Prices Stay Down on the Farm

The widely reported theory from legendary Hong Kong-based economist Marc Faber, that a rally for soft commodities will come hot on the heels of the hard commodities boom, gets short shrift from Australia’s top commodities expert, Brian Fisher. Fisher also has serious warnings about the prospects for key Australian agricultural industries and pastoral property.

Fisher runs the Australian Bureau of Agricultural and Resource Economics, the prime source for Australian commodities intelligence. ABARE applies healthy economic rationalism to the hopes and vagaries of commodities trade with a depth of experience unmatched in the private sector. Fisher himself has a breadth of experience beyond ABARE, including a key role in Australian climate change negotiations and last year’s Prime Ministerial infrastructure task force.

For longer than I care to admit, I’ve been attending ABARE’s annual Outlook conference for a regular fix of commodities news and issues. (By way of disclosure, I am paid an honorarium for chairing some Outlook sessions.) The Outlook 2006 conference over the past two days provided the opportunity to bounce the Faber theory off Brian Fisher, who immediately branded it as a hope rather than a theory.

As you can see in the accompanying video, Fisher’s long experience in the field stresses the importance of checking the fundamentals for each individual commodity; as he explains, there’s not an all-encompassing story.

What time does not permit in the video interview are particular challenges Fisher highlighted for two of our key commodities: wool and beef. (Australian beef is one of the relatively few rural industries with ready access for investors, most obviously through Australian Agricultural Company, but the agricultural sector in general is attracting more city investor dollars through the tax-centred rural investment funds '” beasts of very variable quality.)

The local beef industry has rallied thanks to US-based beef producers being excluded from Japan over mad cow disease. That is an exclusion that might or might not last, but the threat Fisher identified comes from South America, a competitor that has been held back by another disease: foot and mouth.

Uruguay, an important South American beef producer, is now free of foot and mouth and has immediately made serious inroads into the US market against Australian beef. The worry for us is that nearly all our beef exports to the US are made under our quota agreement on very low tariff. The Uruguayans have very little quota but are still exporting plenty, even while paying a 26.4% tariff.

The implied much higher level of efficiency of the South Americans is a challenge for our industry to match should key producers '” such as Brazil and Argentina '” eventually control foot and mouth, too. Fisher notes that because of their size and open borders, it will be much more difficult for those two countries to wipe out the disease, but it would be foolish to think they won’t eventually get organised and do it.

The wool industry, meanwhile, has been going backwards pretty much since the Korean War boom. There have been minor rallies along the way, but the depressing trend for wool is that it’s not just winning a shrinking percentage of the growing international textile market, its absolute sales are going backwards and the wool price is falling. (Maybe former AWB chairman Trevor Flugge needs to do a better job as chairman of the wool commercialisation group, Australian Wool Services, but given his hearing, memory, computer skills and organisational difficulties '¦)

Many sheep farmers have reacted to wool’s woes by concentrating more on sheep meat. Half of sheep farm income now comes from meat. But there is a looming environmental crisis for all of us beyond the wool price as the marginal sheep farms fail. There are large swathes of country, especially in western NSW and south-west Queensland, that have been looked after by sheep farmers who don’t appear to have a future in the industry.

Before any environmentalists start cheering about the land being returned to nature, they should understand that it doesn’t return to its pre-European state. Instead, it commonly becomes invested with woody weeds in a state of “lock-up” '” an impassable and essential barren wasteland that is of little use to native species. If the present wool industry trends hold true, it looks like becoming one of Australia’s biggest environmental disasters.

The headlines from ABARE’s 2006 Outlook were generally favourable '” Australia’s commodity exports to jump 7% to $134 billion in 2006; Plenty of life left in commodities boom '” but the National Australia Bank’s chief economist, Alan Oster, still told the conference that rural commodity prices will fall 10% this year. He expects half of that fall to be cushioned by a lower Australian dollar, but there’s still no message there of a Faber-style boom.

Investors considering the rural sector would be well served to make use of ABARE’s depth of commodities and industry knowledge '” just to help sort the sheep from the goats.

Michael Pascoe: Some investors are hoping that soft commodities might follow hard commodities, with their prices significantly higher. How do you see that at ABARE?

Brian Fisher: I think that’s a hope rather than a theory, frankly. I think in the case of soft commodities it really depends on very specific commodity issues, so if we take sugar, for example, all of the action we’ve seen in sugar in the past 18 months is really driven around the oil price story and ethanol in Brazil. Because Brazil is such a huge producer of sugar it basically dominates the sugar market now, is a very effective, very cheap producer and has a huge ethanol program.

As a consequence of a rise in oil prices, they’ve moved much more sugar into ethanol and therefore sugar prices have risen. We’ve seen a situation where sugar’s moved from as low as US6¢ a pound two or three years ago, up to US18¢ just the other day. So it’s a massive increase in prices, driven entirely by the ethanol and fuel program and nothing to do with the fundamentals of the sugar industry, per se.

So the supply and demand fundamentals for soft commodities remain fundamentally different to hard commodities?

Well the supply and demand fundamentals are important for everything, but in the case of soft commodities I think you have to be more careful about the specifics, particularly on the supply side or in fact the interaction between those two things. In the case of the hard commodities, particularly coking coal and iron ore, we’ve seen a lot of action as a consequence of unexpected increases or unanticipated big increases in demand out of China and the fact that most of the major suppliers have run up against infrastructure bottlenecks and those things happened effectively in every country at the same time as demand ramped up.

Producers weren’t ready. I think every producer actually admits that they weren’t ready and we’re now seeing huge projects coming on line around the world, and in the case of coking coal we see this year prices coming off a bit. Iron ore prices have gone up because we’ve basically haven’t been able to de-bottleneck the big suppliers. Now inevitably when those big projects come online, when extra big projects come online, we’re going to see some softening in those prices as well, so I think you have to look very carefully at the fundamentals and not jump to broad conclusions across the commodity sector as a whole.

Some softening in prices but the fundamentals are strong demand. The China story continues to run. So just a softening not a major fall back?

Yeah I think that’s right. I we’re assuming we’re going to see about 4% gross domestic product growth for the world as a whole '” a fraction less than that in 2007, but 4% is a big number basically. Anything 4% and above that means that demand’s kicking along strongly for commodities. We’ve seen that now for three or four years and I think we’re likely to see that out into 2007, perhaps even 2008, depending on how well the United States holds up in growth. If that’s the case, then we would expect to see continuing demand for commodities particularly out of North Asia and China.

From an investor’s viewpoint, agriculture remains a much harder story. A story challenged by productivity problems.

If you have a look at productivity story in broadacre agriculture in Australia, there’s massive differences in the performance of the sectors. Over the past 30 years, we’ve got productivity improvement in the cropping industries of about 2.7% per annum and that is very good compared to the rest of Australia.

If you look at the wool industry '” that’s the contrast '”about .8% per annum, and that is not enough to have offset the decline in terms of trade. In the case of the wool industry, the wool specialist, we’ve seen real farm incomes trending downwards over the past 30 years and that gives cause for pause, basically, in terms of where the wool industry is headed and what those producers are going to do that depend specifically on wool. In the case of the sheep industry more generally, we’ve seen many people diversifying, not necessarily out of sheep, but moving more into prime lamb production.

In general terms, how does agriculture in Australia stack up as an investment?

The top 25% of farmers continue to do better than equity markets, on average, so if you’re good at what you do, if you’ve got good property and you’re focusing on marketing the product, then it’s pretty clear that you can make good money in agriculture today. We do have issues with a lot of farmers at the other end. A lot of people have small properties; they can’t necessarily expand very effectively and to some extent those people are trapped in a bit of a problem.

The rise in agricultural land prices, does that makes sense given the rate of return you can expect from buying one of those properties?

Well I’d say to quote a famous central banker, just looking at the numbers there’s a bit of irrational exuberance in some property markets around Australia. Why is that there? There are all sorts of reasons why some of these markets have moved perhaps beyond what they should have if you just calculate the net present value of what you can earn off that property over the next 30 years and discount it back. You do that sort of calculation and it would lead you to '¦ it would lead me not to be putting money into certain pastoral areas in Queensland, for example, but I see people are still doing it, so perhaps there are things that I don’t understand.