Investing in Agriculture - August Agcapita

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Agriculture BriefAugust 2009

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Monthly Highlights

CONTENTS

2 Biofuel Update5 Capital Stock in Primary Agriculture 6 Price Drivers of Farmland 7 Survey of Foreign Land Ownership 8 Sweden Cuts a Key Rate Below Zero 8 Negative US Interest Rates Proposed9 Global Government Funding Needs10 China’s Fiscal Stimulus11 Fed to Remain “Accommodating” for Years?12 Emerging Economies To Lead Future Growth?13 Appendix

I wanted to take this opportunity to discuss the inflation/deflation debate in a bit of detail. Proponents of the deflation viewpoint rely in part on the assumption that although central banks can create credit people may decide not to borrow. Certainly this is true, private borrowing appears to have been dropping. However this misses the point that even if the private sector is reluctant to borrow money at the current low nominal interest rates governments can do the borrowing directly. Its clear that this is what’s happening - governments are stepping in to replace private sector borrowing and consumption - effectively becoming the “borrower of last resort” - and doing so on a large scale. The questions then become 1) where will the money to fund this borrowing come from and 2) will this borrowing be inflationary? The main sources of government funding are private investors and central banks. It seems likely that in the US only the Federal reserve will be willing and able to step in and absorb the amounts of debt issuance that the US fiscal deficit will require - direct debt monetization and if it were to happen, highly inflationary. Inflation was always one of the drivers of our investment premise when we launched Agcapita. Farmland returns have a high positive correlation to inflation which simply means that farmland is a good inflation hedge. Keynesian deficit and money printing economic policies are now being pursued globally. If history is a guide, printing modest amounts of money creates modest amounts of inflation and printing large amounts of money create large amounts of inflation.

The economist, Ludwig Von Mises once quipped “Government is the only institution that can take a valuable commodity like paper, and make it worthless by applying ink.”

Kind Regards Stephen Johnston - Partner

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BIOFUEL UPDATE

A 2008 World Bank report unequivocally blamed the mandated production of biofuels for the surge in agricultural commodity prices. Western nations are diverting grains, oilseed products, corn and sugar into biofuel manufacturing in increasing amounts.

As a result, biofuel production has been growing rapidly in most markets and across most biofuel categories - see Charts 1, and 2.

According to the World Bank report, biofuels have increased food prices by 75 percent. By way of comparison, the US Government claims that biofuels have contributed to less than 3 percent of food price increases.

Chart 3 shows that most major oil consuming countries of the world have implemented biofuel targets. Agcapita’s research estimates that current

Farmland Update

move:

When the energy used to produce and refine a fuel crop is subtracted from the yield, sugarcane is the most efficient Net energy yield • = 1 unit Sugarcane •••••••• Sugar beets •• Corn ••

to the main text as seen in the note on previous page. just have Chart 27 - bars and source info.

CHART 1: GLOBAL BIOFUEL PRODUCTION

Billion gallons

20

15

10

50

02000 2001 2002 2003 2004 2005 2006 2007

Source: International Energy Agency: FO Licht

BiodieselEthanol

CHART 2: PRODUCERS EXPAND OUTPUT

Source: USDA, Economic Research Service using USDA Agricultural Projections to 2017

Million gallons1816141210 8 6 4 2 0

2004 05 06 07 08 2004 05 06 07 08

ArgentinaUkraine & RussiaBrazilChinaCanadaEUU.S.

Ethanol Biodiesel

CHART 3: GLOBAL BIOFUEL TARGETS

Region Current Future

Brazil E25/B2 B5 by 2010

China E10, 35 8% by 2020

Europe 5.75%* by 2010

10%* by 2020

India E 10 in 2003 E20/B20 by 2017 (proposed)

Canada Provencial E6/B2 by 2012 (Canadian Law, C30)

USA 15 B gal 2015 36B gal by 2022 (~20% of transport pool)

* Energy content basis

Source: UOP

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biofuel targets in the US, the EU, Canada, Japan, Brazil, India and China alone could require the use of over 400 million acres of arable land or over 10% of the world’s total – a trend that should continue to have a material effect on crop prices.

Some interesting questions arise from this increasing use of food commodities as an input into an industrial

process to create energy – are biofuels as “green” as suggested and are they competitive against conventional petrochemical energy sources?

Chart 4 shows clearly, based on current production methods, the competitiveness of most current biofuels is limited in the current oil price environment. Without government mandates only sugar cane

CHART 4: ESTIMATED COST OF FUEL PRODUCED BY SELECTED BIOFUEL

FEEDSTOCKS (PER BARREL)

Source: Goldman Sachs

Cellulose $305 Wheat $125 Rapeseed $125 Soybean $122 Sugar Beets $100 Corn $83 Sugar Cane $45 0 50 100 150 200 250 300

Farmland Update (continued)

Ethanol per acre Major Crop producer Gallons per acre Sugar beet France 714 Sugarcane Brazil 662 Cassava Nigeria 410 Sweet sorghum India 374 Corn US 354 Wheat France 277

CHART 5: COMPARING FUEL CROPS

Source: Earth Policy Institute

Biodiesel Production from Oils700600500400300200100

0

Soybean Caster Sunflower Rape- Jatropha Palm bean seed seed

84

70

56

42

28

14

0

Gal

lons

per

acr

e

Milli

on B

TU/a

cre

Ethanol Production from Sugars700600500400300200100

0

Barley Wheat Corn Sugar Sugar Beet Cane

52.5

35.0

17.5

0

Gal

lons

per

acr

e

Milli

on B

TU/a

cre

Source: Fulton et al

CHART 6: BIOFUEL OUTPUTS/ACRES

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ethanol could compete in the market. Although Charts 5 and 6 show that on a gross basis ethanol generates large amounts of fuel per acre, most ethanol production methods yield very little net energy with the exception of sugarcane.


CHART 7: FUEL SOURCES

CropUsed to Produce

Greenhouse Gas Emissions*

Kilograms of carbon dioxide

created per mega joule of energy produced

Use of resources during growing, harvesting and refining of fuel

Water Fertilizer Pesticide Energy

Percent of existing U.S.

Crop land needed to produce

enough fuel to meet half of

U.S. Demand Pros and Cons

Corn Ethanol 81-85 high high high high 157%-262%Technology ready and relatively cheap, reduces food supply

Sugar cane Ethanol 4-12 high high med med 46-57Technology ready, limited as to where will grow

Switch grass

Ethanol -24med-low

low low low 60-108Won’t compete with food crops, technology not ready

Wood residue

Ethanol, biodiesel

N/A med low low low 150-250Uses timber waste and other debris, technology not fully ready

Soybeans Biodiesel 49 highlow-med

medmed-low

180-240Technology ready, reduces food supply

Rapeseed, canola

Biodiesel 37 high med medmed-low

30Technology ready, reduces food supply

Algae Biodiesel -183 med low low high 1-2Potential for huge production levels, technology not ready

Source: Martha Groom, University of WA, Elizabeth Gray, The Nature Conservancy, Patricia Townsend, University of WA

Biofuels are also attracting some criticism based on environmental and land use concerns, which can dramatically vary by the type of biofuel involved as can be seen in Chart 7 below.

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CAPITAL STOCK IN PRIMARY AGRICULTURE

Primary agriculture began a period of rationalization in the late 1980’s after the rapid investment growth of the 1970’s. The investment decline reflected several different factors, the most important of which was a significant drop in commodity prices combined with higher interest rates and the restructuring that was occurring in agriculture production. Farms were consolidating, allowing more efficient use of machinery and equipment, as evidenced by large productivity gains.


Most of the decline in capital stock in primary agriculture has been with respect to farm machinery and equipment. Since the mid-1990’s, total capital stock has stabilized at around $50 billion (1997$), and machinery and equipment at around $12 billion (1997$). Capital stock in U.S. primary agriculture has undergone a similar investment cycle to that of Canada.

CHART 8: INVESTMENT IN PRIMARY AGRICULTURE, 1961-2005

Source: Statistics Canada

9876543210

-1-2-3

Billions 1997 $

1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005

Gross InvestmentDepreciationNet Investment

CHART 9: CAPITAL STOCK IN PRIMARY AGRICULTURE, 1961-2005

Source: AAFC calculations.

Billions 1997 $

1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005

80

60

40

20

0

Total Machinery & Equipment

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CHART 11

6

4

2

0

-2

-4

Farmland ValueChange (%)

Farm Product Price Change

(%)

Farmland ValueFarm Product Price

8

6

4

2

0

-2

-4

-8

-81990 1992 1994 1996 1998 2000 2002 2004

Source: Farm Credit Canada, Statistics Canada and AAFC calculations.

CHART 12

Farmland ValueChange (%)

Wheat PriceChange (%)

Farmland ValueWestern Prairie Wheat Price

8

6

4

2

0

-2

-4

80

60

40

20

0

-20

-401993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

PRICE DRIVERS OF FARMLAND

According to FCC and Government of Canada research farmland prices generally follow price movements in wheat with a lag as can be seen in Chart 11.

Chart 12 shows this effect on Saskatchewan farmland values versus prairie wheat prices.

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SURVEY OF FOREIGN LAND OWNERSHIP

Currently, Manitoba, Saskatchewan, and Alberta all have restrictions on foreign land ownership that prevents non-Canadian residents from owning substantial amounts of farmland (Saskatchewan – 10 acres, Manitoba – 40 acres, Alberta – 20 acres). Recently, there have been calls for the removal of foreign land ownership restrictions. Supporters of restriction removal believe foreign land ownership would generate new money and capital in the agriculture sector, provide an additional market for farmers who would like to exit the industry, and result in added value to farm incomes, local businesses and communities. Those who oppose the removal of restrictions believe the legislation prevents absentee landlords from buying large amounts of agriculture land, preserves farm land at affordable prices for purchase by present and future generations of Canadians, and supports the development of viable and strong rural communities. Prairie wide, just slightly more than half of respondents (55 per cent) do not believe provincial governments should revise existing farmland ownership legislation to allow foreign ownership of agricultural land.

Source: CFIB, Agri-Business Bottom Line No. 20, May 2006- Prairie Data

CHART 13: SHOULD PRAIRIE PROVINCIAL GOVERNMENTS REVISE EXISTING FARMLAND

OWNERSHIP TO ALLOW FOREIGN OWNERSHIP OF AGRICULTURAL LAND?

AB SK MB

Yes 14% 54% 26%

No 72% 35% 56%

Don’t Know 14% 11% 18%

Don’t Know14% Yes

31%

No 55%

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Global Macro Outlook

SWEDEN CUTS A KEY RATE BELOW ZERO

In its July 2 2009 statement cutting various key interest rates the Swedish central bank, known as the Riksbank, also announced that the deposit rate was being cut to negative 0.25%. The “deposit rate” is the interest the Swedish central bank pays on bank reserves. We now have a major central bank targeting negative interest rates in nominal terms in a key area of the money supply. The effect of this unprecedented move is to pressure banks with reserves on deposit with the Riksbank to lend those reserves or be penalised. If the US Federal Reserve were to follow this policy, arguably it would force US banks to engage in large purchases of assets with their excess reserves rather than face the losses created by negative nominal deposit rates – driving inflation.

NEGATIVE US INTEREST RATES PROPOSED

In a recent article by Paul Krugman he actually argues again for negative nominal interest rates! Krugman states that the “Taylor Rule” says that the Fed should “lean against” both the business cycle and deviations of the inflation rate from a target of roughly 2%, raising interest rates when actual GDP exceeds potential GDP or inflation exceeds the target, cutting rates when the reverse is true. The specific definition of the Taylor Rule is as follows: “In economics, a Taylor rule is a monetary-policy rule that stipulates how much the central bank would or should change the nominal interest rate in response to divergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product (GDP) from potential GDP. It was first proposed by the by U.S. economist John B. Taylor in 1993. Although the

US Fed does not explicitly follow the rule, many analyses show that the rule does a fairly accurate job of describing how US monetary policy actually was conducted earlier under Alan Greenspan. Similar observations have been made about central banks in other developed economies, both in countries like Canada and New Zealand that have officially adopted inflation targeting rules, and in others like Germany where the central bank’s policy did not officially target the inflation rate. “ Source: Wikipedia

CHART 14: THE “ZERO” BOUND

*GS forecasts beyond 2008Q4

Source: William Poole, St. Louis Fed. CBO. Our calculations.

Percent

Federal Funds Rate:ActualTaylor Rule*

10

8

6

4

2

0

-2

-4

-6

-887 89 91 93 95 97 99 01 03 05 07 09 11

Percent10

8

6

4

2

0

-2

-4

-6

-8

9

As Chart 14 shows the Taylor rule indicates that the Fed should cut rates significantly from the current extreme lows — in fact, to a rate of nominal negative 6%.

The problem as perceived by Krugman is that Central Banks cannot cut interest rates below zero (recent Swedish Central Bank actions make that claim incorrect obviously – see “Sweden Cuts a Key Interest Rate Below Zero”). In Krugman’s view, which appears to be shared by the current US administration, the Taylor Rule problem means the US should undertake further large fiscal stimulus and unconventional monetary policy to “re-inflate” the economy – in Krugman’s words “quite literally, the usual rules no longer apply.””

GLOBAL GOVERNMENT FUNDING NEEDS

Can the US Federal government go to the debt markets for US$2 trillion dollars in 2009 and another US$1.5 trillion in 2010? Base case government assumptions are for a downside fiscal deficit of US$1.5 trillion – a figure that has been rapidly growing over the last few months.

At the same time governments in the rest of the world are also ramping up their debt funding requirements. Chart 15 shows the US will need to issue $3 trillion in debt when you include the federal deficit and then off-budget items like TARP, state and municipal debt, etc. Estimates are that globally government debt financing requirements add to US$5.3 trillion without taking into account private sector borrowing needs.

Global Macro Outlook (continued)

CHART 15: POTENTIAL SHORTAGE OF CAPITAL TO FUND TREASURIES

Source: United States Treasury; Congressional Budget Office; Hayman estimates.

Sources and Uses of US Capital ($ in Billions)

Downside(35% Probability)

Base Case(60% Probability)

Best Case(5% Probability)

Sources Uses Sources Uses Sources Uses

$4,500

$4,000

$3,500

$3,000

$2,500

$2,000

$1,500

$1,000

$500

$-

$1.5 TrillionShortfall $542 Billion

Shortfall

$750 BillionSurplus

SurplusShortfallHousehold SavingsCorporate SavingsLeverage Available to BanksNet Capital InflowAvailable CashFed QE Programs (Agency + Treasury)State/Muni ShortfallTotal Federal Government IssuanceNew Corporate Debt IssuanceNew Corporate Equity Issuance

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The World Bank says that total world GDP in 2008 was $60 trillion so approximately 9% of global GDP in 2009 will be required to fund new government debt. It seems unlikely that there is enough capital available to satisfy this demand at current interest rates. Arguably we will see government debt crowd out private debt issuance – not an attractive outcome in a capital short global economy.

CHINA’S FISCAL STIMULUS

Chart 17 shows that China’s commercial bank credit has recently increased by US$1 trillion.

Furthermore, credit is also expanding in other Asian nations. As opposed to the western economies where monetary actions have only resulted in excess banks reserves accumulating, massive amounts of additional money is actually making its way into circulation in developing nations. On aggregate this expansion argues against deflation in the global economy.

CHART 16: 2009 PROJECTED GLOBAL SOVEREIGN DEBT ISSUANCE (IN BILLIONS)

G7 $4,394EMU $ 708EU-27 $1,063OECD $4,822World $5,365

5-Yr. Avg. of Mature Economies $ 1,429

US, $3,018Japan, $536ROW, $421China, $132Germany, $190France, $166UK, $319Italy, $95Spain, $120Brazil, $53Canada, $69India, $117Mexico, $22Russia, $107

CHART 17: EXPLOSION IN CHINA’S BANK CREDIT

Source: Bank of China

40%

30

20

10

0

80%

60

40

20

02003 04 05 06 07 08 09

Year-to-yearchange in loans

(left scale)

New loans as a percentage of

GDP (right scale)

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FED TO REMAIN “ACCOMMODATING” FOR YEARS?

Federal Reserve Bank of San Francisco President Janet Yellen said the prospect that policy makers will leave the benchmark U.S. interest rate near zero for the next several years is “not outside the realm of possibility.” “We have a very serious recession, we have a 9.4 percent unemployment rate,” and inflation

Sources of Capital Uses of Capital

CHART 18: ANNUAL PERCENTAGE CHANGE IN THE MONETARY BASE,

JAN 1, 1961-APRIL 1, 2009

Source: Laffer Associates

120%

100

80

60

40

20

0

-201961 1966 1971 1975 1981 1985 1991 1975 2001 2008

Y2K

9/11

possibly falling further below the Fed’s preferred level, she told reporters yesterday after a speech in San Francisco. Given the recession’s severity, “we should want to do more. If we were not at zero, we would be lowering the funds rate.” Yellen’s comments go beyond those made by other policy makers after a June 23-24 meeting, when they said the federal funds rate will likely stay at “exceptionally low levels” for “an extended period.” They have held the rate, also known as the overnight lending rate between banks, at between zero and 0.25 percent since December.

The Fed “did succeed in averting a full-blown meltdown,” Yellen said in the speech to the Commonwealth Club of California. Nevertheless, the threat of another financial shock, such as one from falling commercial real-estate prices, is “high on my worry list.”” Source Bloomberg. Given the growth in monetary aggregates (shown in Chart 18) coupled with the magnitude of the current fiscal stimulus and the limited effect both have had on the real economy – does the Fed really have an exit strategy?

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EMERGING ECONOMIES TO LEAD FUTURE GROWTH?

Kurt Kasun of GlobalMarco recently asked an interesting question - “Are the developing markets starting to grow beyond the developed world?”

Charts 19 and 20 support the possibility that this may be beginning. In Chart 19 we see that, for the first time, developing countries oil consumption has surpassed that of the worlds’ top 30 (OECD) developed countries.

CHART 19: SHARE OF GLOBAL ENERGY CONSUMPTION (%)

0.700.650.600.550.500.450.400.35

Dec 31 Dec 31 Dec 31 Dec 31 1969 1979 1989 1999

Source: Bloomberg Finance L.P., Chris Puplava “Commodities: Bursting Bubble or Crouching Tiger?” http://www.financialsense.com/Market/cpuplava/2009/0708.html

OECD CountriesNon-OECD Countries

0.51230.4877

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.001 02 03 04 05 06 07 08 09

CHART 20: MONTHLY MOTOR VEHICLES SOLD (MILLION UNITS)

“Emerging 16”US, EU-15, Japan

Chart 20 shows that motor vehicle sales in developed economies have fallen below those in emerging economies.

Source: Dr. Marc Faber Monthly Market Commentary (July 2009) “The Trouble with Our Times is that the Future will Not Be what it used to Be”

#400, 2424 4th Street SWCalgary, Alberta T2S 2T4Canada

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Investing in Agriculture - August Agcapita

Economy & Finance

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