How to profit from the next drought

Don't take higher food prices lying down. It's already time to invest wisely in sparse rains and higher ag prices.

By InvestorPlace Jan 24, 2013 10:06AM

iplogoUSA, Utah, sprinklers watering farm grass (© John Wang/Photodisc Red/Getty Images)By Aaron Levitt

This past summer's hot and dry weather was great for backyard BBQs and drinking a few Budweisers. But it was terrible for farmers and producers of agricultural commodities. As the drought ravaged key growing regions in the U.S. and Canada, a variety of crops -- especially corn and wheat -- saw lower plantings and output. That caused corn prices to surge toward four-year highs.

While a new year often brings a fresh start, 2013 in the ag sector is shaping up to be a repeat of 2012.

The risk of damaged U.S. corn crops for a second consecutive year is increasing each day as the lingering effects of the worst drought in 50 years continue. Forecasters now predict dry weather in the Midwest and Great Plains will last through April -- the start of the critical planting season.

For investors, this weather offers a perfect chance to get tactical with commodity exposure and profit over the next coming months.

Déjà vu
Last year's record heat and the summer's extreme dryness caused more than two-thirds of the lower 48 states to experience severe drought conditions. That lack of rain managed to cut corn production by 27% from early-season estimates, soybean prices surged, wheat prices jumped to a four-year high and farmers have already collected a record $11.6 billion on insurance claims for damage to all crops in 2012.

And we're about to go through it all again.

Overall, the agricultural sector is bracing for another round of near-zero rain and sustained drought through the next few months. Forecasters expect that the main crop-growing region will remain drier than normal over the next three months as rainfall and snow pack continue to go missing.

While parts of the Corn Belt and sections of the Central Plains did receive snow over the last week, it didn't offer much drought relief. Reuters reports that crop analysts estimate that regions like Nebraska need 300% to 700% above-normal precipitation by April 1 to be ready for planting.

However, forecasters don't expect rain to come anywhere near that because wintertime typically isn't a period of heavy precipitation. Even scarier, the percentage of land still locked in drought-like conditions is more than double for the same date back in 2012.

This lack of rain is incredibly important to the outcome of global food prices. The U.S. supplies more than half of world exports of corn, a key piece of the food value chain. More than 75% of U.S. processed foods contain corn in some form, and it's a critical feed for meat and dairy animals. Plus, as I previously wrote on InvestorPlace, corn goes into a variety of industrial applications like ethanol, paints and plastics. Heck, even some AA batteries contain corn.

Add soybeans and wheat to the mix, and a major hiccup in inflation could be coming.

Portfolio options
Investors, however, do have a few options, other than praying for some El Niño rains.
The obvious one is corn prices. While most of a commodity portfolio is best positioned in broad exchange-traded funds, the drought is a perfect example of when to be tactical -- and the Teucrium Corn ETF (CORN) is the way to go. The ETF tracks a basket of three futures contracts for corn -- specifically the second-to-expire, third-to-expire and the contract expiring in the December -- that are traded on the Chicago Board of Trade.

So far, investor interest has been strong, and CORN's share price has done quite well over the last year. If drought conditions persist into 2013, the fund should continue its upward climb.

The second play for investors is to focus on companies providing irrigation equipment to the heartland, particularly those that focus on water efficiency. After all, making sure every last drop counts is critical during a drought. Small-caps Lindsay (LNN) and Valmont Industries (VMI) both manufacture irrigation equipment that affects water, energy and labor. Currently, these companies provide gear for just over two-thirds of the U.S. harvest and have significant presences in other key regions like Australia, Africa and Canada.

Both stocks have been on fire, with each adding about $45 to their prices in 2012 as the drought took hold. While such gains may not occur in the new year, they represent a solid bet on the need for more food, and any drought-related price action would be certainly warranted.

As of this writing, Aaron Levitt didn't own any securities mentioned here.

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