Nudgem Richyal, manager of the USD338.7m Baring Latin America Fund, outlines the reasons behind the increased interest in soft commodities that has started to emerge in the investment community.
It seems clear that the commodity cycle has finally turned. We have seen strong performance from the energy sector, and history shows that soft commodities, such as soybeans, wheat, sugar and oats, tend to be the next area to see inflows of capital in each commodity cycle.
Secondly, against the backdrop of concern about global warming, demand for soft commodities such as biofuels has grown exponentially. This has created a source of demand that simply was not present to the same extent in previous cycles, and is acting as a further positive support for commodity prices.
Barings believes that many of the most attractive investment opportunities in companies involved in the production or transportation of soft commodities can be found in Latin America. Brazil and Argentina have the most efficient agrarian sectors in the world, and as rising demand pulls prices higher, Barings expects both these economies and individual companies within them to benefit.
There are many reasons why, although there is a time lag, soft commodities tend to follow energy in the commodity cycle. The most obvious is the link between higher energy costs and higher production and transportation costs for soft commodities. As the cost of production creeps higher, producers need to increase prices.
In addition, though, there is a new dynamic in play in the soft commodities markets: competition between people and combustion engines for the same resource. It is a simple process to turn sugar into ethanol, and the price of sugar has started to be determined not just by how much refined sugar people consume, but by the price of ethanol as fuel.
The same dynamic applies to many other soft commodities. As fuel prices rise, so too the price of those soft commodities that can act as substitutes - biofuels - begins to move higher too.
The region of the world with the most efficient agrarian sector is Latin America, with Brazil and Argentina in particular standing out. We believe that as the price of soft commodities begins to rise, not just the agricultural side of the economy but the broader economy itself will benefit in these countries to the benefit of investors.
Global eating habits are also aiding the sector's potential for growth. As GDP in Asia grows, so does the consumption of meat. As GDP per capita in the US rose from the equivalent of USD5,000 in 1909 to USD20,000 in 2004, meat consumption rose by 90 per cent.
Growth in beef and chicken consumption is running at more than 20 per cent per year in China and, according to figures produced by Doane Agricultural Services, it takes seven kilograms of feed to produce one kilogram of beef, and two kilograms of feed to produce one kilogram of poultry. As Chinese and other Asian economies continue to develop and increase their consumption of meat, it seems clear that demand for soft commodities will continue to rise.
Fish farming is another area that Barings believes holds remarkable investment potential. Between 1973 and 1997 exports of fish from Latin America increased from 44,000 tonnes to 2,435,000 tonnes. Demand is now at such a level that the next step is likely to be aquaculture - organised fish farming on a commercial scale.
Once again, with freshwater predicted to become increasingly scarce over the next 20 years, high levels of natural rainfall give Latin America a significant competitive advantage. Barings believes this is an exciting investment story, and one that is investible through not just listed fish farming companies but peripherally through transportation and other companies likely to benefit.
There are also good reasons why Asia and the rest of the world will look to Latin America for these soft commodities rather than seeking to supply themselves. In China, total farmland has been declining by 1 per cent a year since 2000 as industry and urban centres expand. India and other parts of Asia are experiencing a similar agricultural decline.
Latin America, by contrast, has ample land available for agricultural development and importantly water shortages are not an issue. The re-emergence of El Niño, for example, has brought five years of drought to parts of Australia, which used to be the world's third largest grain producer, and has crippled the sector. Parts of Africa and Asia that could potentially compete with Latin American agriculture are more susceptible to droughts.
At the end of January it was rumoured that US private equity firm Carlyle Group had offered to pay college fees for the children of any Latin American grain farmers if they agreed to sell their produce exclusively to them for the next five years. Whether this turns out to be true or not is almost beside the point; it neatly highlights the increased interest in soft commodities that has started to emerge in the investment community.