GROWING PROFITS
by Elliott H. Gue
Editor, The Energy Letter
November 10, 2006

Ironically, one of my top long-term growth themes in The Energy Strategist is agriculture. While farming and energy may seem incongruous, nothing could be further from the truth; in fact, they're intimately related. I suspect that, over time, energy analysts will find themselves as intimately knowledgeable about soybeans, corn, sugar and palm oil as they are about crude and natural gas.

The unappreciated link is biofuels. A decade ago, biofuels, like ethanol and biodiesel, weren't a major factor in the agricultural markets and could be safely and legitimately ignored. But corn is no longer just an ingredient in your morning bowl of cereal or in feed for livestock; it's also the key component of ethanol produced in the US.

Demand for crops as biofuels is increasingly in competition with growing global food demands. Demand for food is rising not because the global population is growing, but because the global population is becoming wealthier.

We've all heard that Americans and many Europeans are becoming fatter because, quite simply, they're eating more food--particularly food that's unhealthy, such as prepared snacks and fatty oils. This trend is nothing new; consumers tend to consume more food and more processed foods and meat as they become wealthier. Check out the chart below for a closer look.


Source: Food and Agriculture Organization of the United Nations

This chart uses data provided by the United Nations known as food balance sheets. For each country, these balance sheets detail the type of foods consumers eat in great detail. I've used China's balance sheets going back to 1961 to produce this chart. I calculated the total number of calories the average Chinese consumer eats per day in a given year. I then calculated what percentage of that total intake came from meat or animal products consumption. For example, a figure of 20 percent indicates that roughly a fifth of total calories came from meat in a given year.

The graph clearly illustrates that meat consumption in China is growing rapidly. Average daily calorie intake grew nearly 80 percent between 1961 and 2003, but meat consumption grew by more than 11 times during the same period.

While animal products accounted for barely 5 percent of daily consumption as recently as 1970, by 2003, meat was already more than 20 percent of the diet. There remains room for more upside; in the US and Germany, meat accounts for as much as a third of consumption.

This same basic pattern has repeated on multiple occasions throughout history. In poorer countries, consumers derive their daily sustenance mainly from basic grains known as cereals; wheat and rice are two common examples.

But as countries become wealthier, meat intake rises, as does consumption of processed foods such as cheese, alcohol and sweets. As you might expect, total daily calorie consumption also rises. The wealth effect on food upgrading is the more powerful trend, however.

You might be asking at this point what this has to do with biofuels. Simply put, it takes eight to 10 pounds of grain and feed to produce a pound of meat. These figures vary depending upon the type of meat produced, but 8-to-1 is a decent rule of thumb.

As meat consumption rises, the effect on grain and feed demand rises at an even faster pace. With literally billions of consumers in emerging markets now demanding more processed meat-based foods, there's an ever-expanding wall of demand for products like soybeans, corn and wheat.

These are the very products that are also used to make biofuels. These two uses are increasingly coming into competition with one another.

The US Dept of Agriculture estimates that around 17 percent of the 2006 US corn crop will be converted into ethanol, up from almost zero a decade ago; ethanol consumption is up more than 20 percent this year alone. Thanks to government ethanol mandates, the fuel will account for some 30 percent of the US corn crop by 2012. That's more corn than the US currently exports.

Meanwhile, China was long a key corn exporter in Asia but is likely to become one of the biggest global importers during the next five years as demand for food and corn feed rises. Much of that corn will come from the Americas (the US and Brazil).

The combination of rising biofuels demand and rising Chinese corn demand spells a bull market in this key commodity. And corn is only one major commodity that's benefiting from the biofuels boom.

Increasingly, even more exotic commodities are gaining attention. For example, agribusiness giant Archer Daniels Midland announced this week that it plans to make investments in sugar and palm oil. The company is currently a giant in corn and ethanol markets but has only minimal exposure to sugar and palm oil.

The strategy is being spearheaded by the CEO of ADM, Pat Woertz, who was formerly an executive at oil giant Chevron. That's an obvious sign of the importance of biofuels and energy to ADM's business. Woertz is also looking to expand ADM's biofuels business to emerging markets like Asia and Brazil.

I've been playing the biofuels theme in The Energy Strategist by buying stocks that benefit from the growth in agriculture; companies that produce fertilizers, sell pesticides and own plantations are just a few examples. That strategy has paid off: My average biofuels pick is up roughly 15 percent since the end of September alone.

But it's also worth keeping an eye on the physical commodities themselves. For that information, I turn to my friend George Kleinman, editor of the free e-zine Commodities Trends (www.commoditiestrends.com). He's put together an absolutely fascinating series on the booming corn and grain markets. I encourage all readers interested in commodities to check out his August 21 issue, Fortunes Made: Repeat in the Making?, and October 16 issue, Grain Fortunes.

A Look Ahead

In the next issue of The Energy Strategist, my focus will turn once again to income. One of my long-term favorite groups has been the master limited partnerships (MLPs). MLPs offer high yields, certain tax advantages and are highly flexible. You can play trends as diverse as liquefied natural gas (LNG), coal and pipelines by purchasing MLPs.

But far and away the main advantage of MLPs is the potential for growth in distributions. If history is any guide, within a few years you could easily be earning annual yields on your original investment exceeding 20 percent. Let me explain.

I ran a few calculations on one of my favorite MLPs. Assume you invested $25,000 in this New York Stock Exchange-traded partnership at the close on the last trading day in 1999. In your first year of owning the MLP--the year 2000--you would have earned some $2,779 on your $25,000 stake in distributions alone, a yield of just more than 11 percent. Although that's not a bad return by any stretch of the imagination, dividends have grown considerably since 2000.

This year, for example, you would have earned about $4,867 on that initial stake. Based on your original $25,000 investment, that's a yield of nearly 19.5 percent. And based on current estimates, the yield on your initial $25,000 stake will top 21 percent next year.

Of course, that doesn't even factor in the $50,000 or so in capital gains enjoyed since 2000. The chart below gives a closer look at how the yield on your $25,000 investment has grown over time.



Source: Bloomberg

Whenever I mention these high-dividend plays, I receive e-mails concerning the tax complications. Instead of paying dividends and sending out a standard form 1099 for dividends, MLPs are partnerships and issue K-1 forms at tax time. There are also some potential tax issues for those wishing to hold MLPs in tax-advantaged retirement accounts.

I find the rewards of investing in MLPs worth the additional legwork at tax time; many subscribers I've spoken to simply use a tax professional to do the work for them.

But for those worried about the tax implications of investing in MLPs, I've found a way around these issues--a way of investing in MLPs without having to deal with a form K-1. Instead, you'll simply receive fully qualified dividends and a form 1099 at the end of the year. I'll be outlining that strategy at length in the next issue.

Elliott H. Gue is editor of The Energy Letter.

© 2006 Elliott H. Gue

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