What countries are truly the have and have nots of the world? Good friend and business partner Niels Jensen of Absolute Return Partners suggests we look at the old equation in a new way? Food and energy resources may be at least part of the definition in the future.

In this week’s Outside the Box we continue with what I mentioned a few weeks ago: agricultural needs are going to be a new and important force in the world and when coupled with energy may shift the balance of power in the world in strange a different ways.

When, as Niels points out, Afghanistan poppy farmers are shifting to wheat farming, the world is truly a different place. I think you will find the research he has done to be truly worth a few minutes of your thinking time.

And as a preface, I was reminded a little while ago that a Financial Times headline story last Friday mentioned that China is buying African farmland and building massive amounts of railroads and infrastructure to get grains to the market. I have long been bullish on African farmland. This week’s OTB will tell you why.

“There is nothing so disastrous as a rational investment policy in an irrational world,” John Maynard Keynes. You just know that something is astray when Afghan poppy growers begin to switch from opium to wheat.

According to the Independent newspaper here in the UK, that’s exactly what is now happening. I have no desire to enter into a pound for pound risk/reward analysis of producing wheat versus opium. However, the consequences of the rapid rise in energy and agricultural commodity prices are far reaching and perhaps not as well understood as they should be. That is the content of this month’s letter.

The Silent Tsunami

My story begins with Al Gore. While most of us lulled ourselves into the belief that he was onto something when he tried to convince us that global warming (or climate change, as I prefer to call it) was the most formidable challenge facing this planet, a silent tsunami¹, also known as the global food crisis, began to develop and is now threatening to undermine global political and economic stability, the latter of which has been key to the benign financial markets we have all benefited from in recent years.

According to the World Bank, just over 1 billion people live on one dollar or less per day. People in the poorest countries in the world spend 80% of their income on food. So when you and I have hardly noticed that the bread we pick up from the local bakery has doubled in price over the past year, it is because only 10-15% of our budget is spent on food items². In many emerging economies the number is much higher. Chinese consumers spend 28% of their income on food. In India it is 33%. If you want to know how much it is in your country, go to:

http://www.ers.usda.gov/briefing/cpifoodandexpenditures/data/2006table97.htm.

There are three food staples in the world today which dwarf all other food ingredients in terms of importance. They are (in alphabetical order) corn, rice and wheat. As you can see from chart 1 below, they have all experienced rapid price appreciation since last summer. What is it that has driven this price explosion and what does it mean to financial markets? As with most things in life, there is no simple explanation; a number of factors have conspired to create a situation which is exceptional but also destabilising and hence dangerous.

It Is The Bio-Fuel Policy Stupid!

The explanation given by most commentators is the bio-fuel policy currently being pursued by the Bush administration in Washington. The policy is driven by a desire to unlock the United States from its rising dependence on imported crude oil. The problem, as Bush and his government have been slow to recognise, is the stupidity of the policy in its current form. Let’s back that claim up with some hard facts.

In the United States, corn (better known as maize over there) is the primary ingredient in ethanol production although wheat and soybeans are also used. According to a recent UN report, it takes 232 kg of corn to fill an average 50 litre car tank with ethanol - enough corn to feed a child for an entire year. It is estimated that almost 20% of total US corn production will go towards ethanol this year and the number is set to rise to 45% by 2015³.

The problem with corn is that it is low on carbon hydrates, which is where the energy comes from. Instead, American ethanol producers rely heavily on fertilisers with the energy being extracted from the nitrogen in the fertiliser. This is an inefficient and very costly approach - in particular in an environment of rising energy prices because crude oil and/or natural gas are major ingredients in fertiliser production. 33,000 cubic feet of natural gas are required to produce just 1 ton of ammonia!

So what does all this mean? According to estimates from Goldman Sachs, the cost of ethanol from corn is now over $80 per barrel, it is about $145 from wheat and over $230 from soybeans. Other countries recognised this problem a long time ago and use crops with higher carbon hydrate content. In the Philippines they use coconut oil and the Brazilians use sugar cane. Goldman reckons that the cost of one barrel of ethanol based on sugar cane is about $35. So why not import sugar cane from Brazil instead of using corn? One simple answer: Brazilian farmers do not vote at American elections. Idaho farmers do.

Are Investors To Blame?

There is no question that the US bio-fuel policy which, by the way, is now being copied in other parts of the world including the EU, has to take its share of the blame. But it is by no means the only reason for the food crisis. The next culprit on my list is our very own industry - investors of all kinds. In recent years there has been rising demand for commodity-linked investment products from investors all over the world. Pension funds, hedge funds, mutual funds and private investors have all allocated more and more to commodities and, in recent months, demand growth has been explosive, as is evident from chart 2 below. It is estimated that the aggregate value of commodity-linked index funds now exceeds $200 billion, a very significant number in a not very large market.

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