The case for investment in grains and oilseeds

Macquarie AGRICULTURAL FUNDS MANAGEMENT

SEPTEMBER 2010

2

Contents

Disclaimer

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Executive summary 01

What are grains and oilseeds 03

Demand side 08

Supply side 16

Where to produce 19

Why invest in grains and oilseeds 22

The future for grains and oilseeds 24

Contents

1

Executive summary

The recent surge in global wheat prices driven by fears of export shortage, coming from the drought in Russia, has served as a stark reminder of the new levels of volatility that are likely to continue to be a part of the global agricultural sector.

Although food supply shocks have occurred throughout history, these were mostly seen as a concern of the developing world. When a crop failed in a major producing country, it was assumed that adequate supplies could be sourced elsewhere. So long as there was food on the table, and no concern that this could change, consumers and governments accepted supply as a given.

Given the abundance of agricultural production worldwide, little thought was given to assisting the world’s farmers with adequate capital to fund the research and development required to improve productivity, or to encourage the development of large scale agriculture to increase efficiency.

The events of the last four years have made it abundantly clear that the era of complacency towards agriculture is over, and that the volatility in the sector, in terms of prices and supply, is here to stay. In no part of agriculture is this more relevant than with the grains and oilseeds sector.

From 2006 to 2008, the global price of most grains and oilseeds climbed to record highs driven by a number of different supply and demand factors. Drought in key growing regions, new demand from biofuels, panic hoarding and trade restrictions by governments, and, to some extent, speculative investment, all contributed to unprecedented price increases in the sector.

Importantly, these events have focused the attention of governments, the media and consumers to agriculture, and generated an awareness that grains and oilseeds can no longer be taken for granted.

Grains and oilseeds were historically seen as primarily a food – perhaps the world’s fundamental food – to be used for producing bread, flour, pasta, oils and many other staples. And while this demand continues to strengthen, global population growth combined with a general decline in arable farming land per capita, means that serious attention must be given to how the world’s food needs can be met in the long term.

But the demands on grains and oilseeds go well beyond food. The citizens of the world’s developing nations, by far the majority of the global population, have an increasing appetite for animal protein, as a result of their rising incomes and demographic changes. As such, vast volumes of grains and oilseeds are needed to feed the animals providing this protein.

In addition, demand from biofuels continues to increase. The grains and oilseeds which are used as feed stocks for ethanol and biodiesel are coming out of the food and feed chain, making supply even tighter. On top of this, the use of grains and oilseeds in industrial products, from glue to furniture, continues to grow.

While global demand for grains and oilseeds both increases and broadens, questions on the world’s ability to supply this need increasingly require answers.

Many of the world’s grain and oilseed producing regions face environmental challenges in their long term ability to produce adequate crops. They are seeing agricultural land continually degraded by pollution and growing cities, while water shortages have affected both developed and developing nations.

2

Executive summary

In many areas which may have the available space to grow crops on a large scale, factors such as political instability or inadequate infrastructure make it an unviable option. The vital efficiency gains needed to increase grain and oilseed production are hampered by factors such as disincentivising government support programs or the difficulties caused by having a multitude of small landholders, rather than large efficient operators. In addition, overvalued land can provide a further deterrent to investment.

In the wake of the events of 2008, and re-enforced by the price shocks of 2010, it is clear that as demand increases, the most effective and efficient grain and oilseeds producers will be in a prime position to take advantage of this new scenario.

Through identifying parts of the world with the best combination of factors for growing grains and oilseeds, and through establishing highly efficient agricultural operations, particularly

through building on the efficiencies of scale, it is clear that immense opportunities exist in this previously overlooked, but essential, sector.

This paper provides an overview of what we believe are the main grains and oilseeds that the world will increasingly demand, and considers the main drivers of demand– food, animal feed, biofuel, and industrial products. The paper will also examine the factors limiting supply of the world’s grains and oilseeds, and consider the specific issues impacting the major crop producing countries. Finally, it will look to the future possibilities in this essential sector.

3

Over the past 50 years, global wheat production has continued to rise steadily, from around 200 million metric tonnes in 1960 to almost 700 million tonnes in 20102. The major global producers of wheat are the EU, China, India, the US and Russia, who account for around 67 percent of global production3. Around 20 percent of wheat produced is exported4.The major exporters, the US, the EU, Australia, Canada and Russia account for around 75 percent of global exports5.

The main importers of wheat are mostly regions which lack the acreage or natural resources required to grow adequate volumes or qualities of wheat for their requirements. Globally, demand for wheat is fairly widespread, with no one country having major market power. For example, the largest five importers of wheat – Egypt, Brazil, the EU, Indonesia and Japan – account for only 26 percent of global wheat imports between them6.

Wheat is grown in a number of varietals, and is often classified in different ways – for example, spring wheat vs. winter wheat, red wheat vs. white wheat, hard wheat vs. soft wheat.

The most widely grown wheat is common wheat or bread wheat, while the second most common species, durum wheat, is used in the production

Wheat

Wheat is the main cereal grain crop for food consumption in most of the world. Wheat is also one of the oldest harvested grains, having known to have been grown since 10,000 BC. It is thought to have originated in the Nile Delta, but to have been first domesticated in Turkey. In using wheat to bake bread, the early Egyptians formed one of the earliest food production industries1.

Food is the primary use of wheat, as it is widely utilized as flour for producing bread. Wheat forms a fundamental component of the diets of developing countries.

What are grains and oilseeds

1 Jared Diamond, Guns, Germs and Steel2 USDA PSD3 USDA PSD4 USDA5 USDA 6 USDA

Major global wheat producers – percent of production exported 2008/09

Australia Canada United States Russia World Ave. EU China India Pakistan

Perc

ent

-100

1020304050607080

Source: USDA 2010

4

What are grains and oilseeds

of pasta. Different varieties such as Hard Red Spring, Hard Red Winter, Soft Red Winter and Hard White are often used for different varieties of foods, including breads, biscuits, pastries and other baked goods. They are also often traded on different exchanges.

Ideal wheat production conditions vary on the region and the climate. In some countries, particularly in the developing world, increased usage of fertilizer has raised yields. Fertilizer usage in the developing world has increased by 25 times over the past four decades7. In places like Australia’s southern areas, despite a relatively low rainfall, farmers have used increased rotation cropping (planting wheat alternatively with other crops) to increase their yields.

Barley

Like wheat, barley was one of the earliest domestically grown crops. Early barley harvests have been traced to the Middle and Near East region, with crops having first been grown around 10,000 years ago8. Today, barley is grown in around 100 countries, with the EU, Russia, Ukraine, Canada and Australia accounting for around three quarters of global production of 150 million tonnes9 in 2009/10.

The major uses for barley are as an animal feed and for producing malt for beer production. In the US, where it is grown in 27 states, over half of all barley grown is used as an animal feed10. Barley is also used in a wide range of breads, soups and flours, and is increasingly seen as important health food.

Barley is a tough crop, relatively tolerant to drought and able to cope with greater levels of salinity than wheat. It is often grown as a summer crop, or as a winter crop in warmer areas11. As it has a short growing season, it is a relatively drought tolerant crop.

An increasing global consumption of animal protein, particularly in developing countries, will continue to be one of the main drivers of barley demand. In addition, rapidly expanding beer production, particularly in the developing world, will increase the demand for malting barley.

Corn

Corn, known as maize in some parts of the world, is a cereal grain which has been grown since prehistoric times. Corn was thought to have been cultivated by the Aztecs and Mayans in southern Mexico, before gradually spreading through the Americas, then in the 16th century to Europe12.

7 Cropscience8 Washington University in St Louis9 USDA10 Barleyfacts11 McGee, Harold (1986). On Food and Cooking: The Science and Lore of the Kitchen12 Foodtimeline.org

5

Corn is the most widely grown crop in the world, with almost half the world’s corn produced in the US, and around 55 percent of global exports13. Between them, the US, China, Brazil, Mexico, Argentina, India and France produce over three quarters of the world’s corn.

Global corn exports 2009/10

United States56%

Argentina 16%

ROTW 10%

South Africa 3%

Ukraine 6%

Brazil 9%

Source: USDA

Corn’s ability to grow in a wide range of climates played a major role in its wide geographic coverage and popularity. The corn plant has a shallow root system, and as such prefers moist soil. Corn is often grown in rotation with other crops which provide increased nitrogen to the soil, such as soybeans.

Corn is a staple food in many parts of the world, either whole or as cornmeal. It is also processed into many forms, including popcorn and breakfast cereal. In the US, by far the largest usage is for animal feed, outstripping human consumption by around 40 times. It is used for livestock in the forms of forage, silage or grain. Corn is also used in other animal foods such as dog food and fish food.

In recent years, corn has increasingly been used for the production of ethanol. Around 30 percent of all corn grown in the US is now used for ethanol production, more than twice the amount which is exported14.

Soybeans

Soybeans were known to have been cultivated in China and Korea around 5,000 years ago15, and in an example of early agronomy, they were known for their ability to replenish nitrogen in the soil. Soybeans first arrived in Europe in the early 1700s and in the US around 50 years later.

Soybeans are extremely high in protein, a factor which makes them an important food for both humans and animals. In addition to their high protein content, soybeans contain a combination of amino acids which allows the body to absorb proteins.

Unlike most other grains and oilseeds, soybeans enjoy major global markets for their unprocessed form, as well as its two byproducts – soybean oil and soy meal.

When processed, a soybean is broken down into around 20 percent oil and 50 percent meal. Soybean oil is used primarily as vegetable cooking oil or a food ingredient. Soy meal is used mainly for animal feed, particularly for cattle, pigs or poultry.

13 USDA14 USDA15 University of Minnesota

6

What are grains and oilseeds

For human usage, soybeans are utilized in a range of foods, including tofu, yoghurt and soymilk.

Globally, soybean production is quite concentrated in a small number of countries. Between them, the US, Brazil, Argentina, China and India produce over 90 percent of the world’s soybeans – the first three alone account for over 80 percent16.

In terms of soybean trade, figures are complicated by whether countries import whole soybeans or byproducts. China, for example, mostly imports whole soybeans, and processes them domestically.

Between them, the US, Brazil and Argentina account for around 90 percent of global soybean exports17. While the US is currently the largest exporter, it is expected that Brazil will claim this

mantle in the next few years18. The same three countries also account for over 80 percent of soy oil exports.

In terms of soy meal, however, while the same countries account for around 90 percent of exports, Argentina alone exports over half of the world’s supply19. This is primarily due to export taxes on Argentine soybeans, aimed at protecting the domestic soybean processing industry.

China is by far the largest importer of soybeans globally, accounting for almost 60 percent of all exports. China is also the largest importer of soybean oil, accounting for over a quarter of global imports, almost double that of its closest rival, India20.

The EU remains the world’s largest importer of soybean meal, accounting for almost half of global imports21.

Global soybean trade forecasts 1999 – 2019f00

0 m

etric

tons

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

f

2011

f

2012

f

2013

f

2014

f

2015

f

2016

f

2017

f

2018

f

2019

f-80000

-60000

-40000

-20000

0

20000

40000

60000

United States, Metric UnitsBrazil

Rest of WorldChinaArgentina

Source: FAPRI

16 USDA17 USDA18 FAPRI19 USDA20 USDA21 USDA

7

Canola

Canola is a variety of rapeseed. While rapeseed itself has been recorded for hundreds of years, actual canola was first bred from rapeseed in Canada in the early 1970s. The name canola was derived from "Canadian oil, low acid” in 1978.

Canola oil is more useable for human consumption than traditional rapeseed, while its reduced levels of toxins also make it more able to be used as an animal feed than rapeseed.

Like soybeans, canola can be crushed to produce oil and a meal. Canola oil is widely used in many foods and cooking processes. It is regarded as “healthier” cooking oil, due to being low in saturated fat and containing a relatively high level of omega-3 fatty acids22. In addition, canola oil is also used in industrial manufacturing, for products such as candles, lipstick, newspaper inks, industrial lubricants and biofuels. Canola meal is used as a high quality animal feed.

In measuring global production data, canola and rapeseed are often counted together. As such, in looking at overall rapeseed production, the EU, China, Canada, India and Australia account for around 90 percent of global production. Canada is by far the largest exporter, accounting for around 60 percent of global shipments, while the EU, Japan, China and Mexico account for half of global imports23.

22 Moi Group23 USDA

8

The international demand for grains and oilseeds is increasing due to population growth, increasing income, changing diets and urbanization. In many ways, each of these have become interlinked – population growth is largely in developing countries, which are the same areas seeing the highest increase in relative incomes, and also with the greatest shift of consumers from rural to urban areas. As a result, these are the regions which are also seeing the greatest changes in population diets, as people move from a grain based diet up the scale to one with a greater degree of animal protein. As result, greater volumes of grains and oilseeds are required to provide feed for the animals which serve this new diet.

In addition to the increasing demand from food and feed, the growth in biofuels production further increases the demand for grains and oilseeds, particularly for ethanol derived from corn and biodiesel derived from oilseeds. Finally, it is important to also be aware of the increasing usage of grains and oilseeds in industrial products.

It is important to examine each of these drivers in more detail, and then to look at the main four areas of grain and oilseed usage, to further realize how the strong long term growth in demand for grains and oilseeds is evolving.

PopulationPopulation growth is the most basic factor driving the increase in consumption for agricultural products. Every year, the global population increases by around 80 million people24 – the rough equivalent of adding one new Germany or Ethiopia.

The global population has grown substantially over the past few decades, and from its current

base of 6.1 billion people, is projected to rise to 8.3 billion by 2030 and 9.1 billion by 2050. This would equate to an increase in global food growth of 42 percent by 2030 and 70 percent by 2050. In addition, by 2050, over 7.5 billion people will be under the age of 5025. As life expectancies continue to increase, this translates into further impetus for population growth.

Many countries that have previously been self sufficient in their food needs will increasingly need to rely on food imports. This is particularly the case for countries in the Middle East. For example, Saudi Arabia at one stage grew over 4 million tons of wheat per year, making it at one time the world’s sixth largest wheat exporter. However, with water shortages becoming a major issue, the country has phased out wheat production26 and will now import much of its grain needs.

Population growth is expected to take place mostly in less developed countries, concentrated in urban areas27. The strongest growth in demand is expected to be from Asian economies, particularly China and India.

Population growth remains the fundamental base for growth in demand for gains and oilseeds. While an economic slowdown may cause consumers to re-evaluate spending on discretionary items such as clothing, cars and housing, they will continue to buy food.

Throughout previous economic slowdowns, consumption of key agricultural commodities has continued to grow steadily.

In particular, wheat has been shown to be relatively inelastic to both income and price over a sustained period. Consumption figures for wheat have been largely unaffected by either the price of wheat or the price of potential substitutes, such as corn, oats or rice.

Demand side

24 CIA World Factbook25 Justfood.com26 New York Times27 UNFPA

9

IncomeMany developing countries have continued to maintain strong GDP growth. For example, over the course of the Global Financial Crisis, China and India were among the least affected countries, continuing to maintain GDP growth in 2008 of 8.7 percent and 5.7 percent respectively28.

Developing world looking to strong GDP growth in 2011

Australia

US

Canada

Japan

GermanyRussia

Brazil Bangladesh

Indonesia

EgyptNigeria

India

ChinaIran

Pakistan

Mexico

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

0% 2% 4% 6% 8% 10% 12% GDP Growth 2011 Bubble size = relative population

Popu

latio

n Gr

owth

Rat

e

Source: IMF, UN, CIA Factbook

28 IMF29 Justfood.com30 IFPRI

In general, growth in incomes translates into rising per capita food demand. Typically, consumers move up from a lower value staple food to an alternative, such as transitioning from rice to wheat. In turn, as people continue to become wealthier, they move on to consuming products such as meat, fish, dairy products, and fruit and vegetables. In addition, they will also increase their consumption of products such as vegetable oils and processed foods. For example, studies by the American Soybean Association show that when a developing population's family income rises above US$1000/year chicken enters the diet; as it rises above US$3000/year other meats enter the diet29.

As mentioned in the previous section, the population increase tends to be seen in urban areas. The urbanization trend will lead to a shift in dietary patterns, related to the continued expansion of worker incomes in the developing world and more reliance on purchased food, as opposed to self-sufficiency.

For example, a one-time increase in the urban population from 1/4 to 2/3 of the national population of China would result in a 10 percent increase in per capita demand for meat, fish, and dairy products30.

On current forecasts, in the Asia Pacific region alone, 600 million people will move from rural to

10

Demand side

31 ADB32 IFAP33 USDA34 IFAP35 FAO

urban areas by 202031. As people move to cities, a number of structural shifts in food demand patterns occur:

a wider choice of food is available in ■

urban markets

enhanced levels of infrastructure and food ■

storage facilities aid the greater choice in foodstuffs

people are increasingly exposed to dietary ■

patterns from foreign cultures

urban citizens seek foods that take less time to ■

prepare.

A major component in this dietary shift is an increasing demand for animal proteins. This in turn triggers a multiplier effect on grain and oilseeds consumption, as these are needed to provide feed for livestock.

FoodAround 41 percent of grains produced globally are for direct human consumption32.

The percentage of particular grains and oilseeds used for human consumption varies markedly. For example, around 70 percent of all wheat that is produced globally, or 450 million tonnes, is for food33. Demand for food wheat continues to increase in emerging markets, where populations are growing and incomes are increasing. In many of these markets, wheat based products are still considered a luxury item. In the higher income areas of emerging markets, consumption of wheat based products such as bread, bakery and noodles continues to rise.

Cereals – including rice – represent 55-70 percent of the total calories of food in developing countries and 40 percent in developed countries34.

Only a small fraction of oilseeds are consumed for food.

World food consumption of grains in 2010 is forecast to remain unchanged from the previous season, at around 193 million tonnes. This forecast is slightly higher than was anticipated at the start of the season but with improvements in production prospects, consumption estimates have also been revised up. At the current forecast levels, global food consumption of grains on a per capita basis is expected to average around 28 kg, similar to the previous season, with generally steady levels of consumption regionwide35.

FeedIronically, as consumers globally increasingly switch their diets from grains and oilseeds to animal protein products, overall consumption of grains and oilseeds will increase markedly. Consumers will increase their consumption not just of meats, including beef, pork, poultry, sheep and goats, but also of milk. To provide this meat will require enhanced quantity and quality of feed.

Global meat demand 1985 – 2025f

0

50

100

150

200

250

300

350

400

450

1985 1995 2005 2015f 2025f

milli

on m

etric

tons

■ Sheep Meat ■ Poultry ■ Pork ■ Beef

Source: FAO, FAPRI, OECD, USDA

11

As per capita incomes trend upwards globally, one of the major impacts will continue to be a rising demand for meat, as consumers find it more affordable, and as they seek new dietary choices. Rising per capita meat consumption is also linked to other demographic trends, particularly the move of people in developing countries from rural to urban areas, where they are likely to earn higher wages and find exposure to more “Western” food options. In the least developed countries, consumers are likely to substitute between lower-priced products within a food group as their incomes change, such as from corn to wheat. However, in developing countries, consumers are more likely to switch from products outside subsistence foods, such as cereals, to meat or vegetables.

The relationship between per capita income and consumption of meat, dairy and vegetable oils is more intense at lower income levels. As a result, it appears likely that volume growth of more expensive foods will be most prominent over the next two decades as the major developing countries experience significant and sustained income growth across their population bases.

The switch from grain based protein to meat protein will result in growing demand for grain and oilseeds, to provide feed for the animals serving the new meat needs. This demand will be proportional, as the conversion ratios of feed to meat is not one to one and thus demand for grains and oilseeds is increased more as meat demand increase.

The switch across food groups is most marked in the world’s major markets. In China for example, per capita grain consumption has fallen 40 percent over the last 15 years while meat consumption has increased more than 250 percent36.

In India meat consumption has increased 40 percent over the last 15 years, even though half of all Indian households are vegetarian. For India, however, the major driver of feed consumption is likely to be dairy growth.

Compared to most developing nations, dairy products are already an established component of the Indian diet. According to some forecasts, dairy consumption in India could treble over the next four years37. Although India is the largest producer of milk in the world, over 50 percent of production is still via the unorganised, or informal small scale, sector and so domestic production will be challenged to increase quickly enough to meet this growing demand.

Soybean meal is one of the major sources of animal feed. Demand for feed has been driven by different factors in different regions. In the developing world, particularly China, rising incomes over the past few decades have seen steady growth in meat consumption. In most parts of the world, animals raised for meat are reared indoors for some or all of the year, due to factors such as a lack of available pasture land, or seasonally unsuitable conditions, such as extreme cold.

In developed countries, demand for animal feed can be shaped by other factors. For example, as European farmers have banned the import of genetically modified soybeans, they have relied on the import of Brazil’s non-GM soybeans to meet their demands.

In addition, the BSE epidemic, also known as mad cow disease, in Britain was seen by many as being caused by the use of animal bones in livestock feed. Following this, European farmers sought to access a non-animal based, protein rich feed for livestock, with soy meal providing an excellent alternative.

FuelAn increasingly important factor in the demand for grains and oilseeds has been the growth of biofuels. Biofuels fall primarily into two categories – ethanol and biodiesel. In many countries, the main feed stock for producing these is corn for ethanol and vegetable oil for biodiesel. The major exception is Brazil, where ethanol is produced from sugar.

36 FAO37 Nestle

12

Demand side

Biofuels are now mandated for use in around 41 countries38. The growth in biofuels has been due to a number of factors. Biofuels are increasingly seen as more environmentally friendly than fossil fuels, in producing lower greenhouse gas emissions. For countries seeking to reduce their dependence on imported oil, biofuels provide a domestically produced alternative.

Ethanol is produced primarily from corn. Around 30 percent of all corn grown in the US is now used for ethanol feedstock39.

US corn consumption categories 1999 – 2019f

US C

orn

Cons

umpt

ion

1999

Other (inc seed and starch)Food (inc HFCS, glucose, etc)

FeedEthanol

Exports

0

20

40

60

80

100

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

f

2011

f

2012

f

2013

f

2014

f

2015

f

2106

f

2017

f

2018

f

2019

f

Source: FAPRI

38 www.biofuelsb2b.com39 FAPRI40 Farm and Ranch Guide41 Seattle Times42 Reuters43 US Environmental Protection Authority

Ethanol has long been used as a fuel for automobiles – the original Model T Ford could be adapted to run on ethanol. Ethanol produced from other feedstocks, particularly corn stover or woodchips, is commonly known as cellulosic ethanol.

Biodiesel is largely produced from vegetable oils, particularly palm and soybean oil. Around 90 percent of all biodiesel in the US is produced from soy oil40. Soybeans and canola both produce around 100 gallons of biodiesel per acre41.

Globally, the US is both the major producer and consumer of ethanol. Within the US, a Federal mandate stipulates that all gasoline will contain at

least 10 percent ethanol, although there is a push from ethanol lobby groups to have this increased to 15 percent42.

In the US, the level of biofuel production is established under the Renewable Fuels Schedule (RFS). The RFS was originally put in place by the Bush administration in 2007, and re-enforced by the Obama administration in 2010. Under the RFS, the US commits to producing a gradually increasing volume of biofuels from 2008 to 2022. For ethanol, this figure is set at 9 billion gallons in 2008, rising to 36 billion gallons in 202243.

Under the legislation, the level of ethanol to be produced from corn was capped at 15 billion gallons. The remainder of the ethanol was

13

forecast to be made up largely of cellulosic ethanol44. However, recent announcements from the EPA have seen forecasts for cellulosic ethanol cut dramatically, from 100 million gallons to 6.5 million, due to the both the technology and the economics of producing cellulosic ethanol being well behind initial forecasts45. As a result, it seems increasingly likely that increased levels of corn will be required as feedstock to meet future ethanol demands.

The events of 2010 in the Gulf of Louisiana have only served to strengthen the outlook for ethanol in the US. On one hand, ethanol’s environmental credentials have only been enhanced. In addition, subsequent restrictions on drilling for oil look likely to increase the role that ethanol will play in US energy supplies.

Such a scenario would have a number of impacts on the grain and oilseed sector. In terms of supply, an increased amount of corn being utilized for ethanol would draw even further volumes out of US domestic and export supply, increasing the competition for other grains. Secondly, increasing biofuel demand for corn would likely place upward pressure on corn prices, leading to an increase in corn acreage, at the expense of other crops. This level of competition, which would particularly impact US wheat supplies, would have an impact of reducing supplies of corn’s competing crops.

Biodiesel is increasingly used across a range of transport modes. In Europe, at present, the European diesel fuel allows biodiesel to be blended at up to and including 5 percent by volume, with moves to lift this to 10 percent46. Some national standards in EU countries allow biodiesel to be distributed as a stand-alone fuel, notably in Germany, for specially adapted vehicles47. Progress is continuing to run trains on up to 100 percent biodiesel, particularly in the US

and the UK, while biodiesel powered planes have already successfully flown48.

While biodiesel usage seems set to continue growing, it may well be with far greater levels of soybean oil as a feedstock than previously used. The growth of palm oil in natural habitats continues to create controversy and it is foreseeable that ongoing palm oil development will flatten or decline. As a result, it is likely that biodiesel processors will seek to utilize greater levels of soybean oil, further raising demand for global soybean supplies.

Overall, it is important to remember that biofuels currently take up only around 1.5 percent of global grain and oilseed supplies49. However, on a global basis, this accounts for major volume of grains and oilseeds. As a flow on, it means that these grains and oilseeds are being removed from other areas, particularly exports, putting upward pressure on export prices. For uses such as animal feed, it means that other grains and oilseeds, such as wheat, now need to feed the gap filled by the loss of these feedstocks. In terms of production, the result is that fewer acres are available for growing crops for food and feed.

IndustrialWhile not as well known as food, feed and fuel, the use of grains and oilseeds in industrial products will play an increasing role in the demand of these commodities going forward.

A number of factors are behind the push to use more grains and oilseeds in industrial products. As with biofuels, societies are increasingly seeking to replace petrochemical feed stocks with renewable resources. In addition, new industrial products need greater specifity and complexity. Finally, the increased need to

44 Ethanol.org45 Reuters46 EU 47 EU48 UPI 49 World Bank

14

Demand side

address environmental and community concerns forms a growing part of product marketing. One major example is DuPont’s commitment to source 20 percent of its products from renewable sources50.

Industrial products from grains and oilseeds come in an array of forms. An increasing number of pharmaceuticals are made from crops. Biopolymers, which are used in products such as packaging materials, resins, adhesives, biolubricants, can be sourced from starches from cereals and oils from oilseeds51.

The development of BiOH polyols has created a potentially large new market for soybeans. BiOH polyols use soy based ingredient for flexible foam used in upholstered bedding and furniture, carpet backing and automotive seats. Increasingly they are also being used for airport seating around the world. As a soy based product, they replace petroleum ingredients typically used in foam production52 and are seen as environmentally responsible.

A growing number of cosmetics and sunscreen53 are also using soy oil rather than petroleum based products.

In addition to soybeans, wheat is also being sourced for a number of industrial uses54. Wheat has the ability to be elastic, bind water and form films that can be stabilized with

heat. As such, wheat gluten can be useful for preparation of adhesives, coatings, polymers and resins, straw particle board, strengthened paper, and adhesives, such as those used on postage stamps.

Demand conclusionOverall, the diversity of uses for grains and oilseeds will result in result in overall demand continuing to increase strongly. Fundamentally, it is important to note that overall demand growth is not dependent on any one factor.

Hypothetically, even if the world were inexplicably not to get richer, population growth alone would still continue to drive demand for grains and oilseeds. Or even in the unlikely event that biofuels policies were to change in some countries, grain and oilseed demand for animal feed would still increase due to improving diets through rising incomes.

And even if the demand for grains and oilseeds to provide the feedstock for a growing range of industrial products were to soften, then the strong increase for biofuels, increasingly pushed by environmental concerns, would be a major source of growth.

Taken as a whole, the combination of these factors will continue to see grains and oilseeds demand climb well into the future.

50 Dupont51 HGCA52 Cargill53 Sciencedaily.com54 Texas Wheat

15

It can be easy to forget how quickly the Chinese economy has changed. From the strict communist economy of Mao Zedong from the 1940s to the 1970s, it was not until the changes brought in by Deng Xiaoping in the 1980s that China began heading on its current path of being the world’s fastest growing economy. At the same time, its per capita incomes have continued to rise.

While China is a major producer of many grains, it has severe limitations on the growing capabilities of its farmland. China has around 20 percent of the global population, yet its arable land per capita is only half of the world’s average55. Increasingly this land is being taken over by cities and other infrastructure, or has its growing capability limited by degradation through increasing pollutants or the loss of water to cities.

China soybean imports vs meat and dairy consumption

000

met

ric to

ns

1975

/197

6

1977

/197

8

1979

/198

0

1981

/198

2

1983

/198

4

1985

/198

6

1987

/198

8

1989

/199

0

1991

/199

2

1993

/199

4

1995

/199

6

1997

/199

8

1999

/200

0

2001

/200

2

2003

*200

4

2005

/200

6

2007

/200

8

2009

/201

0-60000

-40000

-20000

0

20000

40000

60000

80000Soybean balance of tradeDairy Product ConsumptionMeat (non fish) consumption

Source: USDA

But at the same time as the available arable land is falling, China’s appetite for food continues to grow. As average incomes rise in China, the desire for more meat and dairy, and the ability to afford it, also climbs. China now produces around half the world’s pork, as well as 35 percent of the world’s eggs, 65 percent of the world’s duck meat and 94 percent of the world’s goose meat. In addition, China is also the world’s largest producer of farmed fish and China’s dairy sector produced around 40 million tonnes of milk in 2009, up almost 400 percent in a decade56.

The common feature of each of these industries is the huge level of growth in demand for soybean meal they have created. While soybeans actually originated in China, the country has not been self sufficient in them since the mid 1990s. As such, in 2010/11, China is forecast to import almost 60 percent of the world’s soybean supplies57. To process these into soy meal and soy oil, China has built a massive soybean processing sector.

With China’s economy forecast to continue to grow strongly for the foreseeable future, hundreds of millions of rural Chinese are likely to cross the income threshold of around $1,000 to $2,000 at which meat consumption escalates58. This will only lead to increasing demand for imports of the world’s soybeans to meet soy meal demands, particularly as the country has almost no ability to open up new land for domestic soybean production. As a result, and without taking into account increasing demands from other major importers such as the EU and Japan, the world’s soybean exporters face a promising future.

Why China needs soybeans?

55 Worldwatch Institute56 FAO57 FAPRI58 Business Insider

16

Supply side

Acreage required to meet demand by 2050

Source: Macquarie Research

SupplyWhile demand for grains and oilseeds continues to increase, the global supply conditions for producing the required volumes is hampered by a number of factors.

Perhaps the most prominent factor is the area of land per person available for growing the required crops. Between 1961 and 2007, the amount of arable land per person plummeted by almost 50 percent, down to around 0.2 hectares per head59. This decline was due to several factors, including:

growing land degradation ■

rising impact of urbanization ■

climate change. ■

Degradation of arable land occurs due to a number of factors, including chemical contamination, soil erosion, and depletion of the

nutrients in the soil and salinity, or a growing level of salt in the soil. According to some estimates, around 23 percent of all useable land on earth is now subject to degradation60.

As cities continue to expand across the globe, they continue to encroach out onto farmland. The impact of this growth reduces the productivity of the soil, and either limits the growth of crops or prevents it altogether. Growing urban areas result in increased sewage flows, run-off and other forms of waste, which in turn cause environmental issues for farmland.

In the US alone, total farmland declined by 16 million acres between 2002 and 2007, which followed a previous decline of 16 million acres over the five years prior to that61.

A major factor which will continue to inhibit agricultural productivity is the increasing scarcity of water. Agriculture is the major user of water globally, accounting for around 70 percent of water consumption62. Water availability is one of the most fundamental ingredients towards both growing grains and oilseeds and gradually improving their productivity. Without reliable access to water, food producers cannot implement long term projects to improve land, while food importers cannot expect a producing region to guarantee reliable supply.

Just as with arable land, the availability of water is being jeopardized by population growth, urbanization, rising wealth, resource consumption and climate change. The UN has estimated that by 2025, two thirds of the world’s population could be subject to water stress63. In terms of agriculture, it is estimated that the global agricultural sector will require around 50 percent more water by 2015, and around 100 percent more water by 205064.

Supply side

59 FAO 60 UNEP61 USDA62 Ozh2o.com63 Nupara.com64 FAO

0

50

100

150

200

250

300

350

400

450

Corn Rice Soybeans Sugar Wheat

milli

on m

etric

tons

■ Required■ Current

17

Large scale available landTo gain increasing productivity and profitability from agricultural land, it is progressively more important to be able to build farming operations with economies of scale. It is only when farms are of an optimum size that they are able to take full take advantage of such scale benefits as large modern machinery and advanced agricultural technology. In addition, scale of an operation allows a farm to be run more as a business, with dedicated employees devoted to functions such as finance, agronomics and overall management, rather than one farmer covering all bases.

In much of the agricultural world, however, aggregating this level of scale is impossible. In many developing countries, not only are farms of a small scale, but social and political pressures means that it would be impossible to change this. For example, in China, average farm size is roughly 0.32 acres65. Any move to aggregate large numbers of Chinese farms would lead to a rise in unemployed rural workers and potential social unrest. As such, in China, as in similar countries, it is highly unlikely that the current structure will change.

Political riskWhile some countries may contain excellent productive agricultural land, the spectre of political risk makes it an unattractive investment target, and as such, unable to receive the capital to help it lift productivity. For example, while Zimbabwe was once known as the bread basket of Africa, the current government’s nationalization projects have decimated its farming sector. Similarly, while Argentina has a rich agricultural history, the record of its government in imposing tariffs and export restrictions have served as a deterrent for vitally needed agricultural investment.

Flattening yieldsAs arable land per capita continues to decline, increasing importance is placed on the need for increasing yields from the world’s major grain and oilseed crops. In the period from the 1950 to the 1970s, global crop yields rose markedly, as a result of factors including selective breeding of higher yielding strains of seeds and improved plant tolerance to droughts and insects. In recent years, however, yield growth from most major crops has plateaued, as the limits of development with selective breeding are approached66. While further improvements may require increased use of biotechnology, and the true impacts of this continue to be under question, the significant opposition to biotechnology in some parts of the world may see yield growth struggle to grow.

Protectionist policiesLike any business, the top grain and oilseed producers are always seeking to gain greater efficiencies. In terms of grain producing countries however, the farmers in countries who are provided with high levels of government support for their industries have less incentive to become efficient, as they will always receive a standard level of support, such as fixed prices for their crops. For example, in the dairy sector, the production price of a litre of milk in some heavily subsidized European countries has been equivalent to the farm gate price of a litre of milk in unsubsidized Australia67. In terms of grains and oilseeds, countries with strong subsidies are likely to see production growth limited.

Poor infrastructureRegardless of how good a crop may be, it is of little use to a potential buyer, and of little sale value to the grower, if it is unable to be delivered

65 UC Davis 66 Agricultural and Applied Economics Association67 IFCN Dairy Report 2009

18

Supply side

to a point of sale. For this reason, in regions such as Africa where a great deal of transport infrastructure is in great need of modernization, the potential increase in grain supply for use both in neighbouring countries and on global export markets is likely to be constrained for years to come.

Conclusion – supply makes the short term, demand dictates the long termThe recent events in Russia, where the onset of a drought, and subsequent export bans on wheat saw the cost of wheat rise sharply globally, have once again emphasized the impact that supply issues can have on grain and oilseed prices in the short term. These supply issues, usually caused by a weather event, are far from unknown – concerns over floods in Iowa or water logged crops in Canada for example can lead to price rises in the crop affected. Usually, these

price rises are short term, and the market returns to normal. The events of 2008, when prices for most grains and oilseeds rose to record levels, were caused by a range of factors, with low stocks of global grains, the impact of a drought in various major production regions, the emerging demand for corn from biofuels and the role of speculative investors all playing a part. The subsequent export bans and hoarding of grains, particularly rice, by some countries, served to extend the price rally, though eventually prices fell again.

However, what is important to note, is that with each recent price correction, prices have normally fallen to a higher level than where they started68. As a result, the prices of all grains and oilseeds continue on an upward trend. Ultimately, both the increasing divergence of uses for grains and oilseeds, namely food, feed, fuel and industrial, combined with the increasing demand from each of these areas, will continue to ensure that demand for grains and oilseeds will only strengthen in the longer term.

68 Bloomberg

19

In order to determine the optimum location in which to achieve the greatest return from producing grains and oilseeds, it is vital to take into account a wide range of factors. To achieve the maximum possible return from an investment in agricultural land, it is important to have a full understanding of how a combination of these factors may ultimately affect the profitability of the overall investment.

The following are some of the key factors that should be considered when evaluating an investment in an agricultural opportunity:

ScaleThe ability to aggregate farmland into a large operation is vital in achieving the benefits of scale. This is important in farmland, as it allows the operator to save costs through both economies of scale, as well as improved bargaining power. For example, as with any large business, increased bargaining power allows a farm operator to negotiate lower prices for their inputs, such as fertilizers or seeds.

By creating economies of scale, a farm operator is able to extract greater utilization out of their farm equipment. For example, a new tractor used on an aggregated 3,000 hectares provides lower machinery costs per hectare than the same tractor used on a 1,000 hectare farm.

In addition, creating scale in a farming operation allows for greater use of advanced technologies. For example, a larger farm will have the resources to implement advanced fertilizer application techniques, using technology which is unaffordable for a smaller operation. Through using this technology, the larger farm will be able to lower its fertilizer costs, increase its yields, and improve the long term environmental sustainability of it operations.

Globally, areas which allow for building scale of farmland are limited. In Australia, with the average

age of farmers now over 6069, and with many farmers still on unprofitable smaller blocks of land provided to returned soldiers after the Second World War, the opportunities for aggregation are strong. Similarly in Brazil, the changing structure of the farming sector, partly brought about through the impact of the global financial crisis, has provided further potential for conversion opportunities.

This is in contrast to country such as India, where the average farm is 1.4 hectares70. With over 50 percent of the population being farmers71, it is unlikely that we will see consolidation in the near term.

Foreign direct investment restrictionsA number of countries which have reasonable farming conditions impose restrictions on the ability to invest in this farmland. For example, countries such as Paraguay prohibit the ownership of farmland by foreigners. In Canada, while foreign ownership of farmland is permitted, restrictions of the scale of this investment make it an unprofitable option. In the most productive agricultural provinces, ownership restrictions limit the number of hectares foreigners can own to 40 hectares.

In contrast, while Australia requires government approval for agricultural investments over $231 million72, no foreign investment in Australian agriculture has been turned down.

Corporate agriculture restrictionsIn the US, agricultural land ownership is restricted by anti-corporate farming laws in a number of states. These laws, which differ by State, generally restrict corporations and institutional investors from owning or acquiring farmland.

69 ABS70 USDA71 CNN72 ABC

Where to produce

20

Where to produce

States where these laws exist include Iowa, Kansas, Minnesota, Nebraska, Oklahoma, North Dakota and South Dakota73, home to some of America’s most productive farmland.

In Brazil, no such restrictions exist. This situation allows corporate agricultural investors to utilize their enhanced farming and management skills, as well as taking advantage of their superior scale, to maximize returns for their operations.

Political riskA key component of a successful agricultural operation is being able to guarantee major customers a level of certainty of supply. For this reason, countries with a high level of political risk present unattractive investment opportunities, as they are more likely to impose disruptions on supply of crops. For example, while Argentina contains reasonably yielding farmland, the actions by the government in recent years in imposing export bans or high export tariffs on domestically produced crops provides a major disincentive to customers and a deterrent to investors.

Similarly, in many parts of Africa, the potential for agricultural production is overshadowed by the specter of potential nationalization or other form of government intervention in many countries.

This is compared to Brazil, which has a strong history of promoting free and activity within its domestic farming sector.

Subsidy riskIn a number of countries, the domestic agricultural sector is supported by a range of government subsidies. As a result of these subsidies, such as guaranteed domestic prices, farming sectors in these countries have the potential to fall behind non-subsidized countries, as they lack the potential to continually become more efficient. Even more importantly for the investor, the stability of the farming sector in subsidized countries is dependent on the decisions of the government. For example, in the US, which provides subsidies of around ten cents in the dollar to farmers74, if the government were to make major changes to the country’s Farm Bill, this could potentially alter the viability of many farming operations.

In contrast, in Australia, where subsidies are basically negligible, investors in farming operations do not face the risk of a change in a government program affecting the viability of their operations.

73 National Agricultural Law Center 74 OECD

Producer support estimates 1986/88 vs 2006/08

New Zealand

Australia UnitedStates

Mexico Canada Turkey OECD EU Japan Iceland Switzerland Korea Norway

Perc

ent

0

10

20

30

40

50

60

70

80

1986-88 2006-08

Source: OECD

21

Infrastructure riskThe ability to be able to transport agricultural produce to an export point, such as a port, is vital to maintaining a reputation for reliability of supply from a country. In a region like Africa, problems with modern infrastructure present a major impediment to agricultural investment. All too often, crops have major difficulty in being transported from the farm to a central point, such as a grain silo, and then on to a port.

This is in contrast to countries such as the US, Canada or Australia, where modern road and rail networks link the agricultural producing regions with world-leading port facilities, providing maximum opportunities to fulfill each country’s export requirements.

Water riskThe reliable supply of water to a country’s agricultural operations is a vital consideration in analyzing potential areas for investment. In India, for example, up to 40 percent of agricultural land is irrigated75, leading to enormous potential for water scarcity. Similarly, in California, legal proceedings in that state to guarantee supply

of water for farmers continues to place question marks over the long term viability of many parts of the state’s farming sector.

In an area like Brazil, however, the fact that none of its farmland requires irrigation means that it has successfully adopted dry farming techniques. In having an ample water supply and a consistently steady rainfall, Brazil enjoys a competitive water advantage.

Affordable farmlandWhile the productivity of farmland is important, it will still not equate to profitability if farmland is overvalued. In the US for example, farmland in Iowa, while yielding healthy levels of corn and soybeans, is currently selling for up to US$11,000 per hectare76. This is in contrast to farmland in Brazil, where land which achieves the same yields as the US77, and which furthermore can harvest two crops per year, sells for up to US$3,000 per hectare78. Similarly, some of the countries of the Former Soviet Union offer comparatively well priced land, with arable land in Russia selling for between US $500 and $700 per hectare in 200779.

75 Indian National Institute of Hydrology76 Iowa State University77 USDA78 Agrimoney 79 USDA, RBS 2009

22

Investing in grains and oilseed producing farms provides a number of attractive advantages.

Exposure to diverse and fixed demand ■

Global population growth results in increasing food demand, while rising incomes in developing countries increases the need for animal feed to fulfill the climbing animal protein demand. On top of this, the increasing production levels of biofuels, as well as the use of natural ingredients in industrial products further increases the rising demand for gains and oilseeds to be used as feedstocks in these processes.

Exposure to a sector where global supply ■

increases will be limited

As factors such as urban expansion, land degradation and climate change continue to reduce the amount of arable land per capita, and while yield growth rates for most crops have slowed or plateaued, the world’s ability to produce enough grains and oilseeds to meet demand will be severely tested.

Exposure to a sector where supply ■

will continue to struggle to keep pace with demand

Production levels of grains and oilseeds globally are closely aligned with consumption levels. As such, when growing conditions in a major producer are disrupted, an event which

is likely to occur regularly given the nature of agriculture, intensified demand is likely to see continued upward pressure on prices.

Exposure to a sector where the products ■

are inelastic to price movements

Regardless of increases in prices, people still need to eat, even if they switch between different grains and oilseeds. This was emphasized in 2008, where despite wheat hitting record prices, consumption levels remained strong. Compared to many other products, the inelastic nature of grains and oilseeds means that farmers are able to pass on input increases to end consumers.

Exposure to a sector that is a hedge ■

against inflation

Food price increases remain a major component of overall inflation. As food prices are linked closely to inflationary trends, food production provides farmers with a hedge against inflation. While in the US and Europe food accounts for around 15 percent of CPI80, in low and middle income countries the share is much higher.

In addition, returns from farmland also show a strong correlation with the CPI. For example, from 1999 to 2009 in the US, the correlation between the NCREIF and CPI has been 0.509. Importantly, the return on the NCREIF was higher than the inflation rate each year81.

Why invest in grains and oilseeds

80 Businessweek81 Highquest Partners

23

Exposure to an asset that has low ■

correlation to traditional asset classes such as the equities market

In contrast to the correlation between agricultural investments and inflation, agriculture is largely uncorrelated with traditional asset classes. For example, from 1999 to 2009, the correlation between the NCREIF and the Dow Jones Industrial Average was only 0.107, while with the Standard and Poors 2005 it was just 0.17482.

Exposure to a sector where managed ■

farmland provides the best returns from agriculture

While agricultural futures markets may offer liquidity, they are short term and volatile. In terms of equities, very few public companies provide exposure to actual production agriculture. An investment in agriculture provides exposure to profit from:

price inflation from crops –

land inflation from land ownership –

operating margins from farming production –

increased value of land as it is transformed –

to achieve greater agricultural productivity.

Exposure to a sector where only a few ■

key areas, i.e. Australia and Brazil, provide the range of factors which lead to wider profitability

Both Australia and Brazil offer a series of agricultural production advantages unmatched by other countries. These include:

reasonably priced, highly productive –

agricultural landthe ability to secure farms for aggregation –

reliable climactic conditions for agriculture –

diversified input suppliers, as well as –

diversified marketsunsubsidized agricultural sectors, –

therefore not at risk of withdrawal of government supportlow political risk and attractive FDI laws. –

82 Highquest Partners

24

Globally, we believe the demand outlook for grains and oilseeds is likely to continue to strengthen. As the population continues to grow, the fixed demand for food continues to increase. At the same time, the rising demand for animal protein, particularly in the developing world, continues to increase the demand for animal feed. While some countries, such as Australia and Brazil, have available acreage to run cattle and sheep on grass, for most countries, the requirement to raise their animals in intensive feed-lotting operations means that vast quantities of grains and oilseeds are required to provide their feed.

Demand for grains and oilseeds as a feedstock for biofuels shows no sign of abating. An increasing number of countries are promoting domestic consumption of biofuels as not only an environmentally sensitive alternative to oil, but as a means of reducing their reliance on imported fuels. In addition, industrial usage of grains and oilseeds will continue to grow, as consumers seek more “environmentally friendly” products, and as increasingly complex industrial products ironically require more natural ingredients. As the economies of developing countries continue to grow strongly, the demand for these industrial products will only strengthen.

The recent events in Russia, where a severe drought resulted in export retractions, have only served to emphasize the increasing volatility that the world grain and oilseed markets will see in future years. Overall global demand and supply levels of grains and oilseeds remain finely balanced, and any disruption to supply, such as a drought in a major producing country, can have a sudden and major impact on prices.

In 2008, the world saw record prices for a number of grains and oilseeds, and the imposition of export restrictions by countries concerned at low levels of food availability. These events are still fresh in the minds of a number of countries, so while stock levels of grains and oilseeds may currently be higher than they were in 2008, the nervousness by countries at maintaining supply has been a major contributor to current price spikes.

Looking to the future, a supply shock in one commodity is increasingly likely to cause price rises in other commodities. In terms of being used as a food or feed product, a number of grains are interchangeable – for example, when wheat prices are too high, consumers may switch to corn. As a result, corn prices will rise as demand intensifies, with repercussions across to other substitutes.

These price shocks then flow through the food value chain. As animal feed prices rose, the price of meat goes up as meat producers are forced to absorb higher input costs. Even the price of cotton is affected, as cotton acreage is reduced due to farmers planting higher priced grains.

Global grain and oilseed volatility is also likely to see an increase in speculative investments in soft commodity markets, as investors seek to take advantage of price rises. While the impact of this investment continues to be debated, it would be naïve to ignore its potential to increase soft commodity prices.

The future for grains and oilseeds

25

The future for grains and oilseedsFor more information about Macquarie Agricultural Funds Management, please contact: Tim Hornibrook, MAFM Executive Director

P: +61 2 82320579 F: +61 2 82329999 E: tim.hornibrook@macquarie.com

Macquarie Agricultural Funds Management Macquarie Group Limited 1 Shelley Street, Sydney NSW 2000 Australia

26

The future for grains and oilseeds