Bumper Crop

The Neolithic Revolution began around 10,000 BC, when humans began to plant and cultivate crops. Farming is undeniably one of the world’s oldest industries, and the rapid pace of agricultural innovations over the past two to three centuries has enabled us to live a far higher quality of life.

In 1800, the global population stood at less than 1 billion and in many developed countries close to half the population was engaged in agriculture-related activities. Today, the world’s population exceeds 6 billion, and agriculture is no longer the dominant economic activity; yet, fewer farmers, tilling less acreage are producing more crops.

The need for agricultural innovation is growing, especially given efforts to encourage the use of biofuels produced from crops such as corn, sugar and palm seeds. For example, it appears increasingly likely that the US Environmental Protection Agency (EPA) will boost the maximum ethanol percentage in US gasoline from 10 to 15 percent next year.

Meanwhile, strong economic growth in developing countries should usher in a dietary shift that includes more meats and other foods that place further demands on agricultural outputs.

To top it off, the world’s population is expected to grow another 50 percent by 2050; more mouths will require more food at a time when development continues to limit the availability of additional arable land. In this issue we examine one the agriculture and biofuels industries, two of the most exciting and dynamic businesses today.

In This Issue

The Stories

Energy analysts may be focused on the upcoming climate talks in Copenhagen but there’s plenty of opportunity in agricultural commodities. Here’s the scoop on how fundamentals are shaping up in the US corn belt. See Think Des Moines, Not Denmark.

Why record US corn production just isn’t enough this year. See Bumper Crop, Tight Supplies.

There are two primary drivers of global crop demand: increased demand for biofuels and dietary shifts in developing countries. Both demand drivers favor higher prices next year. See Fuel from Food.

Rising demand for foodstuffs is one thing, but shifting diets in emerging economies are another catalyst for agriculture stocks. See Quality, Not Quantity.

Hungry for more? Here’s a recap of how our Biofuel Field Bet has performed since March. See Playing the Field.

The Stocks

Potash Corp (NYSE: POT)–Buy
The Mosaic Company (NYSE: MOS)–Buy
Monsanto (NYSE: MON)–Buy
Syngenta (NYSE: SYT)–Buy
M.P. Evans (UK: MPE)–Buy
Anglo-Eastern Plantations (UK: AEP)–Buy
SIPEF (Belgium: SIP)–Buy
Landkom International (UK: LKI)–Hold
Metabolix (NSDQ: MBLX)–Buy
Novozymes (Denmark: NZMB)–Buy
PowerShares DB Agriculture (NYSE: DBA)–Buy

Think Des Moines, Not Denmark

Between Dubai’s debt debacle and the upcoming climate change talks in Denmark, weather conditions in America’s heartland might seem of trivial importance to global markets.

But a perfect storm is building in the Midwest that will mean far more to investors than the wording of any press release on carbon emissions that originates from Copenhagen. Ironically, while some are watching to see if China will agree to hard carbon emission targets in Denmark, Beijing is likely far more concerned with what’s currently happening in Iowa and Illinois.  

America is the dominant producer of one of the world’s most important commodities: corn. The US is often called the Saudi Arabia of corn, but this overused comparison massively understates reality. The nation produces 42 percent of the world’s total corn supply and controls two-thirds of the global corn market.  In contrast, Saudi Arabia produces just 13 percent of the world’s oil, and the entire Middle East accounts for just over one-third of the world’s oil exports.

And there’s another key different between oil and corn: Despite last year’s global recession and financial crisis, global corn demand remains strong, particularly in emerging markets. While world oil consumption likely fell in 2009 for the second consecutive year, corn consumption jumped 6.5 percent in the 2007-08 harvest year and is projected to rise 0.7 percent this year and 3.2 percent in 2009-10.

As depicted in the graph below, global corn consumption has soared 260 percent since 1965 and is up by a third since 1999-2000. Over the past decade, global crude consumption has grown at less than half that rate.


Source: USDA

And whereas oil inventories are just starting to tighten as demand recovers, global corn supplies continue to hover near record lows.

Earlier this year, the global corn shortage appeared to ease; the recession temporarily dented demand, and analysts expected US farms to produce the second largest corn crop on record. But demand has staged a robust recovery–to the point that the massive US harvest no longer appears quite as impressive as it did just a few weeks ago.

Thanksgiving usually marks the unofficial end of the fall harvest season for America’s grain farmers; the top corn-producing states–Iowa, Illinois and Nebraska–all experience bouts of frost and frigid weather long before the fourth Thursday of the month.

In fact, most farmers look to complete their harvest by early November and spend the final weeks before the holiday fertilizing the soil and preparing for the spring planting. In a typical year, US farmers harvest close to three-quarters of the crop by November 1; however, this year Thanksgiving has proved far from relaxing for anyone involved in US agriculture. As of November 22, 2009, only 68 percent of the US corn crop had been harvested in the 18 top-producing states. In an average year, close to 95 percent of US corn would be harvested by that date. The graph below provides further details.


Source: US Dept of Agriculture (USDA)

The USDA Crop Progress report issued November 30 indicates that 79 percent of the corn crop has been harvested–farmers must harvest an unprecedented 20 percent of nation’s corn by December. 

The late corn harvest eats into yields, reducing the total output. Colder weather at harvest time means that corn isn’t drying out as it normally would; reports indicate that damp conditions have led to fungus growth in some fields.

On November 10, the USDA released its monthly World Agricultural Supply and Demand Estimates (WASDE) report. Though pundits on business television rarely dissect WASDE data, these monthly reports are eagerly digested by anyone in the agricultural commodity markets. To reflect the damage caused by the late harvest, the USDA lowered its expected corn yield from 164.2 bushels per acre to 162.9 bushels per acre. Deteriorating conditions also prompted the agency to lower its estimate of the overall corn crop by nearly 100 million bushels. The USDA likewise reduced its expectations for the amount of corn left in storage at the end of the season from 1.672 billion bushels to 1.625 billion.

The next WASDE report comes out December 10. With the US corn crop coming in even later than was expected back on November 10, many analysts forecast that the USDA will further reduce its corn yield and ending stock estimates.

Corn prices have rallied sharply from the lows of late summer, thanks to growing fears over the late harvest. Check out the graph below for a closer look at the price of December 2010 corn futures–a good gauge of expectations for corn prices at the end of next year’s harvest.


Source: Bloomberg

December 2010 corn futures current stand near $4.50 per bushel, up from September’s low of about $3.60–a significant move for this market.

Rising corn prices translate into rising income for farmers. More important for investors,  rising commodity prices and farm incomes mean higher demand for agricultural inputs such as seeds, farm machinery, fertilizer and pesticides.

Bumper Crop, Tight Supplies

What’s most amazing about the US corn market isn’t the near-record late harvest or rising prices, but rather that supplies of corn and grain are so tight that even a slight downward revision to the estimated size of the US corn crop exerts a dramatic impact on pricing.

And although the USDA lowered its estimates for both US corn yields and the size of the crop already this autumn and are likely to do so again, the US corn crop is enormous and yields are still sky-high by any historical comparison. Consider the graph below.


Source: Bloomberg

As of November 10, the USDA’s forecast put US corn yield per acre at record levels. The current yield estimate of over 10 million metric tons per hectare is roughly three times 1960 levels.

Corn yields have steadily increased for a number of reasons, including introduction of more efficient machinery and more effective fertilizers. At the same time, the development of so-called genetically modified (GM) crops has dramatically boosted yields. GM crops are designed to exhibit certain beneficial genetic characteristics–known as traits–such as resistance to insects and crop disease.

The current trend is to develop seeds that stack multiple traits and yield higher outputs. As I highlight later in this issue, Monsanto (NYSE: MON) is developing corn and soybean seeds that will include over 10 beneficial traits. Yield is the key to understanding why farmers plant GM seeds; rising demand for agricultural products means the world needs to generate more crops from the same amount of arable land.  

Here’s another eye-opening statistic. The total area of US cropland planted with corn has grown only a little over 11 percent, but total US corn production has soared 230 percent. As you can see in the graph below, this year’s corn crop is expected to be second only to the 2007-08 crop in size.


Source: USDA

At first blush, this supply growth would appear to be a major negative for corn prices; for most commodities record yields and output from the world’s largest producer would tend to lead to oversupply and falling prices. That’s not the case with corn.

A widely watched statistic for gauging global supply and demand for agricultural products is the end stocks-to-use ratio (ESUR), a metric that compares the total amount of crop in stock at the end of the growing year to the annual consumption of that crop. To make a long story short, the lower the ESUR, the tighter supplies are for that commodity.

Perhaps the most widely watched ESUR statistic is for the global corn markets, pictured below.


Source: Bloomberg

As you can see, global corn supplies remain ultra-tight despite record production and yields. A bumper crop in the US this year was expected to push the ESUR slightly higher, but the most recent estimates indicate that the ratio should decline slightly this year.

The last time corn supplies were this tight was in the 1970s, during the big bull market for commodities. The current ESUR for corn is over 10 percentage points below the long-term average of about 27 percent.

Although stocks of wheat are far healthier than corn, the total global grain ESUR stands at 20.6 percent–a level that’s significantly below the long-term average and down from the 2008-09. This year’s late harvest is only exacerbating an already tight situation.

Fuel from Food

At this point, some readers are probably wondering why I’m writing about a late harvest in the Midwest and tight stocks of agricultural products in an advisory devoted to investing in the global energy markets. But agriculture and energy are related themes.

There are two primary drivers of global crop demand: increased demand for biofuels and dietary shifts in developing countries. Both demand drivers favor higher prices next year.

Biofuels are liquid fuels derived from agricultural products. The most important biofuel in the US market is ethanol, an alcohol made primarily from corn. This year the ethanol industry is projected to consume 4.2 billion bushels of corn, roughly one-third of total US corn production.

The benefits of ethanol as a fuel are dubious and subject to considerable debate, but that’s not what’s most important to investors right now. Plenty of powerful legislators in the US Congress from both sides of the aisle hail from farm states, and agricultural lobbies generally support greater use of ethanol–a key source of crop demand.

More important, the US is already mandating greater ethanol consumption. The first push for ethanol demand in the US occurred when regulators phased out a key fuel additive, methyl tert-butyl ether (MTBE). MTBE had been added to fuel for many years as an oxygenate to reduce carbon monoxide emissions from cars and trucks. MTBE is also an octane booster that helps to reduce engine knocking and other performance issues.

But MTBE can leach into groundwater supplies and is thought to be a carcinogen; the US government effectively banned MTBE as a fuel additive.

One of the only economical substitutes is ethanol. Because ethanol is among the only MTBE alternatives available in large quantities, it’s effectively replaced MTBE. But ethanol demand is now powered by far more than simple MTBE replacement.

The US also has enacted several mandates designed to foster ethanol use, the most recent being The Energy Independence and Security Act of 2007, signed into law on Dec. 19, 2007. This act replaced and extended renewable fuel mandates already in place from a similar law enacted in 2005.

The 2005 act required that the US use 7.5 billion gallons of ethanol by 2012; for reference, in 2007 the US consumed 6 billion gallons of the fuel. The 2007 bill more than doubled the total mandate to 15.2 billion gallons. In addition, the most recent renewable fuel standard extends the mandates for another 10 years, requiring that the nation boost biofuels consumption to 36 billion gallons by 2022.

This mandate includes several other key provisions. Out of the 36 billion gallons of biofuel that the country is expected to use in 2022, 21 billion gallons must come from advanced biofuels. The term advanced biofuels refers to ethanol (or biodiesel) derived from sources other than cornstarch. The leading form of advanced biofuel in the US is cellulosic ethanol, which is derived from products such as corn stalk waste or switchgrass, a prolific prairie grass.

But there’s a problem with this most recent mandate: It’s not possible for refiners to blend 15 billion gallons of ethanol with gasoline by 2012. The problem isn’t a lack of ethanol production capacity; there’s likely an oversupply of ethanol production facilities in the US. Verasun Energy and other prominent ethanol producers have declared bankruptcy and shuttered plants in recent years because of weak profit margins.

The problem is flat-to-falling US gasoline demand. According to BP (NYSE: BP), the US consumed roughly 9 million barrels of motor gasoline per day in 2009. That works out to roughly 3.29 billion barrels (138 billion gallons) of gasoline annually. The current maximum allowable ethanol blend is 10 percent, which equates to 14 billion gallons of ethanol based on 2009 gasoline consumption.

Of course, US gasoline consumption should recover somewhat alongside the economy. But consumption would need to jump almost 9 percent by 2012 for the country to approach the required 15 billion gallons in blended ethanol at the current 10 percent blend rate. As I’ve written frequently in The Energy Strategist, US gasoline demand growth is likely to remain subdued or even negative because of higher prices.

The real story is going on overseas. As I noted in the previous issue of TES, emerging market demand is key to understanding the global oil markets. But if my flat US demand and strong global demand thesis is even partly correct, the targeted 15 billion gallons of ethanol consumption appears to be unattainable.

One solution that’s under consideration is to increase the allowable ethanol blend rate from 10 to 15 percent, a decision that would allow refiners to meet their mandate even if US gasoline demand falls from current levels. Not surprisingly, the ethanol industry has petitioned the EPA to do just that, and the agency is considering the request.

I suspect the EPA will comply with the ethanol industry’s request for three major reasons. First, as I noted earlier, there is considerable support in Congress for the farming lobby. Second, the main argument against increasing the mandate is that it could cause damage to engines; however, most studies suggest modern US cars can handle blend rates of 15 percent without significant problems.

And third, an increase in the blend rate would promote cellulosic ethanol. At the Energy Information Administration (EIA) conference back in April, I attended a seminar discussing the potential for cellulosic ethanol. All participants I spoke to agreed that cellulosic ethanol research was a major priority for both the Obama Administration and the Dept of Energy (DOE).

The technology already exists to produce ethanol from waste products, but the process is expensive and the industry is still in its infancy.

There are plenty of companies out there that claim to be able to produce cellulosic ethanol at gasoline-competitive prices, but there’s a huge difference between success in the lab and commercial-scale production. I suspect that the industry is not as far along the path to commercial production as its proponents would suggest. Call me a skeptic but I’ve seen too many promises about cellulosic ethanol come to naught over the past five years.

And if corn-based ethanol producers are struggling to make money, cellulosic ethanol producers are unlikely to fare much better. Further, if there’s already overcapacity of corn-based ethanol production in the US, there’s little incentive for a cellulosic producer to add to the glut of ethanol. And given falling gasoline demand, it’ll prove particularly tough for refiners to meet Congress’ mandates for advanced biofuels use.

But if the EPA were to raise the blending limit, it would instantly create a bigger market for both cellulosic and corn-based ethanol. For better or worse, the EPA likely will increase the blending limit to advance the Obama Administration’s goal of promoting cellulosic ethanol. I expect that decision to occur before the middle of 2010. An increase in the ethanol blending rate would accelerate demand growth for corn.

Late-Breaking News: As we were finalizing this issue on December 1, a prominent ethanol lobbying group released a letter it received from the EPA, an excerpt from which appears below:

As we are evaluating your E15 [blended gasoline that contains 15 percent ethanol]waiver petition, we want to make sure we have all necessary science to make the right decision. Although all of the studies have not been completed, our engineering assessment to date indicates that the robust fuel, engine and emissions control systems on newer vehicles (likely 2001 and newer model years) will likely be able to accommodate higher ethanol blends, such as E15.

However, we continue to evaluate the question of component durability when E15 is used over many thousands of miles and there is an ongoing study being conducted by DOE that will provide critical data on this issue. We are told by DOE that this program involves the complete testing of 19 vehicles to examine the long term emissions impacts of higher ethanol blends on newer motor vehicles and is expected to be completed by August 2010. Presently, data are available on only two vehicles, however it is expected that testing will be completed on an additional 12 vehicles by the end of May.

As a result, EPA expects to have a significant amount of the total data being generated through its testing program available to us by mid June. Should the test results remain supportive and provide the necessary basis, we would be in a position to approve E15 for 2001 and newer vehicles in the mid-year timeframe. Of course, if the data highlight potential problems, then the decision may need to be delayed until all testing is received and reviewed.

This letter increases my confidence that the EPA will boost the ethanol mandate by the middle of next year. Clearly, the EPA punted on making a decision until 2010, but note that the agency states that its early findings indicate that such a boost won’t damage modern cars.

Furthermore, the letter indicates that the DOE has completed testing on two of the slated 19 vehicles in its efforts to measure the long-term impact of E15 on newer automobiles. If the preliminary results of that study had been negative, EPA likely would not have issued a letter that’s so positively inclined towards granting the E15 waiver.

The early reaction from ethanol supporters is that the letter is tantamount to an approval. I am inclined to agree with that viewpoint.

Quality Not Quantity

The key to understanding growing global demand for food is to stop counting calories and focus on protein consumption. It isn’t the quantity of food people eat that’s most important but their diet–a point most investors miss when analyzing agricultural markets.

According to forecasts issued by the United Nations, the world’s population will increase 50 percent between now and 2050, reaching over 9.2 billion people. That’s a lot of new mouths to feed, but what these mouths will eat is just as important.


Source: Food and Agriculture Organization of the United Nations

To create this chart I examined data on consumers’ diets in 110 countries. The nations analyzed in this chart span the gamut of economic development, from Zimbabwe’s USD200 per capita gross domestic product (GDP) for to the our country’s over USD40,000 per capita GDP . 

I plotted each country’s per capita GDP (based on purchasing power parity) against per capita protein consumption per day. Each blue dot on this scatter plot represents a single country.

Statistics is never an exact science, but there’s a clear relationship between per capita GDP and protein consumption; the line plotted on my graph illustrates the basic trend. To make a long story short, protein consumption tends to increase with wealth.

Because meats are the primary source of protein consumption in most countries, a similar chart plotting per capita meat consumption to GDP per capita reveals a similar trend.

For example, the average American consumes roughly 114 grams of protein per day and 337 grams of meat, compared to 81 grams of protein and 148 grams of meat consumed by the average Chinese consumer. In poorer countries, meat and protein consumption are minimal; for instance, average protein consumption in Chad stands at just 65 grams per capita and meat consumption is less than 39 grams.

The graph below illustrates how Chinese consumers’ diets have shifted over time.


Source: Food and Agriculture Organization of the United Nations

The average Chinese consumer’s total daily calorie intake has increased gradually since 1965. However, the sources of these calories have changed dramatically. The intake of rice and other basic cereals has declined, while meat, fruits and vegetables have all become vital components of the Chinese diet.

In short, China’s fast-growing economy spells rising per capita demand for meat. And when we multiply rising per capita demand by a population of more than 1 billion, the jump in the total quantity of meat consumed is enormous.

From an agricultural standpoint, this shift presents a problem. Meat, fruits and vegetables are far more intensive to produce than rice and other cereals. It takes 7 kilograms (15.4 pounds) of feed grain to produce 1 kilograms (2.2 pounds) of beef, 4 kilograms (8.8 pounds) of grain to produce 1 kilogram of pork; and 2 kilograms (4.4 pounds) of grain to make 1 kilogram of poultry. As households eat more meat, demand for grains goes up by a multiple of the increase in meat consumption.

As you can see in the graph below, China’s demand for corn has increased markedly, and most of that corn (the area shaded in blue) is used as animal feed.


Source: USDA

Finally, although I’ve spent considerable time discussing corn in this issue, all agricultural output is related to a degree. That is, arable land devoted to corn production is, by definition, not being used to grow soybeans or some other crop; rising demand for ethanol in the US spells more land devoted to corn production and lower potential production of other crops, such as soybeans.

And the same basic demand story applies for other crops as well. For example, check this graph of Chinese soybean imports.


Source: USDA

This graph traces total Chinese soybean imports back to 1960-61. For most of this period China didn’t import any soybeans; in many years China was a net exporter of this commodity. When China did import soybeans, such as in the early 1980s, it was mainly due to a weak crop domestically–China was more or less self-sufficient in its production.

In recent years demand for soybeans and soybean meal has soared, and China has become an increasingly important importer of these agricultural commodities.

Playing the Field

The best investment themes are relatively straightforward and have multiple short and long-term growth catalysts. Understanding the fundamental factors that move a stock or industry group is also important when deciding if it’s time to sell; when one or more of my basic reasons for buying a stock falters, I always reexamine that position and consider selling at least part of my position.

This issue has covered a great deal of ground thus far. Here’s a summary of why I’m bullish on agriculture in both the long and short term.

Long-Term Drivers

  • Changing diets in developing countries spells rising demand for meat and protein. Meat consumption has an outsized impact on grain demand, as feeding livestock is grain-intensive.
  • Biofuel mandates in developed countries will increase demand to use crops as ethanol and biodiesel feedstock. Ethanol is pushing up corn demand in the US and sugar demand in Brazil. Biodiesel growth should increase demand for soybeans and palm oil.
  • There’s a limited supply of arable land worldwide. In some countries, such as China, poor agricultural practices and water shortages have turned once-arable land into desert or land that’s only marginally productive.

Short-Term Drivers

  • The latest corn harvest in at least two decades is prompting the USDA to lower its estimates for the size of the crop, a likelihood that places further pressure on supplies.
  • The EPA looks poised to boost the maximum ethanol blend rate from 10 to 15 percent to make it easier for refiners to meet ethanol blending mandates. Ethanol consumes one of every three bushels of corn produced in the US, and this requirement will increase ethanol consumption.
  • Last year’s financial crisis prompted many farmers to cut expenses to the bone, including cutting back on fertilizer applications and spending on new equipment. With farm incomes picking up again and the outlook improving, farmers will need to play catch-up on that spending in the upcoming spring planting season. The coming wave of restocking spells suggests that companies that specialize in these products will do well.

Sometimes knowing which stocks to avoid is just as valuable as picking winners. Although ethanol producers were once the darlings of momentum traders, I’ve consistently warned investors to steer clear of these stocks. This caution has paid off for investors who followed my advice; several ethanol producers have filed for bankruptcy, while others–such as the formerly hyped Pacific Ethanol (NSDQ: PEIX)–are now penny stocks.

I continue to recommend that investors eschew pure-play biofuels producers and gain exposure to these growth trends via my Biofuels Field Bet. Instead of picking one or two leveraged plays on biofuels, I advise casting a wider net. By buying several biofuel plays of varying risk levels, we limit risks and maximize our chances of hitting a few big winners. Most of my preferred plays are either producers of agricultural products or companies that sell crucial products or inputs to the agricultural industry.

I’ve run this mini-portfolio of biofuels plays since 2006 and at times recommend taking profits in some holdings or adding to other positions. We’ve had a couple big losers but have taken profits as high as 800 percent on other plays; the winners have more than compensated for the losers. The most recent update to the Biofuels Field Bet appeared in the March 18 issue of The Energy Strategist, in which I strongly recommended buying nine of the 11 stocks in this mini-portfolio.

The current Biofuels Field Bet appears below, along with a brief description of each stock and my rationale for adding it to the list.  I have also included a column illustrating the performance of the portfolio since the last update.


Source: The Energy Strategist

The trick to playing trends associated with the biofuels industry is to avoid betting the farm on any one pick. For return calculations, I’ll place 20 percent of a normal position size in each stock; if you normally put USD10,000 in a Gushers recommendation, I’ll assume an investment of USD2,000. Given my bullish stance on agriculture over the near and long term, I recommend that investors increase their allocations to the field bet.

Of the 11 stocks in this field bet, nine are trading higher than they were when I last updated the recommendations. The average gain for the field bet over that period is 30.7 percent, slightly better than the 29 percent gain in the S&P 500 Energy Index over the same timeframe.

Fertilizer

There are two fertilizer plays in the biofuels field bet, Potash Corp (NYSE: POT) and The Mosaic Company (NYSE: MOS). Both picks number among my favorite plays on the coming rally in agriculture stocks, as it appears that fertilizer prices are set for major upside in coming weeks.

Agricultural yields are the key fundamental to watch in coming years, as the amount of arable land is relatively fixed; farmers will need to generate more crops from the same arable acres to meet rising demand for grain.

In fact, yields have been at the heart of a global agricultural revolution that’s been in swing for over 200 years. In the late 18th century, Englishman Thomas Malthus famously predicted that famine and disease would proliferate, as the global population appeared to be expanding faster than farmers’ ability to produce food. Although the UK’s population increased more than tenfold in the ensuing two centuries, the number of Britons without access to proper nutrition declined. Moreover, foods available only to the wealthy in Malthus’ day would be commonplace and rather ordinary by the latter 20th century.

But Malthus failed to anticipate that farmers would dramatically boost the amount of food produced per acre of land to accommodate a growing global population.

Farming isn’t commonly thought of as a high-tech industry, but without a steady succession of agricultural innovations the vast majority of us wouldn’t be able to live in cities and work in industries with little or no connection to food production.

One of the most important innovations behind the dramatic jump in crops yields over the years: advances in fertilization. The graph below demonstrates the importance of proper fertilization and the power of yields.


Source: USDA

This graph depicts the total corn yield per acre for the US, China and the world average. US corn yields are nearly twice China’s average yield, and yields have grown far more quickly in the US in recent years.

It’s estimated that roughly 40 percent of global crop production is a result of better fertilization techniques; much of the difference in corn yields between China and the US can be explained by the fact that China has applied fertilizer less efficiently in years past.

It’s not just the total amount of fertilizer that matters–China actually applies more tons of fertilizer per hectare to its land than the US–but the mix of different types of fertilizer. China’s use of a key fertilizer known as potash has been sub-optimal, though a big jump in potash imports in recent years suggests China is taking steps to change that.

There are three main types of fertilizer: potassium chloride (potash), phosphate and nitrogen.

Potassium chloride is mined from ore deposits created when oceans and seas dried up millions of years ago. With the passage of time, most of the world’s ores have been covered by earth and are now located deep underground.

Companies produce potash by removing salt and other impurities and then preparing the potassium chloride into either solid pellets or a liquid product. The largest producers of potash in the world account for about two-thirds of total global output. Because there are only a handful of global producers, about 80 percent of global potash supply is traded across international borders.

Fruits and vegetables account for nearly a quarter of global potash consumption. Corn and rice fields also command their fair share of potash, accounting for a further 28 percent of the global market.

Phosphate is also mined from underground ores created from ancient sea life. Typically, phosphate fertilizer is combined with ammonia to produce solid fertilizers known as DAP (diammonium phosphate) and MAP (mono-ammonium phosphate. Sulfur derived from oil and natural gas refining/processing is a key raw material for converting phosphate rock into usable fertilizer.

As with potash, phosphate production is concentrated in a handful of countries. China is the largest producer, followed by the US and Morocco. The latter is the largest exporter in the world because the US and China consume most of their domestic phosphate production internally.

Because the big producers of phosphate are also be the biggest consumers, only 20 percent of global phosphate supplies move across international borders. The crops hungriest for phosphate include: fruits and vegetables (18 percent of total demand), wheat (16 percent), corn (12 percent), and rice (12 percent).

Although nitrogen is the most common element in the air, plants rarely make direct use of atmospheric nitrogen. Nitrogen-based fertilizer is made from ammonia that is synthesized from natural gas, which accounts for as much as 90 percent of the cost of making ammonia.

Urea is the most common form of nitrogen fertilizer and accounts for about half the global market. And most nitrogen fertilizer isn’t traded but is applied relatively close to where it’s produced. The biggest crops for nitrogen fertilizer are corn, rice and wheat; combined these commodities account for half of nitrogen use worldwide.

Now let’s examine conditions on the supply side of the equation. Two of the three main fertilizers are mined commodities with relatively limited geographic availability. And check out the table below.

Source: Bloomberg

It can take as long as seven years to bring a new potash construction plant on stream, and building a mining and processing facility costs upward of USD2.6 billion;  as demand for potash rises, supply can only adjust gradually to meet demand.

To make a USD2.6 billion investment in a plant worthwhile, potash prices would have to remain relatively high and stable. Although phosphate and nitrogen fertilizers are slightly less time and capital intensive to produce, it’s not a simple matter to increase fertilizer output quickly to meet demand.

Supply constraints and rising demand beget only one outcome: rising prices. Fertilizer prices increased steadily up until mid-to-late 2008 when the credit crunch precipitated a collapse. But that weakness is near-term and temporary.

Deteriorating agricultural commodity prices prompted farmers to cut costs–for example, by applying less fertilizer than usual and relying on residual nutrients from prior applications to feed crops.

Fertilizer distributors also stopped buying new inventory of fertilizer from producers and simply sold down their inventory to bare-bones levels. Some took substantial writedowns on their inventories as prices on unsold stocks of fertilizer deteriorated.

But relying on nutrients in the soil is, at best, a short-term solution. Failure to apply fertilizer depresses yields immediately, and the problem worsens because each new crop strips more nutrients from the soil.

The collapse in overall demand for fertilizer in late 2008 and early 2009 represents not demand destruction but demand deferral. Ultimately farmers will have to start applying more fertilizer to their crops.

Meanwhile, the fertilizer dealers that act as middlemen between producers and farmers are also low on inventory, having flushed their stocks after demand collapsed last year.

When you couple last year’s under-application with this year’s late corn crop, you have the recipe for a major uptick in prices and demand in 2010. Because US corn and soybean crops were late this year, farmers have less time to apply fertilizer and prepare the soil for next year’s spring planting season. But signs suggest that US farmers are once again applying fertilizer as they harvest this year’s crop, a trend that will continue until weather conditions worsen.

Fertilizer inventories at distributors are ultra-tight and farmers will stock up on fertilizer once the spring season comes around; there’s a real chance that regional shortages could ensue. Reports are already circulating that indicate farmers are nervous about the availability of fertilizer, given tight inventories in key producing regions.

Bottom line: The supply/demand balance for fertilizer is tightening quickly; this year’s late harvest and under-application set the stage for a real supply squeeze in 2010.

Potash Corp of Saskatchewan offers exposure to the three major fertilizers but dominates its eponymous industry, controlling nearly a quarter of the world’s total potash mining and production capacity.

Global potash demand is expected to resurge above 50 million metric tons in 2010 after slumping below 40 million in 2009. Such an increase would return potash consumption to levels that prevailed from 2004 to 2008.

In addition, shipments from producers will likely dwarf consumption because dealers need restock barebones inventories.

In its most recent quarterly conference call, the company’s management noted that inventories are extremely low worldwide, citing the case of Brazil. At the beginning of the year the country’s potash inventory totaled 1.8 million metric tons; that figure will likely end the year closer to 300 thousand metric tons.

A similar story has transpired in Malaysia and Indonesia; both nations have essentially exhausted their supplies of the fertilizer. And China essentially withdrew from the market in 2009. Potash Corp expects the Middle Kingdom will need at least 8 to 9 million metric tons of imports next year to avoid a major drop-off in crop yields. With the government trying to encourage rural development, China likely will buy the fertilizer it needs.

Potash Corp should also be applauded for its discipline. The company has a track record of shuttering production facilities to match demand. The company actually cut its own output by two-thirds in the third quarter due to weak demand for its marquee fertilizer–a move that enabled it to achieve relatively high margins and helped to arrest what could have been a more precipitous slide in prices.

It takes billions of dollars and as long as seven years to bring a new greenfield potash facility onstream. But Potash Corp has the ability to build more capacity on its existing sites at a fraction of the cost.

Potash Corp plans to increase its total capacity from around 12 million metric tons per year in 2010 to 18 million by the middle of the coming decade, primarily via these cheaper brownfield expansions. That means that Potash Corp would control more than a third of the global market, making it an even more dominant player.

Although potash is the company’s largest business line, it also boasts a roughly 5 percent share of the phosphate market globally and 2 percent of the nitrogen market. These industries are far more fragmented than the potash business; the company is actually the third largest producer of both commodities, despite its seemingly paltry market share. Buy Potash Corp.

The Mosaic Company primarily produces potash and phosphate fertilizers. As noted earlier, the outlook for potash prices is bullish–and Mosaic is the world’s second-largest producer.

Mosaic is the world’s largest phosphate fertilizer producer and controls all aspects of the supply chain from mining to fertilizer production. The bullish story for phosphate is similar to that of potash, and the rising price of DAP fertilizer, among other indicators, suggests that the supply situation is tightening. Prices of the fertilizer on the US Gulf Coast have bounced from a low of about $280 per metric ton in late October to $300.

With inventories for DAP and other phosphate fertilizers tight across corn-producing regions of the US, it won’t take much of a jump in demand to send prices to the moon.

Current shareholders should note that the company will pay a special dividend of $1.30 per share on December 3 to all shareholders of record as of November 12.  Although this special dividend won’t likely become a permanent attraction, it is a sign of Mosaic’s pristine balance sheet–the company has $2.6 billion in cash and just $1.4 billion in debt. Buy The Mosaic Company.

Seeds

Two plays in the Biofuels Field Bet are involved in genetically modified (GM) seeds, another innovation that boosts crop yields.

GM technologies have encountered strong opposition from environmentalists and consumer advocacy groups, particularly in the European Union. Such crops are still derided as “Frankenfoods,” but ultimately the consumption of non-GM and organic food is an expensive luxury for consumers in developed countries.

It will be tough to turn the tide: GM crops offer higher yields than conventional seeds, and the latest stacked seeds can grow during droughts and other unfavorable conditions. Regardless of your feelings about GM crops, this agricultural technology is a necessity if the world is to have any hope of feeding the world’s growing population.

Monsanto (NYSE: MON) is the world leader in GM seeds and is at least 18 to 24 months ahead of its competitors in terms of seed technology. GM crops are nothing more than plants designed to exhibit certain beneficial characteristics known as traits. Nowadays traits are stacked so that a single crop offers multiple genetic advantages.

Monsanto recently hosted its biennial two-day analyst meeting, updating investors on progress in the development of cutting-edge crop technologies as well as the company’s growth outlook.

Analysts had expressed concerns that weakness in the company’s Roundup herbicide business would imperil its long-term goal to double its gross profit by 2012. Profitability in the Roundup business deteriorated last year because competition from generic competitors in China, falling prices and general demand weakness. But management makes a compelling case that growth in its seeds business will more than offset these issues.

In the near term the spotlight is on two products: SmartStax Corn and Roundup Ready 2 Yield soybeans.

The former is a GM corn that resists root, stalk and ear insects. In addition, the corn has traits that make it resistant to herbicides like roundup, allowing farmers to kill weeds without damaging the corn. The technology should enable farmers to boost their crop yields 5 to 10 percent. Management expects to SmartStax to be planted on more than 4 million acres of land in 2010 and sees that figure quadrupling to 16 to 18 million acres in 2011. This is a faster ramp-up for the product than many observers had expected.

Roundup Ready 2 Yield soybeans also contain multiple traits, including herbicide resistance. Monsanto claims that these seeds will increase yields 7 to 10 percent.

Monsanto is working on a drought-resistance corn varietal that could grow in what’s now considered marginal farmland. This is particularly attractive proposition, as water shortages remain a big problem for farmers in many regions of the world. Buy Monsanto.

Syngenta (NYSE: SYT) has traditionally focused on herbicides and pesticides rather than GM seed development. But in recent years the company has expanded the latter business as well.

The herbicides and pesticides business also took a hit last year when farmers cut back on spending in every possible area. But with farmers’ income expected to improve into 2010, spending crop protection will also recover.

And Syngenta produces a number of specialized products with limited competition; the company appears to be gaining market share and is well-positioned to take advantage of the coming upturn. Asian rust has wreaked havoc on corn crops across the Americas, and

Syngenta produces a niche chemical that helps control this devastating disease.

Syngenta’s seed business just isn’t in the same league as Monsanto’s, but with a shortage of GM seeds across key markets there’s room for multiple competitors. And Monsanto’s SmartStax corn is more expensive than the older, less-sophisticated corn varietals Syngents produces–some farmers may opt for the older technology rather than paying up for the latest stacked traits. Buy Syngenta.

Palm Oil

Palm oil is produced from the fruit of a particular type of palm tree. As with most palms, this tree requires a tropical climate and is normally found near or around the equator.

Malaysia and Indonesia dominate production of palm oil, each producing around 16 million metric tons per year. The next-highest producer is Thailand, which produces around 1 million metric tons.

Palm Oil isn’t as well-known to US consumers as canola oil (rapeseed oil), olive oil or oil derived from soybeans. However, it’s commonly used in candy bars and other processed food products. China is the world’s top consumer of palm oil; in fact, palm oil has traditionally been the most popular edible oil in the country.

I see strong growth in palm oil consumption for two reasons. First, the same principle of diet upgrading that applies to meat also applies to fats, oils and sweets; as countries become wealthier and consumers’ disposable income rises, spending on fats, oils and sweets increases quickly. The graph below tracks palm oil consumption in China over the past 40 years.

Source: USDA

The data speaks for itself: Chinese palm oil consumption has increased six-fold over the past decade alone and is projected to reach record highs this year.

Of course, food upgrading doesn’t explain the following chart.


Source: USDA

This chart depicts palm oil consumption in North America and the European Union (EU). Consumption of palm oil has increased steadily in North America, but the rise in the EU is far more dramatic thanks to biodiesel. Diesel-powered passenger cars are far more prevalent in the EU than in North America, and biodiesel–a diesel fuel made from oils–is the biofuel of choice. The region has mandates for increased biodiesel use to encourage consumption.

Canola oil is produced in the EU, but palm oil can be a cheaper biodiesel feedstock depending on price movements. Demand for palm oil is also rising as a biodiesel feedstock.

Biofuel Field Bet includes three plays on Palm Oil: M.P. Evans Group (UK: MPE; OTC: MPEVF), Anglo-Eastern Plantations (UK: AEP; OTC: AEPLF) and SIPEF (Belgium: SIP; OTC: SISAF). The first two plays are relatively small companies that own palm oil plantations in Malaysia and Indonesia. Sipef is a bit larger and more diversified, owning palm oil, tea, banana and other plantations. All three have performed well and rate buys.

One high-risk play that has not panned out is Landkom International (UK: LKI), a UK-based company that owns farmland in the Ukraine where wheat and rapeseed are produced, the latter mainly for biodiesel production.

Financing issues and weak pricing for its key commodities have weighed on Landkom’s stock over the past year. The firm is issuing new shares in an effort to raise capital. It’s not worth selling Landkom at this time; the stock has already sustained a hard hit (it’s only meaningful decliner on the table since March), and the company still owns some valuable assets. Hold Landkom if you already own it; investors on the sidelines should remain there. This illustrates why I recommend casting a wide net in field bets to diversify risks.

Miscellaneous

Metabolix (NSDQ: MBLX) produces biodegradable plastics from crops, replacing oil consumption–petrochemicals form the basis of many plastics–with biofuels.

The company’s first product is Mirel, which is being commercialized through a 50/50 joint venture with Archer Daniels Midland (NYSE: ADM), a massive global agribusiness company.

Metabolix is in the early stages of developing its market but the involvement of ADM is encouraging. And a new facility to produce Mirel on a commercial scale is slated to open later this month. For now Metabolix is rated a hold.

Novozymes (OTC: NVZMY) makes enzymes used in a variety of applications, including stain removal. But one of Novozyme’s biggest businesses involves producing enzymes that facilitate the manufacture of biofuels. For example, Novozyme’s enzymes are used to accelerate the fermentation process that’s at the heart of ethanol production. Rising demand for ethanol will be a big positive for Novozymes.

And Novozymes is developing enzymes that convert plant waste products into biofuel–an example of the cellulosic, or “advanced,” biofuels whose development and implementation were mandated in the recent US energy bill. New enzymes are essential to reducing the production costs of cellulosic ethanol to a level that’s competitive with gasoline and conventionally produced ethanol. Buy Novozymes.

PowerShares DB Agriculture (NYSE: DBA) is an exchange-traded fund (ETF) that tracks the performance of a long list of agricultural commodities including corn, wheat, soybeans and sugar. This is a direct play on rising agricultural prices, which I expect rise in coming years because of strong demand growth and higher costs associated with boosting yields. Buy PowerShares DB Agriculture.

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