Perhaps no industry is so exposed to weather and climate change as agriculture. Mike Scott outlines the potential impact and the resulting investment demands
Farming has always been completely weather-dependent and 2012 provided ample examples of what can happen when the weather doesn’t co-operate.
The US experienced its worst drought since the 1930s and poor weather also hit the other key grain-growing areas – Ukraine and Russia, Latin America and Australia. This led to significant increases in food prices, with Rabobank predicting that the cost of food will reach new records in the first quarter of 2013, triggering a period of ‘agflation’. Climate science suggests that such events are going to become more frequent and more fierce in years to come.
And this disruption is not an isolated phenomenon – the global agricultural sector is experiencing something of a perfect storm, with severe supply constraints coming up against a range of demand-side pressures that are not going away anytime soon.
According to the UN Food & Agriculture Organization (FAO), food production will have to increase by 70% over the next 40 years in order to meet demand.
Simon Webber, fund manager of Schroder ISF Global Climate Change Equity, points out that as the population grows, the amount of agricultural land per person is falling at the same time as the growing middle classes and the increasing urbanisation of emerging markets such as India, Brazil and China lead to changes in diets. The resulting increase in demand for meat increases the demand for grain as feed.
Pressures on the supply side include increased soil erosion and degradation, pressure on water and other resources and competition for land from biofuels. In the longer term, climate change will also change rainfall distribution, growing patterns and disease vectors.
“We are living in a resource-constrained world,” as Michael Andrew, chairman of KPMG International, puts it. “The rapid growth of developing markets, climate change, and issues of energy and water security are among the forces that will exert tremendous pressure on both business and society.”
And to further complicate matters, these forces are not acting independently – they interact with each other to produce yet more volatility and uncertainty.
At the same time, improvements in agricultural yields have started to slow. According to research by Schroders, over the past 40 years, yields per acre have increased at 2.1% per year, but since 2000 the increase in yield per acre has averaged less than 1% per year. Credit Suisse estimates that growth closer to 3% per annum is required to keep up with demand.
The Schroders paper on ‘Agricultural production and climate change’ says that the increase in agricultural production over the past five decades was mainly due to the increased use of synthetic nitrogen fertilisers and new seeds. Mark McLornan, of Valiance Asset Management’s Valiance Farmland fund, adds that this Green Revolution of the 1960s was based on cheap oil, which enabled farmers to pump a lot of water and use a lot of fertiliser, whose manufacture is very energy intensive.
The think tank Chatham House, in its new report on ‘Resource Futures’, notes that the growing globalisation of the world economy means we increasingly depend on international trade to feed ourselves, keeping the world “only one or two bad harvests away” from another global crisis. “Volatility is the new normal,” the report warns.
“We can see that there are more extreme weather events and because supply and demand are more finely balanced than in the past, this has led to extreme volatility,” says Michael Landymore, director of listed equities at sustainable investment specialist Impax Asset Management.
The sector’s outlook is further complicated because as well as being affected by climate change, agriculture is a major contributor to it as well. This means that as well as adapting to a new climate reality, it will also have to take action to reduce its own emissions of greenhouse gases.
“Climate change acts as a threat multiplier to the sector on top of the dual impacts of increased demand and decreased supply,” says Rick Stathers, head of responsible investment at Schroders and author of the research paper. “This will present various investment opportunities throughout the value chain.”
Jürgen Siemer, agriculture analyst at SAM Group, says that, in some ways, the risks of investing in agribusinesses are quite low. “People are always going to need to eat, so you don’t need to ask if demand will remain,” he notes. However, he adds that it is crucial to identify companies that are operating sustainably and taking account of the risks created by climate change.
“As opportunities for expanding agricultural land remain limited, the gap between growing demand for food and agricultural production will have to be narrowed, primarily through additional increases in productivity and improved efficiencies,” he reasons. “This will require substantial innovation and investments along the entire value chain, ranging from new application technologies for farm inputs and improved agronomic practices, to greater efficiencies in logistics, transportation, storage, processing and packaging.”
Landymore identifies areas such as agricultural equipment, fertiliser, seeds, crop protection and food processing as promising areas to invest in. Because agriculture accounts for 70% of freshwater withdrawals worldwide and up to 90% in some countries, irrigation companies will also be well-placed to profit in a climate-changed world.
Another way to leverage the strong drivers in agriculture is to invest in farmland, an area that is attracting increasing interest from investors. The opportunities tend to be quite specific and targeted. Craigmore Sustainables, a New Zealand-based funds group, offers the chance to invest in the New Zealand dairy industry, for example. Farmland offers an attractive mix of capital gains and income, says chief executive Forbes Elworthy, as well as being inflation-proof and uncorrelated to other assets.
Agro-Ecological Investment Management is even more targeted and focuses its fund on organic dairy farming in New Zealand. “A resource crisis exacerbated by global climate change is looming,” says managing director Geoff Burke. “The performance of your investments will reflect your understanding of this and ability to execute appropriately.” For non-organic producers, input costs such as fertiliser are set to rise sharply in the next few years, he says, and so is the cost of dealing with environmental regulations. “Increasingly, conventional producers will be held to account and/or charged for their nutrient loading, water use/pollution and land use consequences in general,” Burke says.
Despite the sector’s attractions, there are few significant markets outside New Zealand, the US, Australia, Canada and Brazil with sufficiently strong land ownership rules to attract institutional investors. Western Europe is seen as a mature market with little room for growth. Investors looking for higher returns can invest in a range of frontier markets, from Ukraine and Romania to Africa, but many mainstream investors find the political risks just too large.
For Valiance, the answer is to invest in north-eastern Brazil, an area with predictable and stable rainfall and huge amounts of space. “We need to plant 80-100m extra hectares of land by 2020 to meet demand,” says McLornan. “This region of Brazil is one of the few places that has the land and the expertise to exploit it.” It is an area that is under-exploited because the topsoil is very acidic. But by applying lime, the acidity of the land can be lowered and by applying fertilisers it becomes productive land.
However, to some, this model is an example of why the current system is not sustainable in a climate-changed world. “Simply applying more fertilisers isn’t structurally securing global food supply over the longer term,” points out Rabobank analyst Dirk Jan Kennes. “It only helps farmers to produce record quantities of grains and oilseeds when weather conditions – during planting, growing, and harvesting – are ideal. It doesn’t help the crops cope with changing weather conditions.”
What the world really needs is a technology-intensive approach that enables farmers in mature agriculture-producing countries to push the yield boundaries, while emerging agriculture-producing countries, such as China, India and those in Africa, need a new set of farming best-practices enabling smallholder farms to take a short cut towards a sustainable increase in productivity, Kennes adds.
Companies that will thrive are those that provide the production tools – seeds, fertilisers, pesticides and equipment – that enable farmers in the established agricultural regions to push productivity over existing hurdles. These include crops that tolerate drought and saline environments, that turn nutrients and energy more efficiently into agricultural produce, and that withstand attacks from insects and fungi – without harming the environment.
Such innovations will be accelerated by the current high food prices, Kennes argues. “Although the current high prices are putting a lot of stress on many food supply chains, they are attracting investments in productivity enhancing innovations,” he says.
“Innovations that will ultimately result in structural increases of sustainable food supply.”
There is no cure for high prices like high prices, as the old saying goes. It was always especialy true in food markets. It could be just as true for long-term sustainability as it is for short-term demand.