In the first half of 2011, the price of pork–a staple meat in the Chinese diet–surged nearly 40 percent, hitting consumers’ disposable incomes hard. To combat runaway prices and ease supply shortages, the Chinese government resorted to releasing frozen pork supplies from its 200,000 metric ton national pork reserve. And food prices were one of the key drivers of the spike in China’s official inflation figures to a high of 6.5 percent last July, prompting the government to raise interest rates and hike bank reserve requirements.

China’s ongoing struggles with food price inflation aren’t unique. A spike in corn prices in Mexico in the summer of 2008 made corn tortillas, a national food staple, unaffordable for most Mexicans and sparked large-scale riots in parts of the country.

And in some countries across the Middle East and North Africa, food accounts for more than 40 percent of the average consumer’s budget. A rapid rise in food prices was a major cause of civil unrest in several countries during last year’s Arab Spring.

The cost of agricultural commodities rarely receives as much media attention as the price of oil in the developed world, but it’s of paramount importance for most fast-growing emerging markets.

A Long-Term Secular Shift

According to the World Bank, the global population is set to rise by nearly one-third between 2010 and 2050, from 6.9 billion to over 9 billion, adding to the challenge of meeting global food demand. But contrary to popular belief, the biggest problem isn’t the number of new mouths to feed, but a major secular shift in diets across the emerging markets.

As consumers’ disposable incomes rise, diets become more diverse and meat consumption tends to increase. In the least developed and poorest countries in the world, the vast majority of calories consumed are in the form of basic cereals, such as rice and wheat. In Bangladesh and Chad, for example, cereals account for 78 percent and 61 percent of total calories consumed by the average citizen, respectively. In Chad, the average consumer eats less than 15 kilograms of meat and fish per year, while in Bangladesh the total is less than 4 kilograms.

By contrast, in a developed, industrialized economy such as Germany or the US, basic cereals typically account for just 20 percent to 25 percent of the total diet, and the average consumer eats well over 100 kilograms of meat per year. There are historic, religious and cultural dietary differences between countries, but consumption of more expensive and resource-intensive products such as alcohol, fresh vegetables, fruits and edible oils also tends to rise with income.

Fast-growing emerging markets lie somewhere in-between these two extremes.

Source: Bloomberg

As the chart above shows, consumption of meats in the BRIC countries—Brazil, Russia, India and China—has risen from about 29 kilograms (64 pounds) per capita in 2001 to more than 35 kilograms (77 pounds) at the end of 2010, a gain of more than 20 percent. Nevertheless, the average consumer in the BRICs still consumes less than one-third as much meat as their counterparts in North America. And despite China’s cultural taste for pork, the average Chinese consumer still eats less than half as much meat as their peers in the US and Canada.

But that gap is closing and continued strong economic growth means that the diets of citizens in the emerging markets will continue to evolve toward a greater resemblance to those of consumers in the US or Western Europe.

From an agricultural standpoint, this well-established trend presents a significant challenge because meats, fruits and vegetables are far more agriculturally intensive products than basic cereals. It takes 7 kilograms (15.4 pounds) of feed grain to produce 1 kilogram of beef (2.2 pounds); 4 kilograms (8.8 pounds) of grain to produce 1 kilogram of pork; and 2 kilograms (4.4 pounds) of grain to produce 1 kilogram of chicken. As consumers increase their meat consumption, there’s a massive multiplier effect–demand for grains grows at a faster pace than meat demand.

And it’s important to note that these consumption figures are measured on a per capita basis. The BRIC countries account for nearly one-third of the world’s population–even small changes in per capita meat consumption can have a dramatic impact on the total tons of corn and soybeans needed to produce feed.

An equally important issue is how the world’s producers will be able to meet fast- rising global demand for key agricultural products like corn and soybeans.

Source: Bloomberg

Even as the global population grows and demand for key grains like corn and soybeans increases, the amount of arable land available worldwide has actually fallen over the past two decades. Some of the largest recent losses in arable land have occurred in countries that have fast-growing demand such as China. One of the big challenges China faces is desertification, a process where increased use of water resources means that some formerly arable land is turning into barren desert.

As the chart above shows, in 1961 each hectare of land (2.471 acres) had to feed less than 2.5 people. But by the end of 2008, agricultural intensity had doubled and that same hectare of arable land needed to feed about 5 people globally. And it’s only going to get worse: The United Nations optimistically predicts 10 percent global arable land growth by 2050 to support another 30 percent to 35 percent jump in the size of the population.

That might seem like an impossible feat, but it’s actually part of a long-term trend that began during the Agricultural Revolution of the 18th and 19th centuries. The secret behind such gains is the increase in crop yields, the amount of corn or wheat that a single acre of land can produce. Over the past few centuries, farmers have developed numerous methods to increase productivity, including crop rotation techniques, better irrigation, the use of machinery to harvest and plant crops, pesticides and herbicides to decrease plant stress, fertilizers and, most recently, the use of genetically modified (GM) crops.

GM crops may be controversial, but they are a major contributor to the growth in agricultural productivity. Modern GM variants are being designed to exhibit certain beneficial traits, such as resistance to pests and drought conditions. While few think of farming as a high-tech business, GM seed companies such as US-based Monsanto (NYSE: MON) are developing corn and soybean seeds that offer 10 or more “stacked” traits in a single plant, boosting yields per acre to record levels.

Source: Bloomberg

The gains from rising crop yields have been dramatic. In 1960, world farmers could, on average, extract 1.95 metric tons of corn from a hectare of land compared to more than 5 million metric tons from the same parcel of land today. Yield gains are evident for wheat, soybeans and rice and will be necessary in the future to support demand from emerging markets.

Although the introduction of GM crops has certainly helped push up yields in recent years, proper fertilization remains one of the most important steps farmers can take to boost yields. Global fertilizer sales are roughly $200 billion annually, making it among the more investable themes in agriculture.

Crops remove certain nutrients from soil over time, and if that process goes unchecked, yields per acre will drop precipitously. To replace those nutrients, farmers fertilize must their soil. The amount and types of fertilizer used depend to a great extent on varying soil conditions in different parts of the world, as well as the type of crops being cultivated.

There are three main types of fertilizer used in the world today: potassium chloride (potash), phosphate and nitrogen.

Potassium chloride is mined from ore deposits created when oceans and seas dried up millions of years ago. With the passage of time, most of the world’s ores have been covered by earth and are now located deep underground.

To create potash that’s used for crops, the potassium chloride is separated from impurities such as salt, and then dried and prepared into either solid pellets or a liquid product.

The largest producers of potash in the world, based in Canada, Russia and Belarus, account for about two-thirds of total global output. Because there are only a handful of global producers, about 80 percent of global potash supply is traded across international borders.

Fruits and vegetables account for nearly one-quarter of global potash consumption. Corn and rice are also big potash consumers, accounting for a further 28 percent of the global market combined.

Phosphate is also mined from underground ore bodies created from ancient sea life. Phosphate fertilizer is typically combined with ammonia to produce solid fertilizers known as DAP and MAP. Sulphur, which is mainly derived from oil and natural gas refining/processing, is a key raw material for converting phosphate rock into usable fertilizer.

As with potash, production of phosphate is concentrated in a handful of countries. China is the largest producer, followed by the US and Morocco. The latter is the largest exporter of phosphate in the world because the US and China consume most of their phosphate production in their domestic agricultural sector.

Because the largest producers of phosphate also tend to be the largest consumers, only 20 percent of global phosphate supplies move across international borders. The crops for which phosphate is in high demand include: fruits and vegetables (18 percent of total demand), wheat (16 percent), corn (12 percent), and rice (12 percent).

Nitrogen is the most common element in the air; however, plants rarely make direct use of atmospheric nitrogen. Nitrogen-based fertilizer is made from ammonia that is synthesized from natural gas. In fact, natural gas accounts for as much as 90 percent of the cost of making ammonia.

Urea is the most common form of nitrogen fertilizer, accounting for about half the world market. And most nitrogen fertilizer isn’t traded, but is used close to where it’s produced. The biggest crops for nitrogen fertilizer are corn, rice, and wheat, which account for half of total global nitrogen use worldwide.

Demand for all three types of fertilizer has been on the rise generally in recent years and that trend is likely to continue.

Agricultural chemical inputs, including pesticides, herbicides, fertilizers and GM seeds, account for between one-quarter and one-third of the cost of producing crops. Demand for fertilizer commodities and the price of the main types of fertilizer are sensitive to underlying crop prices and farmers’ income. If the supply of crops looks plentiful in a given year, then farmers can dial back their fertilizer consumption to cut costs, accepting the lower yields that result.

Strong growth in emerging market demand for key crops such as corn and soybeans coupled with the need to grow more crops on less land has led to a sustained, secular shift higher in global agricultural commodity prices. In order to incentive farmers to spend more money on fertilizer, GM seeds, and massive new combines and tractors, agricultural commodity prices will remain elevated. That will support fertilizer producers’ profits over the long term.

Shorter-Term Considerations

But while the long-term case for a bull market in agricultural commodity prices and fertilizer demand is stronger than ever, no trend proceeds in a straight line forever. Even the strongest uptrends are punctuated by periodic and sometimes powerful countertrend moves.

That’s been the case with the agriculture group since last summer, as depicted in the chart below.

Source: Bloomberg

The UBS/Bloomberg Constant Maturity Agricultural Commodity Index summarizes the performance of futures traded on a basket of key agricultural products, including corn, wheat and soybeans. The above chart shows that the prices of these products aren’t far off record highs; for example, the price of corn traded to a record high of about $8 per bushel last summer compared to average prices of $2 to $3 per bushel that prevailed throughout the 1990s. Even the current quote of around $6.50 per bushel for corn is high by any relevant historic yardstick.

Nonetheless, agricultural commodity prices have pulled back roughly 17 percent from their all-time highs set last year, a meaningful sell-off. And the accompanying decline in the price of firms that produce fertilizer has been even more dramatic–the Bloomberg fertilizer index is down nearly 30 percent from last summer’s highs.

There are two main, related factors that are behind the sell-off in agricultural commodities and related stocks. First, the same concerns about global economic growth and the sovereign-debt crisis in Europe that pressured broader markets and commodities also hit the agriculture space. While food demand isn’t as sensitive to economic conditions as demand for energy, there’s still a clear correlation; in particular, notice how sharply commodity prices fell back in 2008 during the global economic meltdown. Prices were also relatively weak during the 2001 recession.

The economic data in the US strengthened in the final half of 2011 and the odds of a near-term recession are declining. Meanwhile, inflation in China appears to have moderated, and that’s allowed the government to provide fiscal and monetary easing to support growth. China’s economic growth may have slowed, but it hasn’t stalled, which suggests that the country will successfully engineer a soft landing.

Nevertheless, estimates for global economic growth have fallen in recent months and Europe appears headed for at least a mild-to-moderate recession. The uncertain economic outlook, especially in the fall, has prompted farmers to delay decisions like fertilizing their land and what type of seed to buy. That’s undoubtedly a driver of the sell-off in fertilizer stocks.

Another issue is the widely-watched World Agriculture Supply and Demand Estimates (WASDE) released by the United States Department of Agriculture (USDA) each month. The report estimates key fundamentals such as crop production, yields and the amount of grain in storage around the world. From late summer through the end of the year, the USDA steadily raised their estimate of the size of the US corn crop. Since the US is the world’s largest producer of corn, a bigger corn crop means more supply at lower prices.

One of the most important metrics to monitor in the USDA WASDE report is the end-stocks-to-use ratio (ESUR).

Source: Bloomberg

The ESUR compares the quantity of a commodity held in storage to total world demand. The chart above depicts how much corn is stored in silos around the world compared to total estimated global demand for corn. It’s easy to interpret this data point: The higher the ESUR, the greater the world’s crop supply cushion–a high or rising ESUR would tend to put pressure on prices, while a falling ESUR tends to support upside.

The global corn ESUR continues to hover near record lows, meaning that the global corn market is vulnerable to any sudden supply or demand shock. Most recently, for example, corn prices rallied when a severe drought in parts of Argentina and Brazil–two major corn and soybean producers–caused a cut in estimates of the size of the South American crop. However, estimates of the global corn and soybean ESURs have generally risen since August due to upward revisions to crop size estimates in most countries.

But while concerns about global economic growth have put pressure on the agriculture space in recent months, any decline looks temporary. Even better, the big decline in fertilizer stocks over the past year has pushed valuations down to levels last seen in 2009 for the group.

At these levels, fertilizer stocks are more than pricing in the recent decline in agricultural commodity prices and, unless you’re looking for a global recession this year, the downside looks limited. Any further bad news about the Argentinean corn crop or a delay to the US corn planting season in April and May of this year could send prices back to their highs; it doesn’t take much of a shift in fundamentals to impact price when supplies are so tight.

Additionally, it appears that Chinese corn imports are trending above expectations, a demand-side factor that could push prices higher.

Two of the largest global fertilizer companies to watch are Potash Corp of Saskatchewan (Toronto: POT; NYSE: POT) and The Mosaic Co (NYSE: MOS).

Potash Corp of Saskatchewan (NYSE: POT) has exposure to all three major fertilizers, but, as its name suggests, it’s truly dominant in potash. The company controls nearly a quarter of the world’s total potash mining and production capacity and is by far the largest player in this market.

The potash market is an oligopoly with the top six largest players essentially controlling the market. These companies have proved fairly adept at managing supplies in recent years, shuttering production facilities when demand drops to maintain pricing and margins. And Potash Corp’s mines in Canada are among the lowest-cost sources of this key fertilizer in the world.

Potash Corp’s fourth-quarter earnings release disappointed investors with an earnings miss and lowered guidance for the first quarter of 2012. The company blamed the weakness primarily on macroeconomic conditions; in particular, cautiousness on the part of North American potash dealers and distributors, which kept their inventories of the fertilizer lean due to uncertainty about the global economy. Even so, Asian sales of potash–strong for the first nine months of the year–also weakened during the fourth quarter.

Management suggested that while its sales of fertilizer declined in the fourth quarter, actual applications of fertilizer by farmers remained strong, an indication that producers and distributors have been drawing down their inventories.

While such caution is expected to continue into the first quarter of this year, the US spring planting season is just a few months away, and agricultural economics are still attractive even if prices are off their highs. The USDA has revised higher its estimates of last year’s corn crop in recent months, but poor growing conditions throughout much of last season stressed crops and hurt yields. Farmers are expected to aggressively plant acreage this year in an effort to offset that showing. The company expects that to lead to more robust sales as the year progresses and dealers restock their inventories.

The bad news about near-term potash demand appears to be baked into valuations, as the stock reacted well despite missing earnings expectations by a considerable margin. Buy Potash Corp of Saskatchewan up to USD60.

The Mosaic Co (NYSE: MOS) is the world’s largest producer of phosphate and the third-largest producer of potash fertilizer. In addition to the macroeconomic catalysts outlined for Potash, Mosaic also has a number of company-specific factors in its favor. First and foremost, the firm was majority owned by agriculture giant Cargill for a number of years, but that stake was spun-off last year, increasing Mosaic’s independence and offering greater liquidity in its shares for large institutions.

Additionally, Mosaic has plans to add significant potash production capacity over the next few years. For the most part, these are brownfield developments–capacity expansions at existing facilities–that can be completed more quickly than new mines at a fraction of the cost. Regardless of the near-term direction of potash prices, the long-term outlook for Mosaic is solid and rising fertilizer production capacity will be a tailwind for the stock. Buy The Mosaic Co up to USD65.