July 2007

BIO FUELS: The soft boom

Dominic Rossi, Threadneedle’s head of global equities, writes about the boom in soft commodities on the back of biofuel demand.  'Biofuels can be produced from a variety of crops.' Global warming has long been high on the environmental and political agenda in many of the world’s economies, but it now also has far reaching investment implications. As carbon emissions have continued to rise, a key global response has been the development of biofuels, such as ethanol and biodiesel. Biofuels can be produced from a wide variety of crops, including corn, wheat, soya, palm oil and oilseed rape. The type of plants utilised tend to vary geographically, with corn (maize) the most widely used in the US and sugarcane most common in Brazil. Wheat and sugar beet are used in a number of other countries, while the production of biodiesel from rapeseed is important within the EU. Indeed, biodiesel has become the most widely used biofuel in Europe and can be used in conventional diesel engines. Moreover, in order to help meet increasing demand in Europe, several Asian countries have also boosted their biofuel production, with Malaysia the world’s largest producer of palm oil. Across much of the globe there are increasing political initiatives to reduce carbon emissions. Biodiesel has gained prominence in Europe, but ethanol is the most common biofuel on a global basis, where it is usually mixed with petrol to power vehicles. In addition to their perceived environmental benefits, biofuels have also come to be viewed as a more cost-effective alternative to fossil fuels. The increased demand for petrol, buoyed by the rapid growth of car ownership in emerging countries such as China and India, has seen oil prices reach all-time highs. And while oil has now fallen back from these record levels, it still costs over $60 (e45) a barrel today, compared with just $30 (e22) in 2003. Yet, along with crude oil, as demand for soft commodities has boomed, so prices have risen strongly. This, in turn, has offset some of the cost advantages of biofuels. For example, in Malaysia palm oil futures reached an eight-year high in May this year.  In the US, several states have mandated that the ethanol content of gasoline should rise to 10% over the next few years and they also have longer-term targets closer to 20%. Ethanol production consumed 20% of last year’s US corn harvest and this figure could rise to nearer 40% by 2009. Currently, the US produces around 40% of the world’s corn and accounts for 70% of global exports of this commodity, meeting 15% of the rest of the world’s consumption. It has been estimated that the growth in US ethanol production will wipe out this export surplus in about two years – putting further upward pressure on the price of corn. The sharp increase in the production of biofuels is rapidly becoming the lead driver in the growth of global demand for many soft commodities, taking over from demand for food and animal feed. Indeed, such has been the impact of the growth in demand for biofuels that within the US, the expansion of existing ethanol facilities and the development of new capacity is set to double the country’s production capabilities by the end of 2008. So, just as hard commodities such as precious and base metals have enjoyed a strong bull run in recent years, driven by increasing demand from China and India, so soft commodity prices are likely to remain strong given the competing demands of the biofuel industry and for crops to feed the world’s growing population. From an investment perspective, there are a number of ways to access the opportunities afforded by soft commodities, although many of these are indirect. Although the ethanol refiners currently look expensive, it is possible to benefit from this theme through agricultural businesses, manufacturers of agricultural equipment, fertiliser producers, exporters and transportation and food retailers. For example, agricultural land prices will probably rise further, there could be less crop rotation and a greater need for fertilisers, food price inflation could accelerate and rising farm incomes could lead to increased demand for agricultural equipment. There will be a need to increase crop yields from available land resources, particularly given environmental concerns over the destruction of virgin rainforest. Overall, the positive environment for soft commodities looks set to continue. © fe July 2007

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