Saturday, July 12, 2008

A Solution to Spiraling Food Prices

"You can't always get what you want. But if you try sometimes, you might find, you get what you need." Rolling Stones

When it comes to commodities, it all boils down to Economics 101. Barring government intervention (not usually a safe assumption), prices will tend to rise when demand exceeds supply, and vice versa. Most commodities have been in a bull market the past few years as demand has been greater than supply, and these bull markets can last for some time. But make no mistake, just like any random federally-chartered, shareholder-owned, implicitly federally-backed, government sponsored housing enterprise, their run will eventually come to an end.

Ironically, one of the signals of the impending peak will likely be that "everyone" starts spouting off that "it's different this time". We're seeing some early signs of that for certain commodities already, but we're really looking for some of that good old-fashioned Greenspanian irrational exuberance. More specifically, I'll be keeping an eye out for the following signs of the top:
  • The cover of Time Magazine or the Economist will show a 22-year old hedge fund manager hugging a gas pump.
  • MTV will roll out a new show called "Pimp My Deere" which will take run-down tractors and combines and fit them with waterproof woofers, satellite internet access, 19-inch monitors for day trading futures, chrome rims, custom flame paint jobs, and solar-powered espresso machines.
  • My plumber will excitedly tell me how he just bought his first soybean meal futures contract and shorted the S&P 500.
  • My clients will push me to buy even more gold because it has been going up for so long and their cousin's neighbor told them it was a no-brainer.
  • My vegetarian wife will want to quit her interior decorating business to trade feeder cattle futures.
  • No one will really care what I think about commodities, because they will have "figured it out."
This is what happens during bubbles. Everyone becomes an expert. I still recall how, prior to the dot-com bubble, I was sought out at parties for investment ideas and my opinion about the market (though I'd like to think it was my overpowering charm and machismo). However, as the Nasdaq accelerated and peaked, interest in my opinion quickly disappeared. Actually, I'd go to a party and once people learned that I was a portfolio manager, they'd start pitching me internet stocks! When they learned that I wasn't a tech bull, they'd look at me with a hint of derision and pity, and the conversation would abruptly end. 10 minutes of self-affirmation in the guest bathroom, and I'd be back at the punch bowl telling people I was a day laborer so they'd talk to me.

Once everyone believes in the commodity bull and has invested in it, the upside obviously becomes much more limited. Of course, we don't only focus on crowd sentiment. We have to keep an eye on supply and demand. All else equal, high commodity prices eventually spur the development of new supply. High prices may also result in demand destruction as consumers/purchasers alter their spending patterns and search for substitutes. As a recent example, driving miles in the U.S. have fallen fairly significantly in the U.S. due to high gas prices.

Yesterday, the Economist offered up a tasty little morsel of an article dealing with the issue of demand destruction and substitution as it relates to food. The following are some excerpts from their piece entitled, "Let Them Eat Bugs."
What with rising fertiliser prices, increasing concerns about deforestation and unreliable rains brought on by climate change, how will we find new sources of nourishment?

Scientists at the National Autonomous University of Mexico have an answer: entomophagy, or dining on insects. They claim the practice is common in some 113 countries. Better yet, bugs provide more nutrients than beef or fish, gram for gram.

Meat provides just under one fifth of the energy and one third of the protein humans consume. But its production uses up a hugely disproportionate share of agricultural resources. Feed crops gobble up some 70% of agricultural land, while a quarter of the world’s land is devoted to grazing. Brazil’s burgeoning livestock industry is responsible for huge swathes of deforestation in the Amazon.

For one thing, the habit could help to protect crops. Some 30 years ago the Thai government, struggling to contain a plague of locusts with pesticides, began encouraging its citizens to collect and eat the insects. Officials even distributed recipes for cooking them. Locusts were not commonly eaten at the time, but they have since become popular. Today some farmers plant corn just to attract them. Stir-frying other menaces could help reduce the use of pesticides.

Those looking for a reliable source of protein might prefer to farm them. Protein makes up a high proportion of most insects’ weight. That makes them much more efficient at converting feed to protein than livestock. For example, a cow yields only 10lb (4.5kg) of beef for every 100lb of feed it eats, whereas the same amount of feed would produce tens times as much cricket.

Environmentally and nutritionally, insects are more appealing than meat: you get more for less. But persuading flesh-loving, ento-phobic westerners of this is going to be tricky. “We’re not going to convince Europeans and Americans to go out in big numbers and start eating insects,” Mr Durst concedes. The trick might be to slip them into the food chain on the quiet. Supplements composed of insect protein could be added to processed food and perhaps also to animal feed. That might help to make meat a little more environmentally palatable.
How's that for an Inconvenient Truth? Now, I'm not quite ready to sell my agriculture positions because of a looming surge of interest in locust burgers and potato bug salad. As a "trap-and-release" vegetarian, I'm likely to keep paying up for my soy products, but I can envision this new food source being popular with the 6-8 year old male demographic.

The key point is that we're probably somewhere in the middle innings of the commodity bull market, and although this bull could run for many more years, we need to keep a close eye out for evidence of new or rising supply and falling demand. Also, it's important to remember that the supply/demand picture for each commodity differs. The ability to quickly ramp supply differs. The cost of increasing supply differs. The ability to substitute differs. And, the willingness of people to eat bugs differs.

Disclosure: The Rubbernecker is long many commodities and short the food preferences of the 6-8 year old male demographic.