How to play the coming tectonic shifts in the global food trade

Amid all the hype surrounding the Russian drought and concerns about weaker wheat harvests there and in Ukraine, China and Canada, it is difficult to believe that as recently as June market participants were bearish on agricultural commodities: prices of grains fell sharply from their summer 2008 peak as favourable weather and bumper harvests in both the northern and southern hemispheres in 2008/09 and 2009/10 boosted stocks while weak oil prices and the slowdown in economic growth lowered input prices and ate into demand for ethanol and feed grains. The emergence of Russia and Ukraine as major wheat producers and exporters (Russia is now the world’s fourth-largest wheat exporter after the US, EU and Canada) also contributed to the benign supply outlook.

Of course that changed when a series of weather and other disruptions affected the production outlook in major grain exporting and producing countries, sending grain prices up sharply from June (see Chart 1 below). Speculators rushing to cover short positions contributed to the speed and magnitude of the price rise.

In a sharp reversal, national authorities have rushed to reduce their food production estimates. With the wheat harvest expected to fall by more than 30 per cent year on year, Russia has temporarily banned exports. The FAO cut its wheat production forecast for 2010 by 25 million tonnes, to 651 million tonnes. The US Department of Agriculture (USDA) in July revised downwards its forecast for wheat exporters’ stocks in 2010/11 and now expects a year-on-year drop of ending stocks by 12 million tonnes (16 per cent), compared to the earlier forecasted expansion.

The recent rise in grain prices is not sustainable, however, and is likely only a short-term phenomenon. The US and Australia are continuing to expand production (Australia is on track for a bumper wheat harvest) and will be able to make up for the shortfalls among other major exporters and benefit from stronger import demand. And even though global stocks will contract, they will remain the second highest since 2002 and well above 2007/08 levels, according to the USDA.

The supply-demand balance remains fragile

Even if does not herald another food crisis, the dramatic reversal in the supply-demand outlook over the last two months highlights the growing vulnerability of the market to supply disruptions. Investors have woken up to the fact that the market was much tighter than previously thought and have shifted their focus from bearish factors to potential future changes in production and demand as the end of the global economic contraction sets the stage for the potential re-emergence of agricultural commodity supply-side limitations.

Indeed the combination of drivers that spurred the food crisis of 2007/08 is still very much with us. Demand for food continues to grow in emerging markets, especially China and India, which are both expected to reshape global food trade as consumption growth runs ahead of slowly expanding production capacity, forcing both countries to increase their dependence on imports. Biofuel production will continue to put pressure on global prices of corn and other feed grains, including wheat and soybeans, especially if the US decides to increase the quantity of ethanol blend in fuel in the autumn.

Increased import demand from China and India creates opportunities for established agricultural exporters such as Brazil, Australia and the US as well as emerging exporters, Russia and Ukraine. The shortage of grain storage capacity among both importers and exporters increases volatility when supply shocks occur. Exporters like Brazil, Russia and Ukraine will try to maximize profitability by increasing storage capacity and improving logistics, while importers will try to enhance supply by investing in storage, reducing wastage and using better pesticides, hybrid seeds and GM crops.

We have looked previously at how China will have to increase food imports (see our December 2009 research note How China propels global food price inflation). Here we focus on India, and how it will be forced into net food imports because of lagging domestic production, stagnating yields and shortages of water and arable land; we then evaluate the investment opportunities arising from this theme. But first it is worth briefly revisiting the situation in China.

China increases dependence on food imports

We argued that China’s policy of maintaining at least 95 per cent self-sufficiency in all grains except soybeans will have to abandoned because of inefficiencies in the country’s farm sector. Small plot sizes, shortages of water, poor irrigation, low-quality nitrate fertilizers, reductions in arable land area and stagnating yields erode the government’s ability to increase grain production in line with rapidly increasing demand for a more varied diet.

China has attempted to encourage domestic grain production by implementing a comprehensive set of subsidies for the agricultural sector. But these have been unable to reverse stagnation in yields of wheat, corn and rice. Instead, the subsidies have boosted overall rural consumer demand, including demand for grains.

Even though the government has not relaxed its self-sufficiency policy, China’s decision this year to import corn from the US for the first time in 15 years to make up for a domestic shortfall and tamp down local prices suggests it is edging in that direction. The government is already taking steps to prepare the country for higher imports. The National Development and Reform Commission (NDRC) issued a statement on 30 July reassuring farmers that corn imports will help contain “excessive” gains in corn prices and will not significantly affect prices in producing areas. Despite the NDRC’s assurances, imports will of course have an impact on domestic farm prices and production, especially since imported US corn is significantly cheaper than the Chinese equivalent. Domestic corn was trading at an almost US$3.5 premium over Chicago corn futures as of late July.

China’s sharply rising soybean imports are an important reminder of just how quickly import dependency can increase once the government opens up the domestic market – China liberalized soy imports in 1995 and is now the world’s biggest importer and consumer. Corn could follow a similar pattern as the country struggles to meet feed grain demand fuelled by rising consumption of meat, dairy and eggs.

Corn will likely be only the first of many agricultural commodities that China will import in increasing quantities. The country is already the world’s biggest importer of soybeans and vegetable oils (India is the second-largest importer of edible oils). According to OECD projections, China’s food consumption growth will be double domestic agricultural production growth by 2019. A recent Financial Times article notes that US farmers are already investing in grain export infrastructure on the Pacific coast to take advantage of Chinese demand.

Indian agriculture stagnates, setting the stage for increased imports

Like China’s, India’s unreformed agriculture sector lags the broader economy. A pioneer in the use of high-yielding varieties of grains in the Green Revolution of the 1970s, India was transformed from a food-deficit country into a net exporter of wheat and rice in the 1990s. But since then, and possibly as a result, New Delhi has largely ignored the agricultural sector. Indian agriculture suffers from chronic underinvestment and there has been no attempt to extend the gains from the Green Revolution beyond the country’s breadbasket in Punjab to its rice-growing eastern regions, even as food security and food prices have re-emerged as a political issue with wheat and rice production stagnating vis-à-vis accelerating demand. The agricultural sector grew by a mere 0.2 per cent in FY2009/10 compared to overall economic growth of 7.4 per cent.

India’s agricultural sector faces problems that are similar to China’s, including small, economically inefficient plot sizes, shortages of water and arable land and a system of price supports and subsidies that has failed to boost yields. In addition, a misguided fertilizer subsidy policy has resulted in improper use of fertilizers, increasing soil salinity and reducing potential yields while the area under cultivation stagnates.

Small farmers, who hold 80 per cent of the total arable land, are hard pressed to increase yields and adopt modern farming practices. Large farms such as those in India’s grain heartland of Punjab in the north – which produces 22 per cent of the country’s wheat and 13 per cent of its rice – are already using unsustainable amounts of water, pesticides and fertilizers. According to Indian newspaper reports, with 80 per cent of groundwater in Punjab over-exploited farmers there are now being forced to tap into deep aquifers that cannot be recharged by rainwater.

Food inflation has emerged as a major political problem, in part due to an underdeveloped supply chain and distribution bottlenecks. Food inflation, which had been running above 15 per cent since November 2009, dropped in late July to 9.5 per cent. Approximately one-third of harvested crops rot before they reach the market, while large government stockpiles of wheat, rice and other food articles sit locked away in dilapidated warehouses or rotting in the open instead of being distributed (on which more later). Per capita availability of rice, wheat and other food grains is well below their levels of 30 years ago. Agricultural productivity remains low and there have been no significant reforms in the sector in the last two decades.

India will significantly boost food imports

Prime Minister Manmohan Singh recently called for a second technology revolution to shake up India’s moribund agriculture sector. Indian crop yields significantly lag those in the most productive countries (see Chart 7 below). There is potential for improvement, but the likelihood of India attacking the structural causes behind food inflation and raising yields and productivity remains remote – especially as the recent fall in food inflation to single digits reduces pressure on the government to act.

Instead of taking steps to boost production, the government is relying on imports to deal with food inflation by lowering import duties on wheat, rice, pulses, cotton and sugar to near-zero levels. Opening the market to relatively cheap imports reduces Indian farmers’ competitiveness and is a disincentive to production unless the government dramatically increases the guaranteed minimum support prices (MSP) it pays farmers to grow rice and wheat. High transport costs within India also boost the demand for imports. Mills in southern India started importing wheat from Australia in November 2009 even as the government was sitting on wheat stocks in excess of 28 million tonnes – because the Australian wheat at a landed cost of US$300/tonne was cheaper by up to US$50/tonne than domestic grain.

Meanwhile the government’s periodic increases to the MSP paid farmers to maintain rice and wheat production has resulted in higher rural incomes and increased demand for food. At the same time, the government’s purchases of rice and wheat for its own stockpiles have been blamed for some of the food inflation. This problem is likely to get even worse if the government passes a food security law that is currently being debated in parliament: the proposed bill could mandate up to 35kg/month of subsidized grain for Rs3 (US$0.06) for the poor across the country. This would boost government purchases of grains and feed into higher prices while reducing the amount available in the open market and increasing incentives for traders to import food.

The bottom line is that Indian food demand is already growing faster than supply. According to a 2008 study by Saurabhi Mittal of the Indian Council for Research on International Economic Relations, India will rapidly increase its import dependency for edible oils and pulses and will face significant supply shortfalls in cereals unless measures are taken to increase productivity.

Source: Mittal

India is already the world’s second-largest importer of edible oils (after China) and the biggest importer of pulses and is likely to become a net importer of sugar within the next two years as consumption continues to accelerate faster than supply. Given current patterns of production and demand, and the lack of political will to undertake significant reforms of the agricultural sector, we believe India is on track to start significant imports of wheat and rice within the next five years.

Indian food imports will reshape global food trade

India’s shift to net food importer status will destabilize global agricultural markets because of its large share of global food production and consumption (see Table 1). Given the precarious nature of India’s food balance, any shortfall in production or increase in demand could have an outsized impact on the global market.

Source: Ministry of Agriculture.

India’s impact on global markets was apparent in 2007 and 2008, when it imported wheat for the first time in years after inventories fell below the government’s minimum stock levels. India’s unexpected wheat imports were one of the catalysts of the surge in global wheat prices in 2007/08. With food demand outpacing production, further imports are inevitable – setting the stage for further surges in international prices and a realignment of global food trade patterns.

Major agricultural exporters to benefit

The main beneficiaries of India’s growing appetite for food imports will be those countries that already export to it. India will increase imports of pulses from Argentina, Brazil, Malaysia and Indonesia; sugar imports from Brazil; and palm oil imports from Malaysia and Indonesia. Grain imports are likely to come from Australia, the US and Russia. Increased Chinese grain imports will likely benefit the US, Brazil and Russia.

One consequence of India’s need to boost imports will be a renewed focus on entering into long-term purchase contracts with exporters to avoid dependence on volatile spot markets for its food import needs. India is reportedly in talks with Russia to grow crops there under long-term supply contracts. A June meeting of the Prime Minister’s working group on agriculture suggested that private Indian companies buy or lease land in Canada, Burma, Australia and Argentina to farm under long-term contracts. Moves are under way to make similar arrangements for supply of oilseeds with ASEAN countries.

China is also investing in agricultural land in Africa and South America and will likely increase those investments as import demand rises. For example, the state-owned Chongqing Grain Group intends to invest R$525 million (US$300 million) to purchase of 100,000 hectares of land in western Bahia, with the goal of producing soybeans for the Brazilian and Chinese markets. This trend will benefit those firms – including Bunge, SLC Agricola, BrasilAgro, El Tejar, Black Earth Farming and Louis Dreyfus – that have already purchased agricultural land in Brazil, Russia and other prime farming regions.

Increased food demand to spur investments in logistics and storage

The shift in global food trade triggered by India and China increasing grain imports will refocus government and investor attention in both exporting and importing countries on safeguarding and maximizing the production and stocks that they already have. That means investing in modern storage facilities to minimize crop loss due to spoilage, theft or insect and rodent infestation.

Among major exporters, Brazil and Russia will both be investing more in storage and logistics to maximize profits. In Brazil storage capacity has failed to keep pace with grain production: Brazil currently has storage capacity equivalent to 90 per cent of the annual harvest, well below the FAO’s recommended 120 per cent. The lack of adequate storage capacity has not only forced Brazilian farmers to sell their product as soon as it is harvested – instead of waiting for the best prices – but has also resulted in significant grain losses.

The Lula administration recently announced a plan to increase the amount of on-farm storage capacity by up to 30 per cent over the next five years. To achieve this goal, the administration plans to invest US$550 million in storage capacity, significantly increasing demand for new silos in Brazil. The initiative will benefit silo manufacturers including market leader Kepler Weber, logistics firms like Agrenco do Brasil, and large agricultural groups such as SLC Agricola, which will be better able to time the market.

Russia and Ukraine are positioned to make a substantial addition to global grain supply now that their enormous endowments of arable land are being properly cultivated. Lack of modern elevators and storage facilities and shortages of grain terminal capacity are emerging as major bottlenecks in meeting Russian President Dmitry Medvedev’s goal of doubling grain exports over the next five years. The state-owned United Grain Company (UGC) estimates that total elevator capacity will have to be increased by 30 million tonnes from the current 118 million tonnes to meet that goal.

UGC plans to invest Rb99 billion (US$3.3 billion) to increase grain elevator capacity, expand ports’ grain handling capacity and acquire a new fleet of railcars. Spanish silo manufacturer Prado has sold silos to private operators in Russia and may benefit along with Russian railway firms Globaltrans and Transmashholding. State-owned Russian Railways, which is to be privatized and has traded debt obligations, will benefit from its control of railcar suppliers. However, these projects will be implemented via public private partnerships (PPP), which have not had a good track record in Russia due to legal and financing problems. Progress in building the infrastructure therefore is likely to be slower than in Brazil.

The opportunity in India’s grain storage crisis

Among food importers, China already has relatively highly developed storage infrastructure. But India, which loses a third of its crop on the way to market and suffers from a chronic shortage of storage capacity, has the furthest to go and offers the most opportunities in terms of developing the storage infrastructure needed to maintain the buffer stocks that a net food importing country will require.

Substandard and inadequate storage and distribution facilities are contributing to shortages, wastage and food inflation at a time when India has record surplus stocks of food. The Food Corp of India (FCI) had stocks of 36 million tonnes of wheat and 24 million tonnes of rice on 1 July. Of this amount only 42 million tonnes are in government warehouses, while 18 million tonnes are being kept in the open under tarps – of which 10 million tonnes are at risk of becoming completely unusable. FCI Chairman Siraj Hussain notes that another 15 million tonnes of covered storage are required. In an interview with Trusted Sources, RT Patil, Director of the Central Institute of Post Harvest Engineering and Technology, noted that storage losses in food grains run at approximately 10 per cent.

Initiatives to improve storage infrastructure are advancing only in a piecemeal fashion, with schemes to construct and rent warehouses having only mixed success due to problems ranging from land acquisition to obtaining finance and caps on rates of return. Adani Agri-Logistics (AAL), part of the Adani group, has built and is operating the country’s first modern bulk storage facilities. The pilot silo storage project was initiated by FCI in 2000 to test the build-own-operate model in this sector. AAL now runs two silos, each with a capacity of 200,000 tonnes, along with transport facilities including dedicated rail cars for the FCI at two sites in Punjab and Haryana. AAL has also developed six other regional storage centres across the country. Adani has proposed to construct more silos in Punjab and the IFC has entered into a partnership with the Punjab government to launch a PPP programme to build 50,000 tonnes of wheat silo capacity in the state. Meanwhile, Indian millers are already going ahead and setting up silos on their own.

Currently only a handful of firms in India can manufacture silos. The Indian government has been seeking Chinese expertise on grain storage, potentially opening the way for Chinese silo manufacturers to tap the Indian market. India’s Agriculture Ministry is launching a new public-private initiative, based on the Chinese model, to boost grain storage in the country.

Pressure to adopt biotech increases

Increased import dependence will encourage use of hybrid seeds and make it more difficult for India and China to resist wider use of GM crops. India has approved Bt (insect-resistant) cotton but recently postponed a decision on introducing GM aubergine on the basis of health and safety concerns. China, which imports GM soy from the US, is undertaking research on GM rice and corn, but has yet to approve commercial use of GM crops in the face of public opposition and worries about dependency on foreign suppliers.

Food security concerns will likely win out, however, and both countries will be forced to adopt GM crops to the benefit of international biotech firms including Monsanto, Sygenta and Bayer CropScience, and local firms like India’s Nath Biogene, JK Agrigenetics, Mahyco and Metahelix Life Sciences.

The emphasis on maximizing supply creates new investment opportunities

Indian and Chinese demand will increasingly shape global food trading. India’s emergence as a net food importer is likely to take the market by surprise in view of the country’s current food surplus situation. High transport costs and inefficiencies in food distribution and storage will drive imports in the near term, while lagging production will make India increasingly import dependent in the longer term.

Rising import dependency will drive both countries to enter into long-term supply contracts with food exporters both to hedge against volatile spot prices and to lock in stable supplies. Dependency will also put a premium on maintaining buffer stocks and result in increased investment opportunities to manufacture, develop and operate storage facilities, particularly in India. For Indian politicians, it will be easier to help fund new silos than to undertake root-and-branch reform of the agricultural sector. Both China and India will be forced to take other supply-enhancing measures including adoption of hybrid and GM seeds.

Exporting countries will also likely target a boost in investments in agricultural storage and logistics as they compete for a share of the Asian market. We believe Brazil, with its proven track record of boosting agricultural productivity and its experience in developing export infrastructure for its mining industry, offers more investment opportunities than does Russia.