By Eli Neusner

You don't need me to tell you that, over the past six months, food prices have been climbing through the roof of your neighborhood grocery store. A combination of factors have brought food inflation upon us, including greater worldwide demand, isolated food shortages, weather and currency swings. The price of oil has also had an impact. Not only do higher fuel prices make farming and the transporting of foodstuffs more expensive, but the production of alternative fuels, such as ethanol, has also pushed up corn and other grain prices.

On Wall Street, the themes of food, feed and seed have been safe bets over the past six months, as the demand for all three have led to the sharp rise in agricultural and commodity prices. Investors have been pushing higher the stocks of seed producers like Monsanto (NYSE: MON) and fertilizer makers like Potash Corp. (NYSE: POT) and Mosaic (NYSE: MOS). In the index world, indexes that track agricultural commodities have been on a nearly uninterrupted climb. The benchmark Dow Jones AIG Commodity Index is typical of the year-to-date trend.

The problem with using the Dow Jones AIG Index to represent agricultural performance is that the index is too broad. It includes all commodities, including energy, petroleum, precious metals, grains, livestock and agriculture. Fortunately, to hone in on the agricultural components, Dow Jones gave us subindexes that are focused on single agricultural products. The subindexes are a bit harder to get data on, but we are able to dig up charts that show us how robust the recent agricultural track record has been. Here's the one-year chart of the Dow Jones AIG Soybean Oil Sub-index [DJAIGBO]:

Likewise, the Dow Jones AIG Corn Sub-index shows how the May floods in the Midwest, and the demand for corn-based ethanol, have pushed the price of corn higher.

What's With Wheat? 

The wheat market has been a little more interesting, and is not a carbon copy of the other agricultural indices. A few weeks ago I wrote a piece on the lack of "convergence" (futures and cash prices coming together) in the wheat market. Factors such as sharply higher barge rates (the price of actually shipping the commodity); high futures valuations; and a large carry in the futures markets (the costs of actually holding a physical commodity, e.g., for insurance, storage and interest) explain why the price of spot wheat often trades askew from the price of wheat in the futures markets. These same factors may explain why the Dow Jones AIG wheat sub-index has a flatter one-year chart than the other agricultural indexes

Will the bull market in agriculture and agribusiness continue for the rest of 2008 and beyond? The charts of most agricultural indexes have topped off this past month, and have even dipped, indicating a potential retreat. For investors in agricultural ETFs or futures indexes, one of the keys to the agricultural commodity markets over the next six months will be the weather. In recent days, corn and soybeans fell to the lowest point in six weeks on speculation that warm, wet weather will hasten plant development and boost the yield potential of the two crops. As we've known since we planted our first tomatoes in the backyard, excessive dry spells are bad for crops. Since severe heat in the nation's heartland is not forecast from now until the end of August, we should expect our farms to be more bountiful. So agricultural investors should anticipate greater supply, and with increased supply comes lower prices.

Corn prices are a prime example of where the market may be heading in the near future, because of better weather. Corn has plunged 20% in the past month, driven lower by ideal growing weather in the U.S. Corn Belt, and a big drop in oil prices. Corn had soared to nearly $8 a bushel in June as the Midwest was ravaged by floods, but the return to warmer, dryer (but not too dry) weather has revived crops, and corn is now down to $6 a bushel.

Agricultural indexes may also fall on speculation that investor demand for agricultural commodities may decline as global equity markets rise and energy prices fall from their highs. In fact, investors are already starting to shift their positions. According to Bloomberg News, hedge fund managers and other large speculators cut their net-long futures position by 11% in Chicago corn futures in the week ended July 15. Index funds that invest in a basket of commodities cut net long positions by 2.3%. Hedge funds and other large speculators also cut net-long positions in soybean futures by 0.4%, in the week ended July 15, also according to Bloomberg.

Furthermore, cotton, a major agricultural market, is down more than 7% in July alone, but that's a typical summer pattern, reflecting lower demand. Prices from now until year end may rebound if the weather becomes too hot and dry in India, a major cotton-growing country, or in the growing regions of the U.S., such as Texas, the largest cotton-producing state.

There's one other issue that might suggest further downward sledding in the agricultural markets. Agricultural futures may be the most vulnerable of the U.S. commodity markets to proposed limits on speculative trading that are being considered by the government. Lawmakers are reviewing several bills to curb excessive speculation that they blame for surging commodity prices. In a recent report, Barclays Capital said that agricultural futures markets are the most susceptible to forced trading conditions because they are small relative to the size of index holdings.

Six-Month Forecast 

So the forecast for the next six months is for a pullback in agricultural markets. But what if we look beyond 2008, at the real long term, i.e., the next 10 years? The UN Food and Agriculture Organization [FAO], the definitive body when it comes to worldwide agriculture, has already looked out over the long-term horizon and concluded that we're in for a prolonged period of food inflation. They recently released a study saying that agricultural commodity prices should ease from their recent record peaks, but over the next 10 years, they are expected to average well above their mean levels of the past decade. They forecast that real prices will increase from less than 10% for rice and sugar, to under 20% for wheat, to around 30% for grains and oilseeds.

The FAO report also said that food prices may become more volatile because stock levels are expected to remain low, hedge funds will continue to actively trade and speculate in commodity futures markets, and climate change will affect crop production and supply in unforeseen ways. The FAO is less concerned about drought conditions, which are temporary, and more concerned about the cumulative effect of high oil prices, the demand for biofuel, changing diets, urbanization, economic growth and expanding populations.

We are definitely in the midst of a breather from a raging bull market in agricultural commodities. Better weather for crop growing, a gradual migration by investors away from commodities, a healing stock market, and lower fuel costs have taken the froth out of agriculture. Investors should keep a close eye on these trends, because if they continue, then the next six months don't bode well for long positions in agricultural ETFs. But if the UN is right, then this is only a temporary respite, and the next six months may be remembered as only a hiccup in what will become a secular agricultural market beset by inflation and more challenging growing conditions.

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