A major investment theme in 2010 will be growing tightness in agriculture and soft commodity markets as secular demand growth driven by rising per-capita incomes and Westernizing diets in Asian  markets meets relatively inelastic global supply. Globally, grain consumption was estimated to have increased 1.7% in 2009 despite the economic shock, according to the U.S. Department of Agriculture. In many ways, food looks like energy a few years ago, with a widespread assumption that after a prolonged period of real annual price declines we can look forward to sustaining this trend. However, just as with oil, those decades of low and negative returns have led to chronic underinvestment in everything from seed research to supply infrastructure. The rapidly aging profile of the current generation of farmers in the US and Europe is another factor likely to detrimentally affect medium-term productivity.  A rebound in global growth to the 3-4% range in 2010 will likely result in substantial price increases unless growing conditions prove exceptionally benign.

The Goldman Sachs Agricultural Commodity Index has lagged the wider commodity rally in 2009, despite record highs in several markets from sugar to cocoa. Food consumption is generally less sensitive to economic conditions than energy and metals, but a series of abnormal weather events around the world upended supply and demand fundamentals for corn, soybeans and sugar. An unusually late planting season in the U.S. due to excess rainfall led corn prices to rally more than 30% in the spring; a serious drought in South America curtailed soybean plantings and yields and sent soybeans prices soaring 50% in the first half. Prices came down through the summer as weather patterns normalized and eased supply worries. Overall, there is far more sensitivity to weather factors than a few years ago, making the agricultural commodities particularly volatile. While corn prices edged up just 2% in 2009, and wheat was down 11%, sugar prices soared to a 28 year high (up 129%) and cocoa at a 30 year high (up 23%) on supply disruptions in India, Brazil and West Africa, combined with tight global inventories. Livestock prices suffered losses as cost-conscious US consumers ate less meat. In the U.S., average red-meat and poultry consumption was estimated to have decreased by 2.6% to 210.6 pounds per person in 2009, according to the USDA. As a result, prices for lean hogs and live cattle rose by 8% and 2%, respectively, last year and that's likely to accelerate this year as the livestock herd has shrunk to a 3 year low.

For 2010, corn is likely to be the best bet in the agricultural complex, in large part because higher ethanol mandates in the U.S. will soak up one-third of total U.S. corn supply. The outlook for soybeans hinges on the production outlook in the U.S., as South America looks to have a record-high crop year in 2010. Absent an unexpected bout of poor weather in the U.S., the increase in world supply will cap prices.

There are various ways to play the opportunity but investors should look along the whole value chain in agriculture and not just invest in futures or ETFs. Some investments are a more leveraged play on rising agriculture prices, notably fertilizer stocks like Mosaic and Potash. After a poor 2009 for fertilizer demand (prices down 50%) driven by tight credit conditions for US farmers, to maintain productivity a rebound is likely in 2010 as agricultural credit imprioves. You simply can't do without nitrogen and potash fertilizers for more than a season or two without seriously damaging crop yields. The same goes for crop protection products from Monsanto and Syngenta. Japanese farm machinery maker Kubota fits both the agriculture theme and my preference for Japanese large caps this year on a weakening Yen, and Deere offers a US alternative.

ADM, BRF, Olam International and Bunge offer more diversified downstream/logistics agribusiness exposure. In China, I'd highlight China Mengniu Dairy, China Yuru Food, and Sino-Forest (the latter not strictly food related, but a play on the imminent launch of wood-frame housing in China, so maybe money will grow on trees). The Claymore COW ETF tracks the MFC global agriculture index, and there are a variety of actively managed equity funds such a the Baring Global Agriculture Fund for UK investors.

Think of the sector in a similar way to investing in energy; you want exposure at different times to the underlying resource, to the oil service stocks profiting from investment in new production and to the product refiners/retailers when crack spreads make them profitable. The relative value along the food supply chain also shifts over time, and right now the best bets are probably in fertilizer and seed related equities.