Three Factors Affecting Food Prices You Cant Ignore

by Scott Pape on May 3, 2008

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Desperate times call for desperate measures: in Haiti hungry protesters forced the
Prime Minister to resign; in Cameroon 24 people have been killed in food riots; and
Egypts president has ordered the military to start baking bread.

You could be forgiven for wondering just how much the world food crisis will affect a
country where fat people try to lose lard each night on TV. But dont be fooled. The
economic forces that underpin this unfolding tragedy will be felt everywhere.

Economics 101: raw materials

Economics 101 tells us that the biggest piece of the prot pie is in the value-adding
process taking raw materials and creating something people will pay a premium for.

An example is turning a piece of silicon into a computer chip (or Pamela Anderson).

In the past dozen years weve witnessed this unfold in the new economy of
breakthrough technological innovation, and more recently in the alchemy of nancial
engineering that saw billions of dollars created, shued around and disappear.

Underinvestment

Yet throughout this economic whirlwind, and perhaps because of it, there has been a
signicant under-investment in our capacity to produce the most basic commodities
of food and fuel.

Ten years ago if youd spoken about investing in the raw materials that account for
the bottom end of the economic food chain, people would have thought you were
crazy.

Yet investors are now playing catch-up. Some $US200 billion has moved from paper-
based assets (stocks and bonds), into bullish bets on tangible assets.

First we saw the price of hard commodities, such as iron ore, oil and coal, go through
the roof. Now its the so-called soft commodities and grains that are experiencing
record price increases.
In the past few months the agricultural staples of wheat, corn, oats and rice (where
stock is at 25-year lows) have hit record highs. These price rises have been driven by
many factors, but they all have the same outcome higher food costs.

According to the United Nations World Food Program, this potentially puts 100 million
of the planets poorest people on the brink of disaster.

Three things affecting prices

There are three main factors that are contributing to the price increases all of which
have ramications for our economy.

Resources boom

The rst is what I call the second act of the resources boom.

As the level of economic activity and prosperity increases in developing countries like
China and India, so does their consumption of resources both hard and soft
commodities. India is estimated to have a middle class of 300 million people as big
as the entire US population. China will soon follow, and then overtake.

Culturally, and because of necessity, the staple diet in Asian countries has historically
consisted of rice. Yet, as more people are pulled up the economic elevator, meals are
starting to take on a high-calorie Western avour.

My recent travels through India showed me that cows there have a better life than
many of the people. These sacred cows are free to roam through the city trac,
without having to worry theyll end up slathered in pepper sauce at the end of the
evening. The same, however, cant be said for the Chinese, who are consuming 2.5
times the amount of meat they did in 1980.

Heres the rub. Fattening up a cow requires an average ratio of 6kg of grain for each
kilo of meat. The more meat that is consumed, the less grain there is available for the
masses.

Oil prices

The second factor is record oil prices, which are again being driven by the insatiable
demand from China and India.

An essential ingredient in the agricultural process is fertiliser, which is generally made

with an oil-based compound. As oil prices have doubled, so has food.

Certain types of fertiliser have nearly tripled in price over the past year, making them
less available to farmers in developing countries and reducing the output of crops.

Increased fuel costs makes distributing food from the farm gate to the dinner plate
that much more expensive. These higher costs are eventually passed on to
consumers.

Biofuels

The nal factor in food ination is the emergence of the use of biofuels billed as a
sustainable way to wean us off our oil addiction and aid in the ght against global
warming. Governments worldwide are introducing mandatory targets for the use of
biofuels to be integrated with the use of traditional fuel.

The result has seen a disproportionate amount of crop being used for biofuel rather
than food. Its disproportionate because it takes 240kg of corn to make 100 litres of
ethanol. The same amount of corn could feed a person for a year.

Western countries are better placed to absorb the increasing costs of dietary staples.
Australians spend roughly 15 per cent of household income on food. In developing
countries, it can be higher than 50 per cent.

Governments that cannot provide the basics for their people generally dont stay in
power for too long. This is why many countries have imposed export restrictions on
their home-grown produce, which further limits supply and causes prices to rise in the
international market.

An eye to the past and future

While the US sinks into what many suggest could be a prolonged recession, market
bulls increasingly hang their hats on the growing, self-sustaining middle class of
China and India to provide expanding markets.

It was six months ago that I stood admiring the Shanghai skyline, watching the break-
neck construction unfold before my eyes. Today the Chinese share market (casino)
has slumped by half and ination is running at more than 8 per cent.

The rise of India and China will continue to be the investment story of our time, but
the by-product will be scarce resources.

Smart investors will do well to recognise this trend and keep a close eye on those
companies that are providing alternative resources. This will be the next boom.

Tread your own path!

Photo: ickr.com/photos/viamoi/3417420554/