The First Commentary: Investing in Resources
For the period I led CMA I wrote a monthly report of the progress of the company. I plan to do the same thing for investors and potential investors in Craigmore Resources.
This month I first write generally about resource investments in the global context and then go on to outline the specific investment strategy of Craigmore Resources.
Resource Investments in the Global Context
The key determinants of any market are demand, supply and technological change. For 120 years these factors have driven down global relative prices (the “terms of trade”) of the produce of the land. Why? Well my pioneering ancestors have a bit to do with it. Australasia and Africa were colonized by Europeans in the nineteenth century. By the 1870s steam shipping and railways (into e.g. the American mid-west) meant that the abundant agricultural land of these regions could be used to grow grain, wool, and meat for rich markets such as Europe. Supply exceeded demand and, with increasing productivity in agriculture, demand never really caught up (no matter how rich you are, or how cheap food is, you can only eat a certain amount of food each day). Food, having absorbed 25% to 50% of household incomes 120 years ago, fell to perhaps 5% of household incomes. A “glut” or inventory of 200 to 300 days of global demand for food hung over the market, dampening down any short term price action from shortages.
All of this has changed in the past two years. China, a net exporter of foodstuffs until last year, has become an importer. The diet of the new rich economies is shifting in favor of (resource intensive) protein foods. According to the Financial Times food inventories have fallen massively to currently only around 40 days of food inventory to feed the world.
Supply and innovation (including the activities of organizations like Craigmore Resources to raise levels of production from the land) is of course responding. However the food market has very “steep” demand and supply curves. Small changes in quantities (supplied or demanded) can have massive impacts on price. The net result is it appears that the 120 years of real term price declines in the produce of the land is now decisively over.
Amid all the “chaos” it appears that there are three major factors increasing demand for output from land, and one major force which is curtaining land productivity.
The three major factors driving up “demand” for the produce of the land are:
i. Increased wealth in emerging markets
The demand for food in general, and protein in particular, from especially China and India, is already creating shortages of foodstuffs like dairy products. This is going to be an on-going trend and require enormous increases in international availability of grains plus protein products like dairy and meat. Recently the Japanese, aware of food shortages, have tried to negotiate two year dairy supply contracts with Fonterra, the NZ farmer-owned co-op that controls a significant part of the international trade in dairy products. They have not been able to secure the contract. They have been out-bid and out-negotiated by China.
One of the greatest agricultural assets on earth is the deep soils and reliable rainfalls of the American mid-west. The “Maize belt”. One third of the production of maize in this region has recently been diverted to production of bio-fuels (Financial Times report). Similar switches in land use are occurring in Europe (rape seed), in Brazil (sugar cane) and in China. It is clear that especially maize-based biofuels are not particularly “efficient” in their energy usage. However their centrality in American energy planning, where they are viewed primarily as an energy security tool (not as an efficiency tool) and their massive support from the American agricultural lobby mean that it unlikely they will be phased out any time soon.
iii. Carbon Sequestration
The process of photosynthesis absorbs CO2 and produces oxygen. With a global market in CO2 emerging farms like “Te Moata Station” recently purchased by Craigmore Resources look like they will earn a significantly higher yield sequestering CO2 rather than their present use (in this case growing sheep and beef). Te Moata should be able to sustainably sequester around 20 tonnes of CO2 per ha per year. The price of carbon in international markets is around EUR 30 per tonne. Hence around EUR 600 per ha per year gross yield, perhaps 500 after costs. Te Moata cost us around EUR 2,500 per ha. A 20% annual yield looks attractive compared with its current yield from production of meat and wool of around 3% to 4% per year. As understanding of the carbon market becomes more widespread in New Zealand (it is currently in its infancy) we expect these calculations will lead investors to revalue the lower value, remoter parts of high rainfall NZ hill country (the land that grew podocarp forest before it was cleared 100 years ago). We expect this process to drive a doubling or tripling in the value of NZ land like Te Moata. i.e. it might attain perhaps EUR 7,500 per ha – in line with the price of land of comparable productivity in less remote, less mountainous parts of New Zealand.
The key factor reducing the supply/productivity of land is desertification. The spread of shortages of natural water. Australia, in particular, is suffering from a significant reduction in available productivity of dry-land soils as rainfall becomes more variable. This is made worst by a fall in supply of available irrigation water. This is also occurring in other regions of the world (a related paper from the International Water Management Institute is attached).
The above four trends each began “in earnest” only three or four years ago. However the world has only woken up to shortages of “soft commodities” in the past six to 12 months because the price effect was masked by the market’s absorption of the previous excess inventories.
Agricultural price increases began when prices of wheat and dairy products doubled 12 months ago. The price of rice, stable for many years, doubled in the last six months.
The prices of red meats and pork have only begun to move in the past three months. Prior to that a very significant “cull” of stock in Australia (resulting from the drought) and in the U.S. (as farmers shifted resources into bio-fuels and out of beef) meant that red meat prices and pork were actually rather depressed.
This counter-intuitive market behavior is called the “hog cycle” and suggests that red meat and pork prices should recover sharply over the coming period as the market incentivizes farmers to re-build lost breeding flocks and, in turn, produce the young stock (calves, lambs and young pigs) which are the primary source of meat proteins when the market is in equilibrium. Prices of sheep-meats and beef in New Zealand have been depressed for the past two years as a result of the cull of maternal stock and resultant excess supply of red meat globally. However they rose approximately 40% in the past two months. I expect this is the beginning of a very significant upturn in the international price of meat proteins.
Clearly higher prices for agricultural commodities will elicit a supply response. Farmers will strive to convert marginal land and to irrigate dry-land in order to produce more. Scientists will (continue to) develop new and more productive cultivars. We do not yet know for sure whether, once again, agriculture will produce more than the (affluent) world can eat as a result of these supply responses. My view is, however, that it cannot. That marginal land, much as it might be socially desirable it be brought into production of cheap food, is going to primarily be used to produce bio-fuels and carbon sequestration i.e. trees. Just look at the Te Moata example above. To compete with growing trees to sequester carbon the prices of Te Moata’s current meat and wool production would need to approximately treble. That, in turn, would approximately treble the price of agricultural land in Craigmore Resource’s portfolio. And this is at world prices for carbon of EUR 30 per tonne. Many people expect that carbon will need to trade closer to EUR 100 per tonne before behavior is significantly changed.
Biology meanwhile, can only work within nature, not over-leap it, and therefore productivity can only increase at perhaps 1% to 2% per year, not the 5% odd that is needed to meet food, bio-fuel and carbon sequestration forecasts. They are not making any more land. Or water.
So much for the (generally favorable) international market in the produce of the land. What is Craigmore Resources’ strategy?
At the outset at 90% to 95% of Craigmore Resources’ capital will be invested in land. The remainder will be invested in “infrastructure projects”, e.g. a dam to bring water onto dry-land we have purchased for irrigation. Or perhaps a hydro project or a wind power project (NZ has very strong winds such that wind projects in the right areas can be economic in NZ even without government subsidies).
In time I expect we will raise the proportion of “project risks” in CR’s capital base. In the meantime we feel that investors will benefit, for the next few years, simply from the high levels of price rises in agricultural land that we expect, and from the land-use change that we will be working to achieve on our properties. As a new equilibrium is reached in prices for the produce of the land, and therefore in land prices, we would expect to then need to “work harder” to make the consistently good returns that we are targeting for our investors.
I expect Craigmore Resources to make a return of at least 10% every year for investors, and to make 30% in some good years when our larger projects come to fruition. As a result I target an average compound return of at least 15% per year, after fees. Many of you will know that an investment yielding 15% per year for five years will double in value over that period. That is our aim.
Leverage (debt) will be restricted to no more than 50% of the value of assets.
It is likely that we will focus on New Zealand in early years, as we see significant opportunities there and the legal and agricultural infrastructure environment is first rate. In time, however, I expect we will expand the portfolio internationally. There are opportunities to take cutting edge New Zealand farming techniques and apply them in other countries (including e.g. feeding American dairy cows on pasture, in the field, rather than the expensive practice, which is “normal” in the USA, of feeding them harvested grain in a barn).
New Zealand is a small and entrepreneurial country with a volatile currency. The Fund will therefore give non-NZD investors some exposure to fluctuations in the NZD. Generally however these should be hedged by the export nature of NZ land-based production. Commodities, internationally, are generally priced in USD and, as the NZD falls, the value of farmland in NZ rises. For example the NZD has depreciated about 15% against the USD in the past two months (from 20 year highs). I view this as a buying opportunity for NZ assets. New Zealand is a country of four million people with the land resources to feed 60 mm and I view this sell-off (relating primarily to falling interest rates in NZ as an over-heated urban sector goes into recession) as a buying opportunity.
New Zealand has a curious law which means that foreigners may not own land in NZ. Or at least, if like Shania Twain who recently purchased an iconic sheep station in NZ, they really want it, they must apply to the “Overseas Investment Commission” for permission. A process which takes about five months. During this period the local, kiwi buyers will normally have found a way to “slip in front of” any foreigner other than those prepared to pay “top of the market”.
In order to avoid these challenges the first Craigmore Resources Fund will be NZ owned, which is to say it will take in no more than 25% of its capital from outside New Zealand. Potential investors located in foreign parts will nevertheless be allocated up to 25% of the first CR Fund.
The Fund will contract management of the portfolio to a new management company I am setting up called “Craigmore Resource Advisors”. I am building up a team of experienced agricultural experts to help us source and decide upon the best investments and to negotiate e.g. terms on which land can be leased to farmers.
Many aspects of the Craigmore Resources structure are still being finalized. Also please understand that, if you wanted to invest in Craigmore Resources, we would need to ensure that we complied with the securities laws of your relevant jurisdiction. It is important to keep in mind this Newsletter is not an invitation to invest, rather an information document for anybody interested in the progress of the Fund.