Speculating on Agriculture Prices with ETFs
Complex financial issues have been brought to the dinner table.
Complex financial issues have been brought to the dinner table.
Recent times have seen food-price inflation become a hot-button issue at home and abroad. This comes as little surprise, given sustained price increases across the broad commodities space and the further-reaching geopolitical implications it has already posed.
In his Semiannual Monetary Policy Report to the Congress on March 1, 2011, Federal Reserve Chairman Ben Bernake acknowledged the trend, but quickly reassured his congressional audience that it was a temporary and containable one. Notwithstanding arguments over the Fed's ability to quell rampant inflationary pressures across a number of commodity sectors, to many, Bernake's speech has only reaffirmed the trend's existence. Here we will discuss a number of the drivers behind food-price inflation, both its foreign and domestic repercussions, and the number of ETFs that investors may tap to capitalize upon continued volatility in the space.
A number of adverse weather-related events have provided stiff positive price pressures on the supply side of the market. A drought last year in Russia consumed significant portions of the nation's wheat harvest, leading Prime Minister Vladimir Putin to bar grain exports altogether. As of February 2011, the USDA's annual World Agricultural Supply and Demand Estimates place 2010-11 projected Russian wheat production at 41.5 million metric tons. That WASDE projection represents a year-over-year production decrease of 33% and accounts for greater than 56% of total wheat production decreases worldwide. Not surprisingly, the Agricultural Statistics Board (ASB) of the USDA reports that wheat prices have increased on an inflation-adjusted basis by roughly 34% over the past two years. Wheat prices were further influenced by similar drivers in the wider FSU region and by fears stemming from severe flooding in Australia, a prominent exporter of wheat.
On par with wheat, corn has been on an unprecedented upward tear. The ASB pegs inflation-adjusted price increases at 41.8% during the last two years, placing corn prices over the past several months at the highest levels on record in the last 15 years and on par with precollapse highs. The price increase is due in no small part to the consistent and drastic increase in corn demand for ethanol. The last decade has seen ethanol demand account for increasingly large percentages of U.S. corn production. In each of the last three years, ethanol production claimed 5% more of overall production than the year prior. The USDA's WASDE projects ethanol to claim 40.2% of domestic production next year while production falls by roughly 5% at the same time. While the rate of increase of ethanol-related corn demand is expected to slow into the future, the USDA forecasts roughly 36% of total corn use to go to ethanol through 2020.
Soybeans have also seen substantial price increases in the last two years with a 32.6% runup, though that's less than corn's and wheat's. Price volatility for both corn and beans may ramp up going forward. Stocks-to-use ratios provide information about the quantity of any particular commodity that has gone unused throughout the previous crop year and thus may be carried over into the next season's production. Beginning stocks serve as a buffer crop within the various commodities markets, providing a reserve that can be tapped to mitigate event-driven commodity-price increases like the supply shock posed by the Russian drought. The smaller the buffer as a percentage of total use of the crop, the more drastically prices are apt fluctuate. As of this writing, stocks-to-use for corn and soybeans sit at historically low levels of 5% and 4.2%, respectively.
Recent sustained runups in the grains can be seen trickling through to the meats as feed prices increase. The Agricultural Statistics Board pegs inflation-adjusted price increases for cattle and hogs at 42.9% and 42.8% over the past two years, respectively. The U.N. projects an 11% global population increase by 2020 and a 20% increase by 2030. Goldman Sachs projected the global middle class to expand drastically over the same time frame, to over 3.5 billion by 2030, so while population growth will necessarily drive increases in agricultural commodity demand, disproportionate increases are likely to be seen in demand for meats.
At Home and Abroad
Given the outsized runup of agricultural commodity prices, some may be surprised to find the impact to Americans relatively muted. In the U.S. only 5% to 7% of per capita income is devoted to food purchases. Further, a significant share of food costs to end consumers in the U.S. comes from non-commodity-related inputs like packaging and distribution.
In the developing world the story is a bit different. The agricultural industry has grown from the highly local and regionalized markets of the early 20th century into a truly global complex. Accordingly, price increases are realized on a global scale. Unlike highly developed nations, the populations of developing nations can spend as much as 40% to 50% of their per capita income on food.
While it may be a bit myopic to peg rising food prices as the sole driving force behind the recent unrest in Northern Africa, there is no question that the lack of a stable food supply and prices is a contributing factor in compounding internal political pressures. According to the September 2010 Nomura Food Vulnerability Index (NFVI), household spending on food as a percentage of total consumption for Tunisia, Libya, Egypt, and Algeria sat at 36%, 37.2%,48.1%, and 53%, respectively. In contrast, American consumers are largely shielded from the outsized effects of increasing agricultural commodity prices. Still, U.S. investors may want to look to a number of exchange-traded products to capitalize on the trend.
Market Vectors Global Agribusiness ETF (MOO) offers global exposure to the agricultural complex by tracking the DAXglobal Agribusiness Index. The index is composed of 47 firms involved in agriproduct and livestock operations, agrichemicals, and production or transport of agricultural equipment and biofuels.
Within the agribusiness industry, market share and scale are vital to success. Price control is exercised by a select few firms, but MOO looks to avoid concentrated exposure by devoting no more than 10% of its assets in any one holding. Nevertheless, MOO is extremely top heavy, with roughly 61% of its assets claimed by the top five holdings, and nearly 60% relegated to North American holdings. The fund charges a 56 basis-point fee, annually, more or less in line with other comparably focused funds.
Investors should note, however, that despite its diverse set of holdings, by virtue of its equity-based structure, MOO exposes investors to non-commodity-related, equity-specific price pressures and risks. For a closer approximation of the price performance of agricultural commodities one might consider a fund that leverages agricultural commodity futures to provide exposure.
Hitting the Meats with COW
IPath Dow Jones-UBS Livestock Subindex Total Return ETN (COW) delivers futures-based exposure, highly focused on two of the most prominent meat contracts: live cattle and lean hogs. As of the end of February 2011, cattle accounted for 59.38% of COWs exposure, while the balance went to hogs. The fund levies a 0.75% annual fee, reasonable given its relatively niche exposure, but investors should take note of the fund's ETN structure.
There are pros and cons to the ETN structure. Unlike other exchange-traded commodity-focused offerings, ETNs do not maintain a basket of underlying holdings. Rather, they can be considered an unsecured debt obligation, a promissory note that stipulates the return of an underlying index, less an annual fee. The recent financial crisis broke a number of ETN issuers, and while we feel that the banks are in relatively better health than they were in 2008 and 2009, it wouldn't be unreasonable for investors to consider part of their required return a level of compensation for their exposure to the credit default risk of the backing bank. On the up side, however, ETNs provide perfect tracking, and investors pay capital gains taxes only on sale of the position.
The Lone Corn Offering
Like COW, the relatively new offering Teucrium Corn (CORN) offers similarly focused exposure to its target commodity. The fund procures its exposure through the use of futures contracts.
Liquidity and the absence of carrying costs make futures a much more convenient way to gain exposure than direct physical ownership. The catch is that the futures curve--the prices of contracts at progressively distant expiration dates--can take an upward slope (known as contango) or downward slope (known as backwardation). That slope can cause futures and spot returns to decouple, also known as basis risk.
Many of the early futures-based commodity exchange-traded products put contracts on at predetermined expiration intervals, leaving them vulnerable to losses when the shape of the futures curve shifted. By spreading its assets across a number of corn futures with different expirations, however, CORN attempts to mitigate the impact of rolling contracts forward in contangoed markets. CORN spreads its assets across three corn futures: the second-to-expire, the third-to-expire, and the following December contract at weights of 35%, 30%, and 35%, respectively. In doing so, the impacts of contango are realized by only roughly a third of the fund's assets at any one time.
While contango-related losses should be tempered to a large degree, there are several considerations to be had before establishing a position here. Investors looking to make a very short-term speculative bet on corn prices would likely do better to hold the front-month futures. The closer a futures contract is to expiration, the more sensitive it will be to movements in the price of the underlying commodity. In spreading its assets along the curve, CORN avoids the outsized effects of contango on the front end of the curve, but also dampens short-term responsiveness to the spot price. At a 1% per annum fee on top of trading costs, the fund also stands as one of the most expensive within the exchange-traded-product space. Nevertheless, CORN is the sole corn-focused ETP on the market today.
A Dynamic Twist on Broad Agricultural Exposure
Investors looking for an offering that will tap the broad agricultural commodities space can also consider PowerShares DB Agriculture (DBA). Using futures contracts, this fund provides exposure to feeder cattle, cocoa, coffee, corn, cotton, lean hogs, live cattle, soybeans, sugar, and wheat, rebalanced to weightings of 4.17%, 11.11%, 11.11%, 12.5%, 2.78%, 8.33%, 12.5%, 12.5%, 12.5%, and 12.5%, respectively, on an annual basis.
Like CORN, DBA looks to mitigate the adverse effects of a negative roll yield in contangoed markets in a number of ways. Levels of backwardation and contango are almost certain to vary between the individual commodities-future markets at any point in time. Thus, by maintaining exposure to a set of 10 commodities, DBA diversifies away from an outsized level of contango in any particular market. DBA goes further, however, by employing a dynamic futures strategy.
Using Deutsche Bank's DB Optimum Yield indexing methodology, the fund puts on contracts with expiration dates as far out as 13 months that stand to maximize gains or minimize losses posed by the implied roll yield. Like CORN, DBA can spread its assets along the curve of any particular commodity-futures market, but its quantitatively based methodology also allows it additional flexibility in selecting the best contracts with which to do so. Thus, DBA provides an outlet for investors who want broad agricultural exposure but don't want to have to worry about how the daily dynamics of the futures market are changing.
DBA charges an annual fee of 0.85%, on top of trading related costs. The estimated 0.16% brokerage fee projects a total fee of 1.01% annually, so as with CORN, investors here should seriously consider the fund's expenses.
Cogito Ergo Sum �
There is a strong case to be made for a continued bullish run of agricultural commodities. Investors holding this view may look to a number of available exchange-traded products to gain exposure, but understand just what type of exposure you are getting. Equity-based funds will introduce non-commodity-related price pressures. Futures-based funds do not hold the physical commodity. While the price performance of agricultural commodity futures are tied to movements in the spot markets, they are derivatives and thus only track imperfectly in the short term. These funds will also be impacted by a number of other factors, and investors should not assume that they will always serve as a perfect proxy for the underlying commodity. The drivers for these types of exposures are highly speculative, and investors looking to establish positions here should be aware of these risks and take appropriate precautions.
Note: A version of this article last ran on March 9, 2011.
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Abraham S.H. Bailin does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.