In Search of Sunshine, Water and a Safe Haven in the Brazilian Highlands

In This Edition

The Brazilian Highlands comprise potentially the most productive agricultural region on earth. Rich in soil, sunshine and water, in theory their produce could feed most of the world. The present reality, however, is far different. A remote location, poor infrastructure and corruption render the region far less productive than it would otherwise be. But given excessive debts, zero interest rates and associated asset price bubbles in much of the world, investors must search far and wide to find undervalued assets that can serve as protection against the risks of default, debasement and devaluation. Earlier this year I set out by airplane, automobile and tractor to survey the Highlands. In this report, I summarize my key observations and some associated investment ideas.

[Hear More: Ned Schmidt: This Year Likely Marks the Bottom in Agricultural Commodities]

Miles From Nowhere

For much of my working life I worked for major banks as a global macro investment strategist. While this occupation required frequent, long-distance travel, at least I was generally able to fly business class and stay in modern, city-center hotels.

While I hardly regret my decision several years ago to set out working independently, with rare exception I now travel in more humble fashion: economy class by air; spartan accommodations on the ground. Yet when it comes to the Brazilian Highlands, humble is simply the only class of travel. And so, when I was invited to visit the region and tour some large farming operations earlier this year, I packed my bags appropriately with clothes that would not show the dirt and dust; a hat to block the intense sun; boots that could handle the heavy mud; and some skin cream that would supposedly repel the bugs (which it did rather effectively, I would add).

On arrival at the Brasilia airport I was greeted by two drivers, neither of whom spoke any language other than Portuguese. This was not a problem as I speak a few words and they knew who I was and where we were going. But on the long, long car journey to the town of Luis Eduardo, communication difficulties became a source of entertainment and, at times, frustration. In one instance, the drivers attempted to explain that the traffic was unusually heavy and so the trip would take nine rather than the expected eight hours. My minimal knowledge of Portuguese—I vacation in Portugal with my family most summers—resulted in a misunderstanding that we had only one more hour to travel. Sadly, we were only about halfway to Luis Eduardo at the time.

Most readers of this report probably have never heard of Luis Eduardo. But although you might not have heard of it, you are almost certain to have served up some of its produce on your dining table; to have worn an article of clothing made of its cotton fiber; or to have drunk a cup of coffee brewed from local beans.

Luis Eduardo is located deep in the Brazilian Highlands that rise up out of the Amazon basin to the west and the north and stretch all the way to the Atlantic coastal cities of Sao Paulo and Rio. In total they comprise nearly half of Brazil, some 4.5mn square kilometers. Luis Eduardo is in Western Bahia, west of the São Francisco River. Western Bahia consists of 6 million hectares, of which 4 million is suitable for rain-fed or irrigated agriculture. In general, it can be divided into two sub-regions: the "Valley", characterized by clay soil and undulating topography with an altitude of 500-600 meters, and the “Cerrado Highlands”, where Luis Eduardo is situated, which is flat and consists of more sandy soils and an altitude of approximately 800 meters.

Not all of Western Bahia or other parts of the Highlands are comprised of producing farmland. Indeed, only a fraction is already under cultivation. That fraction, however, has been growing fast and has tremendous future potential. This is due in part to its proximity to the equator, ensuring much sunlight; the fair quality and diversity of its soil, providing for a huge variety of crops; and, perhaps most important, a sufficient and highly reliable supply of fresh water, courtesy of the tropical rains.

Some readers may be aware that, in some parts of the world, fresh water is in increasingly short supply. Once a given arable region reaches what might be called ‘peak water’, it is probably inevitable that it becomes less efficient and, unless other additional inputs are provided accordingly, less productive. While I don’t want to sound Malthusian,[1] the fact that much of the world’s existing farmland faces some sort of water supply constraint implies potentially higher production costs. This is increasingly true of the US plains breadbasket, for example, which has drawn down its underground water table in recent decades to levels that threaten the future productivity of this hugely important region.

U.S. Water-Table Depletion to 2008

Water is precisely why the Brazilian Highlands have such a natural advantage: Not only do they receive, on average, sufficient rainfall for all commonly-grown crops; they can also draw on huge underground water tables to carry them through the occasional year of relative drought. Combined with the equatorial-proximity, powerful sunshine, the region is well on the way to becoming the global ‘breadbasket’ of the 21st century.

I use the term ‘breadbasket’ loosely here: Of all the major global staple crops, wheat does particularly poorly in the highlands due to a lack of winter frost to kill off pests. But when it comes to soyabeans, rice, corn, cotton, sugar, coffee, and a broad range of specialty agricultural products such as tropical fruits, the Highlands have more potential for expanding the production of the above than any other region in the world, and by a wide margin.[2]

Tractors, Trailers and Automobiles

For all this vast potential, however, most of the agriculturally productive parts of the Highlands are not yet easily accessible to the global marketplace, in that they lie at great distance from the ports at Salvador and near São Paulo. Yes, there are some roads, but most are narrow and subject to seasonal flooding. There is only so much capacity for transport from the Highlands to the ports and it falls way, way short of the region’s agricultural productive potential.

Until recent years, Brazil struggled to attract substantial foreign investment, in part due to political instability. Coastal regions have claimed the vast bulk of what has come in. The Highland interior, by contrast, has received comparatively little outside of the sprawling metropolis of Brasilia.

The lack of transport infrastructure is palpable.

Although it is possible to fly directly into Brasilia from Europe and North America, access to the agriculturally productive areas requires long journeys by road. When it comes to transporting produce at peak harvest times, road congestion is severe. It can take fully 24 hours for an articulated lorry to complete the journey from Western Bahia to a shipping port at the coast. And the ports themselves can have issues as facilities are not yet capable of handing the peak traffic, providing surplus storage or loading ships at all under conditions of unusually high or low tides.

By way of example, Chinese soybean customers reneged on large Brazilian soybean purchase contracts earlier this year, citing unacceptable delays in loading bulk carriers at Salvador. This left the local grains brokers in a difficult position, holding huge excessive inventory with no immediate buyer. So while the farmers may have, in aggregate, manageable risk around production, the transport providers, brokers and other middlemen have complex logistical risks to manage and therefore must demand large premiums over production cost.

The solution to this logistical problem is obvious: The Brazilian federal or various Highland regional governments could work with private firms to build a modern railway infrastructure linking major Highland agricultural towns with the coast. Luis Eduardo to Salvador, for example, would be a prime route for such a project. But what makes sense on paper can be complicated in practice and the politics of railroads or other public works projects in Brazil are anything but straightforward. Even if a plan were to be put in place tomorrow, it would be many years before the infrastructure was operational to the point of relieving the existing logistical bottlenecks that promise to only get worse in the meantime.

There is also the stark reality of doing business in a frontier market. As is the case in all developing economies, the rules of doing business are not always clear and what qualifies as ‘fair’ business practice to one may appear to be a form of ‘corruption’ to another. Greasing the gears of agricultural production, processing and transportation in remote parts of the Highlands requires on-the- ground, first-hand knowledge and strong local relationships. A global agro company can’t just parachute in, buy up a big farm, and expect to run it efficiently from the get-go. Indeed, one thing I learned on my trip is that the larger the farming operation, the LESS profitable it tends to be, with mid-size family operations the most profitable. There is a reason for this. You can trust your family, and a hardworking family can run a mid-sized farm. Large farms can only be run by large businesses and, at that point, some degree of corruption tends to creep in around the edges, reducing profitability and introducing qualitative risks that can be difficult to manage. As the region’s wealth grows, progress no doubt will be made in this area. But as with the logistical situation, we are talking years here.

Another aspect that can make business difficult is the availability of trade credit, or rather the lack thereof. Rates of interest on trade credit are extremely high in Brazil, starting at 20-30% for creditworthy farmers. (Rates can exceed 100% for weak credits, believe it or not.) This is due to high rates of default, as local law allows farmers to default on trade credit, yet keep the title to their farms. As such, lending is secured on crop production only, not on the land itself, and creditors require high rates of return to compensate for the combination of frequent defaults and inability to claim land in compensation.

From the perspective of the global agricultural marketplace, therefore, it is unreasonable to expect that the Highlands are going to be able to supply a vastly greater amount of production over the coming decade. The infrastructure just can’t support it. The difficulties of operating efficiently on a large, agribusiness scale are just too great. To paraphrase Coleridge, there might be “water, water everwhere,” but not more food to eat.

Implications for Agricultural Commodities and Investments

The Highlands offer theoretically vast future potential, both outright and relative to other agricultural regions of the world. Those seeking to invest in farmland for the long-term should familiarize themselves with the region, as difficult as that can be.

Yet notwithstanding this tremendous future potential, it is clear that the effective, logistically- adjusted production capacity of the Highlands is not going to continue to grow at the same rate as over the past decade. This has a number of important implications. First, when combined with the growing water constraints in other regions mentioned earlier, world grain output is not going to be able to grow as quickly until the Highland logistics are materially improved. Second, now that the logistical infrastructure is operating at full capacity, Highland farmers are increasingly likely to switch some production over to higher value-added crops, such as tropical fruits and high-grade Arabica coffee. While this might be nice for those who enjoy their papaya juice, avocados and strong espressos, other factors equal it could imply upward pressure on global staple grains prices in the coming years. Naturally prices will rise and fall with global weather patterns, but the secular trend is more likely to be up than down.

Readers should therefore consider whether the current, low level of grains prices is an opportunity to start building a position. Soybean prices have recovered somewhat of late but are not high in a historical comparison. Wheat is not a Highland crop, but wheat prices are also depressed and water constraints could reduce yields and/or increase the costs of wheat production in several regions in future, impacting the global market at the margin.

Wheat and Corn Prices Now at Mult-Year Lows

Also worth noting is that livestock prices, in particular cattle, have been rising in recent months even as feedstock prices have declined. Such fluctuations happen all the time but occasionally they become extreme, and all the grains appear to offer unusually good relative value at present versus livestock, even if livestock prices themselves are not particularly high in a longer-term historical comparison.

Cattle Prices Rising as Grains Fall

Finally, I pointed out some weeks back that coffee had cheapened up to the point where it offered good relative value when compared to other tropical products, in particular cotton.[3] Coffee prices have yet to recover, although the downtrend has slowed substantially. Cotton prices have slipped a little of late, but speculative net long positions remain sizable and reports that China may begin de- stocking, if true, could send prices sharply lower in the coming months. From a risk-reward perspective, therefore, cotton remains a sell here.

Coffee Prices are Severely Depressed

That said, the Amphora Report investment mantra is always and everywhere to protect against the growing risks of debt deleveraging, default and devaluation, taking full advantage of commodities diversification. Developed economy governments and central banks continue to buy time with stimulus of various kinds but I see no evidence of the fundamental structural reform that would be required to resume healthy rates of sustainable economic growth, enabling them to pay down their colossal accumulated debts. Indeed, the risks are tilted toward further capital misallocation due to the unprecedented degree of policy activism and market manipulation of interest rates, currencies, credit spreads and, by extension, equity market valuations.

Therefore, while livestock and cotton might look expensive in relative terms, I would not advise my readers to go outright short, as that implies going ‘long’ some fiat currency at risk of devaluation. No, the better strategy is to go short commodities that appear overvalued and long commodities that appear undervalued. In this way, investors can take advantage of the natural, speculative overshooting that takes place in commodities markets without exposing themselves to the risk of a resumption of the global financial crisis, a sudden surprise debt restructuring, bank bail-in, or currency devaluation.

Finally, in closing, my recommendation from back in July to begin adding to gold holdings again remains in place as gold has again sunk below ,400. A floor appears to have been put in alongside depleting inventories in New York and London. Physical demand in Asia remains strong and attempts by the Indian government to rein in gold demand are backfiring as the rupee slips sharply lower. We are thus in a highly favorable environment for gold again and I would not be in the least surprised were gold to resume its secular bull market before the end of this year. In particular, in the event that the Fed gets cold feet regarding the rumored, upcoming ‘taper’ of QE, gold could recover sharply in a short period of time.[4]

Gold Re-Entering the Bull Market?

Readers’ feedback is always appreciated, so if you like to contact me regarding this report please do so at [email protected]. Note also that the Amphora Report is in process of a transition to a paid subscription service, so please contact me if interested. Also, I am a semi-active ‘tweeter’ on the topics of international economics, finance, monetary policy, commodities and investment strategy generally. If you would like you can follow me at: https://twitter.com/ButlerGoldRevo

Resources:

[1] The Rev. Thomas Malthus was an early economist who postulated that resource depletion would eventually constrain economic growth, in particular with respect to agricultural production. Malthusians to this day continue to make a similar argument, although technological innovation has, so far at least, kept well ahead of resource depletion.

[2] With respect to grains, the black soils of the Ukraine still offer much potential for modernization. However, while the soil is extremely high quality, other factors, including extreme winter cold, make the region completely unsuitable for a large number of agricultural products.

[3] Please see "Will the Fed Re-Arm the Bond Market Vigilantes?" Amphora Report vol. 4 (July 2013).

[4] Please also see "Will the Fed Re-Arm the Bond Market Vigilantes?", as referenced above, to see this recommendation to add to gold holdings and a discussion of the Fed ‘taper’ plans.

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Vice President, Head of Wealth Services