The PR campaign toting ethanol as the end-all-be-all to our long-term energy needs keeps the faithful still believing, like a sports fan whose team needs to sink a last-second half-court shot to send the game into overtime.

By now, we all know ethanol is readily made from corn. And we all know we have abundant land in the Midwestern Corn Belt with the full-faith backing of the American government.

So what’s not to love?

For one thing, in the United States, ethanol yielded only about 10% more energy than was required to produce it. And that’s assuming we’re blessed with corn to harvest. What happens in the event of a major drought?

It gets trickier.

According to Martin Hoffert, physics professor at NYU, we would need more than 10 percent of the world’s landmass, or the equivalent of all the land currently under cultivation, to grow enough biomass to meet the world’s energy needs.

It’s looking grim, but consider this…

Corn is primarily used as feed for livestock. And demand for corn’s role in producing chickens and cattle will only grow, considering there are approximately 2.4 billion people (roughly 36.5% of the world population) living in both China and India, and who are all quickly changing their diets from grains to protein.

And as these countries get richer, they will begin consuming more and more meat. You can see it already in places like Beijing and Shanghai, where people line up around the corner and wait more than an hour just to eat at a Kentucky Fried Chicken.

Producing enough livestock to feed that part of the world will require massive amounts of corn. And that may be a problem for China. Coastal lands once used for cultivation have been sacrificed to accommodate China’s industrial machine. But there may be an even bigger problem. An extensive drought sweeping across northern China wreaks havoc for corn and soybean crop yields. The lack of water has made dust storms capable of choking visibility to less than 100 yards common in Beijing.

What does this all mean?

From last week, you may recall my argument that Asian central banks were nearing the crossroads with their dollar reserves. The more they pile up dollars, the greater the eventual losses when their respective currencies rise relative to the greenback.

This problem is especially troubling for China and it’s more than $1 trillion in foreign exchange reserves, of which 70% are conveniently tucked away in U.S. dollars.

A mere 20% increase in the yuan against the dollar would reduce the value of China’s estimated $700 billion in U.S. treasuries by $140 billion — or roughly 6.3% of China’s 2005 GDP. And many estimate the yuan to be undervalued by upwards of 40%. That would equate a value reduction of China’s treasuries $280 billion — or roughly 12.6% of 2005 GDP.

Analysts estimate China would need roughly $400 billion in reserves to stabilize the country in the event of another financial crisis similar to the fiasco that hit the region in 1997.

Consequently, the Chinese have too many eggs in one proverbial basket…the American dollar. Shifting some of those eggs away from the greenback seems to becoming more and more than just an academic exercise.

The point: If you knew the Beijing-based State Administration of Foreign Exchange were about to go on a shopping spree, you would want to own the assets they intended on buying.

Many have argued the Chinese will shift their fiat paper into tangible assets like gold and oil. I have actually argued that point on more than one occasion myself.

It’s true that when compared to other major industrialized nations, China holds very small gold reserves. For example, it’s estimated that China currently holds approximately 19.29 million ounces, or about 600 tons of gold in reserve. Calculated by a spot price of U.S. $624/ounce, the reserve amounts to only 1.2% of China’s total foreign reserves.

It’s true that developed countries usually change a good percentage of their foreign reserve to gold reserve. As of September 2005, gold as a percentage of foreign reserve in different countries are… U.S.: 63.8%, Italy: 56.7%, France: 56.4%, Germany: 50.5%, and Holland 51.3%.

I wouldn’t be surprised to see China convert some of those dollars to gold. To merely achieve a level of 15 percent of reserves in gold, China would need to consume roughly all of the gold produced in the next two years.

The other assets many believe the Chinese will begin hoarding is oil. I too believe that China will continue stockpiling its strategic reserve. But there’s a commodity even more valuable than either gold or oil that the Chinese can’t live without.

I’m talking about food…as it relates to feeding more than a billion people, a majority of which are growing much older and will require more assistance in the latter years of life.

The Chinese are well aware of their dynamic 5,000-year history that’s produced multiple eras of poverty, colonial suppression and civil wars. So there should be no surprise that Beijing’s top three domestic priorities currently are — and will always remain to be — stability, stability, and stability.

So just as Americans deem oil dependence from foreign suppliers to be a critical setback to this nation’s security, I believe the Chinese will deem long-term sustainable food suppliers to be a significant risk to their own domestic serenity.

I believe they don’t want to rely on places like the U.S., France, South Africa, and Brazil to supply their country with grains like corn to keep their people fed. We already see countries like Russia and Venezuela leveraging their own domestic energy reserves for political capital… What’s to stop the French or the U.S. from leveraging their meat and grain supplies to apply diplomatic pressure as well?

The endgame: I tend to believe the Chinese will use their Forex reserves to begin buying up a diversified portfolio arable land across the globe to address this problem. Whether it’s Argentina, Brazil, Africa or even North America, the Chinese imperial reach will require much more than gold and oil. The Chinese will need to outsource their domestic food supply.

Buying this arable land will ensure that the sun will never set on the Chinese empire.

So that’s my theory.

You may be asking how this related to small-cap stocks. Well, I’m not sure yet. I’m working on that. I’m searching for specific areas the Chinese would most likely target.

While the world keeps focusing on energy security, I’m going to begin to turn my attention to food and water security.

Roughly 50% of the world’s population rests in the region of the world experiencing the most dynamic growth. Last year alone, these economies accounted for more than half of global GDP. They now churn out 43% of the world’s exports and hold 70% of the world’s foreign exchange reserves.

And while real wages in the developed West are either flat or falling, wages among the up and coming nations of Southeast Asia continue growing.

As these countries rise from the depths of poverty, their demand for the world’s resources will stretch much further than iron, coal and light sweet crude.

Their first demand will be the most basic: Bread and water.

Have a nice holiday season.

Sincerely,

Christopher Hancock
December 15, 2008

Christopher Hancock

Christopher Hancock lives and breathes emerging markets. He travels extensively and utilizes his contacts across the globe to recommend the best international investments in the world. After working with Citigroup in Hong Kong on the challenges and opportunities associated with the forthcoming RBM flotation reform, Christopher left many of his friends behind and decided to return to the States to pursue a career in equity research. Special Report: Imagine Getting Rich as Ignored Stocks Soar- How you could turn $200 into $1.2 million!

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