10:39AM)  Complain about this comment

    I would be very happy to stake a chunk of money on next Wednesday's weather any time!!! But yep John is right, soft commodities and also energy markets are very weather sensitive. Nothing is ever a given but get a meteorological company on your side, tell em what you are looking for/at and you are more than half way there!

  • 2. Chris G

    (05 July 2010, 04:02PM)  Complain about this comment

    There was a brief paragraph about the practice of short selling and I think there are some justifiable issues with this. I think the issue is not that people have taken a short position, but that they can actively try to cause a potentially bad situation to become a reality.
    An individual who seems to epitomise this to me would be the well known short seller Hugh Hendry. If you type in ‘Hugh Hendry’ in the Youtube search then the video that appears at the top of the list has the title “Newsnight 26th May, Hugh Hendry 'I would recommend you panic'.”
    I do think it is clear those with short positions will often try to create panic when the opportunity arises and try to create a vicious negative cycle disproportionate to that the situation merits, as this is in their interests and therein lies the problem. I think the problem with a situation such as the sovereign debt issue is that this affects the lives of millions of people, as much as the debt does have to be dealt with.

  • 3. Rajahbrookes

    (06 July 2010, 02:34PM)  Complain about this comment

    Er...with respect to Hedge funds not being bailed out. Long term Capital Management 1998? Ring any bells? $3.625 billion. OK so they were bailed out by the big Wall street banks (including Lehman Bros!) rather than the tax payers... but who ended up bailing out the very same big Wall Street banks 9 years later?

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