Soft, strong, and very, very profitable

The great oil and metals bull run seems to have come to an end - perhaps not with the bang many had predicted, but with a whimper of underperformance. But the commodities story is not over. Soft commodities - agricultural products such as grain, pork bellies, coffee and sugar - seem to be taking over as a hot investment area.

The fundamentals are strong. On the demand side, there's a global food scarcity, and with the world population increasing by 75 million people a year, it looks set to continue strong.

Even in tough economic conditions, demand for most soft commodities is relatively inelastic. People won't stop eating because they have less money - they may trade down in brand, but that will hurt retailers and food product manufacturers, not the commodity markets.

For some softs, though, the market has suddenly expanded dramatically, as biofuels have introduced a new source of demand. Changing eating habits have also contributed to growth in some markets. For instance, the market for grain is driven not just by human food demand, but by demand for animal feedstock. Consumers in developing countries are eating more meat, which creates more demand for feedstock grain, so the market is likely to remain buoyant - though the record prices seen in 2008 might not be repeated

In the US, more corn is being processed for ethanol, putting upwards pressure on corn prices. In 2008, over 90m tonnes of US corn was processed for ethanol - for the first time, more than the amount of corn that was exported. The USDA expects biofuels to use nearly a third of world supplies, so this is a step change in demand for the commodity.

Like metals and oils five years ago, before the bull run started, soft commodities have seen 20 years of low prices. That has led to underinvestment - which sets up the conditions for a tight supply side. Lower yields, lower acreages, and inefficient production processes can tighten supply considerably.

However, each commodity has its own foibles - getting the overall direction of the market right doesn't necessarily mean investors will make money. In corn, conditions have been favourable this year, and the harvest will probably be larger than expected. That's led to a slump in prices, against the trend. Government intervention ion one market can also lead to unexpected impact in others - for instance because farmers have been allocating more acreage to biofuels, cotton and soybean acreage was down last year, leading to a surge in prices.

None the less, soft commodities is a boom area. Sugar prices are hitting their highest level for 28 years on concerns about a supply shortage (India, one of the two biggest producers, has seen a monsoon season without enough rain, and is actually importing sugar). Other soft commodities are also experiencing unprecedent price peaks.

Many institutional investors are now pulling back from metals and oil companies,  believing the bubble has burst. China has been restocking, but once the inventory build-up is complete, some argue that the fundamentals will weaken rapidly as construction and industrial sector demand remains low. On the other hand softs still look strong, since inelastic demand doesn't leave them exposed to a downturn in the same way. BNP Paribas for instance is currently advising clients to buy into soft commodities, while advising them to steer clear of metals, which are seen as more cyclical.

Investing in commodities hasn't historically been easy for the small investor. Unless you were prepared to get into the future and options markets - and that requires a day trader approach and some specialised data feeds - there weren't too many places you could go. Plantations take 20 years to mature, and a decent sized arable farm would cost millions. If you want to invest in metals, there's Kazakhmys, Vedanta Resources and Bhp Billiton, and oils investors have British Portfolio Trust and Royal Dutch Shell B - there's no such equivalent for softs.

While there are a couple of palm oil stocks available on the London market - M.p.evans Group and Anglo-eastern Plantations - they are quite small, with GBP 172m and GBP 136m market cap respectively, and there's little research available on them. Both have come back from their highs as the palm oil price fell, but are still profitable. Liquidity is tight, though, and they're not a good way to get into softs as a whole, because they are tightly tied to a single commodity.

The development of exchange traded funds, though, allows investors to take positions in soft commodities markets. ETF Securities pioneered ETCs (Exchange Traded Commodities), and now has some USD 13bn of ETCs under management. These can be bought through a broker, just like shares, with the added advantage that there's no stamp duty to be paid. The selection is wide - single commodity ETCs are available, and 'baskets' such as Grains (£AIGG) which includes corn, wheat and soybeans. There are even 'short' ETCs for those who want to take a pessimistic view of the market.

While soft commodities probably shouldn't account for more than 5 percent of an investor's total portfolio, they do appear a good way to add diversification. And right now, they also look like a good way to add some recession-resistant returns.

References:

• Rabobank press release, 11 August 2009, http://www.rabobank.com/content/news/news_archive/069-Higherpricesbutgreatervolatilityforfeedgrainsindustryreport.jsp
• Moneyweek, June 5, 2008: http://www.moneyweek.com/investments/commodities/the-soft-commodities-you-should-buy-now.aspx
• The Star Online, 5 September 2009: http://biz.thestar.com.my/news/story.asp?file=/2009/9/5/business/4648294&sec=business
• ETF Securities press release, 26 August 2009: http://www.etfsecurities.com/en/news/etfs_news_090825.asp