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Agriculture & Water Rights

Issues to be addressed in this research paper

According to at least one estimate, mankind is facing a formidable challenge in the years to come. Between now and 2050, we will need to produce more food than we have done in the previous 10,000 years put together (Source: The Economist). This research paper will assess how investors can take advantage of that.

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Does the world need a new farming model?

When living standards are low, diets are simple and cheap. We know from various episodes of famine in Europe that people can survive on potatoes for a very long time, and many people around the world survive on rice to this day.

That said, we also know that per capita income will rise quite dramatically across emerging markets in the years to come - particularly across Asia - and we know that, when people have more money to spend, the very first thing they spend it on is on more and better, usually protein-rich, food such as meat.

As a consequence, there is little doubt that the demand curve will change meaningfully over the next many years. At the same time, the supply curve is also changing. Arable land continues to vanish as urban areas expand. Take Africa: In 1950, only 15% of Africa’s population was considered urban. By 2000, that number had risen to 33% and, by 2030, 55% of Africa’s population will live in urban areas (Source: United Nations).

Adding to that, changing demographics cause a challenge in their own right. The average farmer in most DM countries is now in his late 50s and, in many cases, his children either cannot afford to take over the farm, or they have no desire to do so. A new farming model is therefore required. Note: Various sources can be used to obtain this information. I have used Eurostat for Europe www.usnews.com for the US, and research provided by Laguna Bay for Australia.

Which route to take

Many investors are admittedly put off by the complexities of the asset class. Volatile commodity prices, soil health, animal diseases, water scarcity and adverse weather conditions are all factors that can ruin one’s sleep at night. On a combined basis, those factors represent quite a formidable challenge. Our very first recommendation is therefore to leave the investment(s) to people with proven expertise. Don’t attempt to get involved yourself by investing directly in farms as some do.

Having said that, farmland investments have, on average, performed rather well over the last 20 years (chart 1). Although the numbers in chart 1 look very attractive, it is not clear how much of those returns is due to rising land prices – a point I will return to later in this paper, as I have some concerns about land prices going forward.

Given the need for a rather dramatic increase in food production as stated above, the next 20 years shouldn’t be too shabby, though, and we would expect (certain) crop prices to do very well over the long term.

Chart 1: Return on various asset classes, 1994-2013
Chart 1: Return on various asset classes, 1994-2013
Source: The Economist

Our second recommendation is not to invest in farming across the board, but target specific geographic areas and crops. Farming is not as simple as it sounds and, in a world of accelerating global competition, it is exceedingly important to be a low cost producer. A given country may be a low cost producer of one commodity but a high cost producer of another.

Chart 2: Corn crop yields in various countries
Chart 2: Corn crop yields in various countries
Source: USDA, Silverstreet

Take corn. We all know that it is a major crop in the US, so it is not really much of a surprise to see the Americans at the top of the chart, as far as corn crop yields are concerned (chart 2), but who would have thought that Zambia comes second in the global league tables? Given the high correlation between crop yields and production costs, you would certainly expect Zambia to be amongst the lowest cost producers of corn, and it is (Source: http://www.yieldgap.org/zambia)

Use of modern technology

Our third recommendation is to decide ex ante what sort of return profile you are looking for. Returns on agricultural investments can be relatively stable, where the returns are likely to be comparatively low, or they can be more equity-like in nature; higher returns but also much higher volatility. To a large degree, that choice is a function of the level of technological innovation used by the farming community in question.

Farmers around the world are at very different stages in terms of how they take advantage of modern technology. Most farming in Africa is largely based on manual labour, whereas the majority of farms in DM countries have adopted modern technology to varying degrees and have, as a result, managed to keep labour costs very low, which is important for them to be able to compete with EM farmers.

Extensive use of farming technology not only keeps labour costs low, but it also reduces some of the risks associated with farming, e.g. various diseases and adverse weather conditions. On the other hand, the use of farming technology has increased overall debt levels in the farming industry, as the implementation of modern technology is almost always financed by debt. It is therefore quite logical that high-tech farmers generate more stable, but also lower, returns than low-tech farmers do, at least in the good years.

Take Australia, which is a country at the leading edge of technological innovation in farming. Consequently, Australia is the world’s lowest cost producer of many agricultural commodities today. The flipside of that is that Australian farmers are, on average, deeply indebted. On top of that, 99% of all Australian farms are family owned, so the demographic challenge that I referred to earlier is a massive issue in that country.

How to get started

As a consequence of this, we believe there are two (realistic) options. You can either opt to invest in a country that is at, or near, the leading edge of farming technology, or you can go for the low hanging fruit – i.e. EM farming, where the scope for technological improvements is significant.

In order to generate relatively stable returns, we believe it is very important to be the lowest cost producer (or, at the very least, close to). The operational flexibility that follows is almost priceless. Hence our fourth recommendation: We would recommend that you make the first agricultural investment in a country that is technologically advanced and in a commodity (or commodities) that the country (region) in question is a low cost producer of.

We would then, at a later stage, recommend that you add a second agricultural investment – this time in an EM country, where expected returns are higher, provided the country and commodity in question have been selected with care.

Valuation of farmland around the world

If one knows the cost of farmland as well as the average farming income (all per hectare) for a particular country, a traditional P/E model can be applied and, in that respect, the global dispersion is significant.

A couple of examples: Wheat farms in Australia sell at 10-16 times gross margins (subject to region), whereas wheat farms in the US typically sell at 35-40 times gross margins. Likewise, beef enterprises sell at 14-16 times gross margins in Australia and at about 45 times gross margins in the US. Interestingly, beef enterprises in Uruguay are even more expensive, trading at an average earnings multiple of about 48 times (Source: Victorian Government, USDA, Farm UY.)

As mentioned earlier, the demographic profile of the farming community in many countries raises at least a yellow flag, and nobody knows exactly what that will do to farm prices over the next couple of decades. Our fifth recommendation is therefore not to enter into any agricultural investments, where the total return to a significant degree depends on rising land prices, and that would particularly be our recommendation in countries where the P/E ratio on farmland is very high.

Ageing will force a lot of farmers to sell their farm in the years to come and, until we have a much better idea as to which farming model will prevail, you don’t want to be too dependent on rising land prices in order to generate decent returns.

The relevance of government subsidies

The importance of agriculture, measured as a % of GDP, is low all over the developed world (chart 3). The consequence of this is that most farm subsidies have already been cut back or entirely eliminated, making it a relatively even playing field to invest in agriculture around the developed world. Investors are recommended not to ignore this aspect when investing, as you don’t want to make an agricultural investment that only makes sense because of lavish subsidies.

Chart 3: Total agriculture as % of GDP in various countries
Chart 3: Total agriculture as % of GDP in various countries
Source: Laguna Bay

How foreign exchange rates my affect the outcome

Exchange rates could have a massive impact on the net result of your investment and must be carefully considered. An example: As you can see in chart 4 below, AUD/USD lost 36% between January 2011 and December 2015.

As most agricultural commodities produced in Australia are priced in US dollars, the immediate P&L effect was minimal but land values, when calculated in US dollars, depreciated significantly. These sorts of moves in exchange rates could make a dramatic difference to the bottom line.

Chart 4: AUD/USD exchange rate (1984 to present)
Chart 4: AUD/USD exchange rate (1984 to present)
Source: Laguna Bay, RBA

Water consumption around the world

Water is not consumed even remotely evenly around the world. Take the UK vs. the US - two economies that are not too dissimilar in terms of average income and living standards. The amount of water consumed per day in the UK averages about 150 litres per person, whereas the average person in the US consumes about 420 litres per day. A large part of that difference is explained by agricultural use (irrigation). Where the agricultural industry in the UK is modest in size - agriculture consumes about 9% of all freshwater in the UK - and the growing season is wet, agriculture is much bigger in the US, where it consumes 40% of all freshwater, and the growing season is very dry.

If one looks at the global picture, approximately 70% of all the freshwater in the world is used by agriculture, but the number does vary quite dramatically from country to country (see here for details), just as it did in the example above. Not surprisingly, in those countries where the climate is relatively dry, and the agricultural industry is significant in size, the percentage is comparatively high.

Take Argentina and Australia, both of which have a sizeable agricultural industry, and the growing season is dry; agriculture consumes about 70% of all freshwater in both countries. In Denmark, where the agricultural industry is also sizeable, but the growing season is much wetter, the percentage is only 25%.

Let’s go back to Australia for a moment. Water consumption there is largely confined to the eastern and south-eastern parts of the country (chart 5), which is where the majority of Australians live, and where most of the agricultural industry in the country is based.

Then look at water availability across Australia. It is the driest continent on earth. 70% of the continent is classified as desert or semi-desert, which means it has little or no annual rainfall. This makes the effective management of the water supply for agricultural, domestic and industrial use a major challenge.

The most significant scarcity of freshwater in Australia is along the same coastline in the east and south-east (chart 6). Given agriculture’s dependency on water, one would have thought that affordable access to water could make or break an investment in agriculture, and that turned my attention to water rights. I would have thought that an investment in agriculture and an investment in water rights could possibly go very well hand in hand.

Chart 5: Freshwater consumption across Australia
Chart 5: Freshwater consumption across Australia
Source: Laguna Bay
Chart 6: Freshwater availability across Australia
Source: Laguna Bay

Which countries have introduced water rights?

Only 2.5% of all water on earth is freshwater, and only 1% of all freshwater is actually fit for human consumption or other human utilisation (such as agriculture). As the number of people on earth continues to rise, it is no wonder that freshwater is already a major issue in many countries. Given the critical nature of water for mankind’s survival, it is not even unthinkable that humans will go to war one day over freshwater. (It has in fact already happened, but only sporadically.)

The next step, we believe, is not war, though, but a growing use of tradeable rights on freshwater, which is a concept that a few countries have already adopted. Chile introduced the model all the way back in 1981, but the Chilean scheme is often criticised for being poorly regulated and unfair.

The South African model is touted as one of the most advanced schemes, but the uptake so far has been minimal. The US model is not considered as strong as the South African one, and have some serious limitations. For example, one cannot trade water across state lines in the US, and property rights are considered relatively poor.

That leaves only one model – the one in Australia. Introduced in 1994, the law separates water rights from land rights and is today considered the most comprehensive water right system in the world. Permitting cross-border trades of water rights, it has proven much more successful than other schemes around the world. Australian water rights can be traded through a number of dedicated brokers, or they can be traded electronically on dedicated exchanges.

Proximity to Asia

Another unique aspect about Australian farming is its proximity to the rapidly growing consumer market in South-East Asia. As living standards rise across the continent, demand for meat will almost certainly rise as well. Adding to that, Australia has recently signed free trade agreements with some of the largest Asian countries (China included), putting Australia in pole position to benefit.

Final comments

Absolute Return Partners were first introduced to the asset class in 2011, and we have followed it since but, admittedly, there is still a lot for us to do, before we make a specific recommendation.

Summing up our findings so far, we find many more positives than negatives associated with investing in agriculture in Australia. Being the lowest cost producer of many agricultural commodities is a massive advantage, as it gives Australian farmers a level of operational flexibility not granted to many others.

Farmland in Australia is, on average, much cheaper than elsewhere and, following the significant decline in AUD/USD from 2011 to 2015, investors can enter at much more attractive prices.

Demographics are a negative for the local farmer and his family but a positive, if you are an investor, looking to enter the market. The farmer has no choice, if his children don’t want to carry on. He must sell, and my sources tell me that a lot of farmers will sell over the next few years; hence farmland prices may not continue to rise the way they have done in the recent past. That leaves a question mark around agricultural projects, where rising farmland prices are an integral part of the total return.

One of the negatives about Australia is the limited scope for improvements in farming technology, as the country is already at the leading edge. The low hanging fruit will simply have to be picked elsewhere, and one should therefore not expect the highest returns in agriculture to be found in Australia.

Admittedly, we are still at an early stage in our research into agriculture, and our further work may push us away from Australia towards other farming opportunities. That said, regardless of where we end up going, when investing in agriculture, some basic rules should be adhered to:

  1. Only invest in agricultural funds managed by people with well documented expertise in the field.
  2. Don’t invest in farming across the board – for the long term, we would target protein-rich crops and animals in low-cost producing countries.
  3. Distinguish between farming opportunities in DM and EM countries. On average, EM farmers are likely to deliver higher returns, but those returns are also likely to be much more volatile.
  4. The first, and core, investment should be in a country that is well up the farming technology ladder, and where the producer is, or very nearly is, the lowest cost producer.
  5. Don’t invest in agricultural projects where a successful outcome requires for farmland prices to appreciate.

Niels Jensen

7 September 2016

About the Author

Niels Clemen Jensen founded Absolute Return Partners in 2002 and is Chief Investment Officer. He has over 30 years of investment banking and investment management experience and is author of The Absolute Return Letter.

In 2018, Harriman House published The End of Indexing, Niels' first book.