Dear Reader,

The topic of today’s guest essay is corn. Stephen Belmont, chief market strategist at RMB Group, joins us to explain why the stuff is unusually cheap, and offers a strategy to profit from corn prices returning to normal.

Steve’s corn trade requires a futures account, so before turning this column over to him, let me quickly offer an alternative idea to those of you with only stock-trading accounts.

Pacific Ethanol Inc., PEIX, an ethanol producer, has gained a whopping 341% year to date through August. Its stock chart is jaw-dropping.

Ethanol fuel, of course, is primarily made from corn. Cheap corn equals fatter margins, so with corn at multiyear lows, ethanol producers are raking in profits. Other ethanol producers up big in 2014 include Green Plains Inc. (GPRE, up 131%), and REX American Resources Corp. (REX, up 142%).

If you want to bet on rising corn prices without using futures, consider shorting one of these high fliers. You’ll have to do your own due diligence, but I strongly suspect that these companies’ breathtaking run-ups are not sustainable—especially since it’s a matter of when, not if, corn will return to more historically normal prices.

With that, here’s Steve. This article originally appeared in World Money Analyst—a publication that I consider required reading for its unmatched boots-on-the-ground intelligence on international investment opportunities. Enjoy.

Dan Steinhart

The New Gold

The need for food is unrelenting and universal. It has been the force behind mass migrations and wars. English cleric and scholar Thomas Malthus (1766-1834) was fascinated by the relationship between population and food. He believed food production increased arithmetically while human populations grew geometrically, and predicted humans would have to 1) limit their population growth voluntarily, or 2) have it limited for them naturally by scarcity, famine, and disease.

What Malthus didn’t see coming was the discovery of crude oil (and other hydrocarbons, such as natural gas) which enabled humans in developed nations to dramatically increase food production to levels inconceivable in his time. The chart below shows the impact of this discovery. Crude began flowing from the first commercial well in Titusville, Pennsylvania, in August 1859. In 1850, world population was 1.2 billion. Today it is 7 billion. Poor Malthus got blindsided by the future.

Today “Malthusian” is often a derogatory term hurled at those predicting catastrophe of any kind. Its implicit message? We will find a way to keep feeding our growing population no matter what. All we have to do is wait for the next big discovery.

We are not predicting catastrophe. But having enough food—at least in the developed world—is not the same as having cheap food.We believe there are a number of factors converging right now that have the potential to greatly impact the cost of what we need to survive, not the least of which is the connection between the price of grain and the price of hydrocarbons—especially crude oil and natural gas.

This makes sense, because farm productivity relies on two key factors: mechanization and fertilizer. Crude oil produces the diesel fuel to drive the former. Natural gas provides the nitrogen to enrich the latter. Higher energy costs directly impact the price of food.

“Crude and Food” Connection

The chart below shows the correlation between food prices and crude oil through 2012. This correlation has broken down in recent months, providing us with what we believe is an excellent opportunity to own grain cheaply. (We’ll detail two strategies later in this report.)

Perhaps the most ironic part of the crude-food connection is the relationship between high oil prices and the price of food in oil-producing economies. The graph below shows the percentage of income spent on food in nearly every major nation—the larger the circle, the greater the percentage.

Hungry people are angry people, so we are not surprised that the countries which spend more money on food tend to be those either involved in, on the brink of, or just recovering from violent internal clashes. Unfortunately, we expect to see more of this as prices climb. Since many of these violent clashes are occurring in the oil-rich Mideast, we don’t expect crude oil prices to drop substantially any time soon. Our real fear is a cycle of violence, leading to higher crude oil and food prices, which sow the seeds for even more violence.

Where’s the Beef (and Pork and Chicken)?

The price of crude oil is not the only fuel for higher grain prices. The world—particularly China, which has managed to feed 25% of the world’s population on just 7% of the planet’s arable land—has done a pretty good job of producing food. However, the newfound prosperity of the Middle Kingdom and the rest of Asia is changing dietary habits. Populations in developing countries are consuming more meat. A meat-rich diet requires far more fertilizer and water than one based on grains and legumes.

Meat is grain (and water) in another package. It takes 4.5 pounds of grain to produce 1 pound of chicken meat; 7.3 pounds to produce 1 pound of pork; and 20 pounds to produce 1 pound of beef. Only 4% of the protein in corn is converted to edible protein in beef. It’s just 10% in pork and 20% in chicken.

The global demand for animal protein is increasing rapidly, according to the Food and Agriculture Organization of the United Nations (FAO). Global meat consumption increased from about 100 to 235 tons from 1970 to 2000 and continues to climb. In the meat-eating US, livestock consumes 7 times the amount of grain consumed directly by America’s entire human population. Asia hasn’t approached this level yet, but its higher standard of living means the demand for meat will continue to grow.

While the Chinese prefer pork, their demand for beef—the least protein-efficient meat—is pegged to increase substantially and jack up imports from 75,000 to a record 500,000 tons, according to the USDA. There’s a whole lot of grain chewed up in those numbers.

The desire to eat more meat increases the demand for grain. More grain requires more arable land and more water. Both are currently in short supply in China. China recently admitted that 19% of its farmland was polluted and that 8%—roughly 8 million acres—was too polluted to grow anything.

And we haven’t even mentioned water…

The Chinese economic juggernaut has left watersheds depleted and many sources of aboveground water polluted. Not only is China losing farmland, it is losing the ability to adequately irrigate what’s left.

China has not yet lost the ability to feed itself, as it remains one of the world’s biggest corn producers. However, higher demand, combined with shrinking acreage and lack of water, pose a threat. China’s arable land per capita is less than half of the global average, and 20% of it is polluted and 40% is degraded; five of China’s largest freshwater lakes have substantial dead zones, due to fertilizer runoff (Mother Jones, August, 2013). Because of these and other factors, we expect to see a steady increase in Chinese imports of critical agricultural products, including grains and oilseeds, as well as the potential for higher prices down the road.

Corn and Climate Change

One can debate the causes all they want—how politics got mixed up with weather, we have no idea—but we live in an era of significant climate change. Loss of sea ice, numerous heat (and cold) waves, stronger hurricanes, and longer, more severe droughts are all part of the same package. It’s not that these haven’t occurred in the past, but the frequency of these “freak” weather events is climbing.

Weather is, by far, the biggest factor in the price of grain. On the chart below, notice the increased volatility of corn prices since the 2008 drought compared to the period prior. The culprit is mainly weather. Good growing conditions returned in 2009 and 2010, only to be replaced by major climatic events in 2011 and 2012. What will the next 12 months bring? Only Mother Nature knows for sure. Nonetheless, there is no question that the weather (and corn prices!) are much more volatile.

Data Source: Reuters/Datastream

Peaks in the price of corn tend to occur during the mid-summer maturation phase, after which the crop is either “made” or not. Expectations of perfect growing conditions this year have driven the price of the yellow grain into oversold territory, right above support at $3.50 per bushel. This has happened despite crude oil prices north of $100 per barrel and a big rally in natural gas. The costs to grow corn are rising while the price of corn is falling. This is a phenomenon that cannot last long.

As the chart above suggests, summer expectations, whether bullish or bearish, have a pronounced tendency to reverse themselves over the course of the next few months and years. It would not surprise us to see a similar reversal from the current support zone as well.

Most of the corn grown in the US is used to either feed livestock or be distilled into ethanol. Roughly 1/3 of the crop is dedicated to the latter, and that percentage appears to be climbing. The higher the cost of gasoline, the more profitable it is to blend cheaper ethanol into it. It is yet another reason why high crude oil prices tend to reinforce higher corn prices in a normal environment.

Will El Niño Have an Impact?

Many forecasters predict the return of El Niño this year. This weather phenomenon results in higher temperatures in the Eastern Pacific (off the west coasts of North and South America) and lower water temperatures in the Western Pacific. El Niño is associated with drought-like conditions in corn-growing areas of China. China has already increased corn imports over 200%, due to many of the problems we highlighted earlier. A drought on top of all this would be devastating. However, China’s huge foreign reserves would enable it to make up the difference by purchasing corn from Argentina, Brazil, and the US. This would help support prices on this side of the Pacific.

El Niños are also known to delay or disrupt the Asian Monsoon. This could potentially impact food production in India, home to 1.25 billion people and the world’s second most populous country after China. Previous El Niños have been associated with drought in Australia, affecting key wheat growing areas and creating an environment for catastrophic bush fires. On the other side of the Pacific, too much rain during South American spring could delay planting in Brazil, negatively impacting corn yields there.

Protein Is the New Gold

Corn is consumed. That means it will react much more rapidly to changes in supply and demand than physical gold.

The US is the world’s largest producer and exporter of corn, but most of it is earmarked to feed domestic livestock and make ethanol to blend into gasoline. The world’s second-largest producer of corn, China, is faced with polluted cropland and possible El Niño-inspired drought conditions for the next two years. That leaves America as the “go to” source in case of an emergency.

Source: FAO

Corn requires lots of arable land. The US has plenty, but not all big corn-consuming countries do. The graph above shows the effects of a growing population on the shrinking supply of land. Harvested acres per person have dropped nearly 40% in the last half-century. Some of this drop can be attributed to advances in technology, including genetically modified hybrids, but not all. The developing world is losing farmland at the same time diets are changing. Odds are it will need to rely on big North and South American crops in order to meet demand.

USDA expectations for a big American crop have left corn much cheaper on a relative basis than gold. Near-perfect growing conditions in the corn-producing regions of the US have driven the price of the golden grain down to levels not seen since summer 2010, just before the big 2011 run-up.

Even if the forecast for a big US crop pans out, global stockpiles will be at a relatively low level. This will leave the market vulnerable to any bullish surprises and continue the volatility that has defined it since 2005. The USDA estimates corn ending stocks as a percentage of global demand to be at roughly the same level they were in 2009, during the last cyclical low in price, and that’s assuming a record US crop this year.

“Harvest” Your Own Corn Crop for Pennies on the Dollar

Recent weakness in the golden grain is giving us the opportunity to take a long-term, low-cost bullish position, with the potential to pay off substantially should corn continue its volatile roller-coaster ride and rebound from current levels. We’ve chosen corn because it is cheaper on a relative basis than wheat and soybeans, although many of the same long-term bullish forces are at work in these markets as well. Corn is also the beneficiary of American ethanol demand. This keeps huge amounts off the international market and helps support price.

So how do we play it? Instead of sinking a lot of capital into expensive farmland or buying agricultural companies whose stocks may or may not rise with the price of corn, we “rent” the golden grain for approximately two years. How do we do that? We’re recommending our trading customers use corn options traded on the Chicago Board of Trade (CBOT). Our first price target is $6.50 per bushel, and our second is $7.50 per bushel.

Data Source: Reuters/Datastream

Stephen Belmont is chief market strategist and senior partner with the Rutsen Meier Belmont RMB Group, a futures and futures options brokerage firm in Chicago that specializes in commodities, currencies, and interest rates since 1984.