Institutional Investor's Alpha Magazine - February 2008 - (Page 26)

Commodities n January 2007, while touring Brazil on a research trip, Dwight Anderson, founder of New York–based hedge fund ﬁrm Ospraie Management, visited a 32,000-acre farm near the town of Cristalina, 85 miles southeast of the country’s capital, Brasilia. Over dinner Anderson listened closely while the owners explained the difﬁculty they were having meeting the rising demand for corn, cotton and soybeans. Yet even as they worked to extract higher yields from these mainstay crops, they were also adding incremental acreage to plant sugarcane — and supply a local ethanol plant. For David Russ, the chief investment ofﬁcer of Dartmouth College, the moment of enlightenment came much closer to home. Last spring Russ was startled to see that one of his neighbors in Lyme, New Hampshire, had razed the forest of white pine, sugar maples and birch on his property to plant 100 acres of corn. “He believed that he could sell it into the ethanol market,” Russ says. More and more investors are picking up on what Russ and Anderson have seen ﬁrsthand: Food and biofuel producers are locked in a global struggle that has sent the price of arable land and agricultural commodities skyrocketing. Farmland prices have nearly doubled in the U.S. since 2000 and are now selling for an average of $2,160 an acre. In Illinois, per-acre prices have surged to an average of $4,330. The prices of soft commodities are soaring too. Last year the food price index of the Food and Agriculture Organization of the United Nations, which is based on export prices of 55 internationally traded foodstuffs, climbed by 23 percent. Futures contracts continue to rise as well. Corn futures have in— FRANCISCO BLANCH, HEAD OF COMMODITIES creased more than 100 percent RESEARCH, MERRILL LYNCH since January 2006; wheat and soybean contracts recently hit historical highs. In mid-February winter wheat prices on the Chicago Board of Trade reached a nominal record $11.53 a bushel on news from the U.S. Department of Agriculture that reserves would drop to a 60-year low this spring. “Food was always personal fuel,” says Anderson, 40, whose ﬁrm, with $8 billion under management, runs one of the world’s biggest commodities hedge funds. “But now it is becoming transportation fuel too, and that is causing a repricing of those calories. The government has taken the economics of the grain markets — which have had a steady, decent, positive dynamic on their own — and made them explosive.” Until recently, those economics were easy to decipher. But for the past ﬁve years, the world has consumed more grain than it has produced, and global grain stocks are at their lowest levels in 35 years. Global GDP has grown at a rate of slightly more than 5 percent annually (weighted by purchasing power parity) for the past three years on the strength of developing markets in Asia, particularly China and India, according to the World Bank. Those countries’ burgeoning economies and populations have required everincreasing infusions of energy and food, putting unprecedented pressure on producers and contributing to price surges, particularly in the energy markets. The cost of a barrel of crude oil rose from $58.49 at the start of January 2007 to $99.29 in November, ﬁnally breaching the $100-abarrel barrier early this year before retreating. Not surprisingly, governments in the U.S. and Europe are racing to promote the development of cheaper, greener sources of renewable energy — namely crop-based biofuels that can be grown and distilled domestically or imported from non-oil-producing countries. In March 2007 leaders of the European Union agreed that 10 percent of the EU’s transport fuels should come from biofuels by 2020 as part of a larger effort to combat climate change. On December 19, President George W. Bush signed the Energy Independence and Security Act of 2007, meant to boost vehicle fuel economy and reduce U.S. dependence on foreign oil. U.S. fuel producers will now be required to use 36 billion gallons of biofuel a year — a ﬁvefold increase from current levels — by 2022. Pouring grain into the fuel tanks of American SUVs and German sports cars is having unexpected consequences — both for consumers and for investors. Absent a major global recession, people around the world will have to get used to paying higher prices for food, as corn, wheat and other soft commodities might as well be coal or natural gas. At the same time, investors who have focused on traditional drivers of supply and demand — population growth, the wealth effect (that is, developing countries getting richer and consuming higher-quality foodstuffs), the weather, crop yields, plant disease, even the cost of fertilizer and insecticides — have had to add a whole new set of variables because food is being priced as an energy source. The decoupling of prices from traditional valuation models may help explain why so many commodities managers have struggled to make money over the past 12 months despite the bull market (see box, page 28). According to a portfolio manager who specializes in commodities hedge funds at a London-based fund-of-funds ﬁrm, only a handful of managers did well in 2007. “It really wasn’t a great year to be a commodities trader,” he says. “We saw a lot of managers’ returns clustering around 8, 9 and 10 percent, which is really not normal. But I don’t think that 2007 was an easy year to trade, despite the rally in oil prices.” Anderson doesn’t deny it. His ﬂagship Ospraie Fund managed to post a low-double-digit return in 2007. “The reason why a lot of commodities hedge fund managers have struggled over the past two years is that prices in “One of the side effects of strong global demand for biofuel may well be food shortages and political unrest.” 26 • INSTITUTIONAL INVESTOR’S ALPHA • FEBRUARY 2008

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - February 2008

Institutional Investor's Alpha Magazine - February 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Alternative Perspective The Good Guys: A Simple Plan Cover Story: Energy and Commodities: Fueling Opportunity Regulation: Energy Trading: The Brawl on the Hill Interview: Master of Values Regulation: Hedge Fund Registration: Way Out West Research Center: Top Hedge Fund Analysts Alpha Bytes: Rocket Man Unhedged: Commentary: Structured for Success

Institutional Investor's Alpha Magazine - February 2008

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