Can you name the top performing industry over the past year? If you guessed something in the energy sector, you'd be wrong. Investment research firm Morningstar tracks the performance of stocks in more than 100 distinct industry groups, and over the past year, the agrochemical sector stands at the very top of the chart -- with an impressive gain of more than +100%. Not far behind, the agricultural machinery group comes in eighth, sporting a one-year return of around +38%.

For many years, agriculture was considered a mundane sector -- hardly befitting the eye-popping gains of the past year. But as headlines about food prices and localized shortages are starting to surface, investors are sensing that agriculture stocks still have room to run. 

Supply/Demand Imbalance
In all likelihood, you have read a number of glowing reports about the heated economic expansion that is taking place in emerging markets like China and India. In turn, that growth has fueled tremendous demand for everything from electricity to steel.

However, there is another even more basic requirement that must first be filled -- the need to eat. Given the explosive population growth around the world, demand for grains has been constantly growing, but there is a shrinking amount of arable land for farming. This has created a booming market for companies that can develop pesticides, genetically engineered seeds, or anything else that will lead to increased productivity.

Fueling the Imbalance
At the same time, a new variable has been introduced into the equation -- ethanol. High oil prices and a global push for cleaner energies have prompted nations around the world to encourage the production of alternative fuels and additives. Thanks in part to tougher environmental regulations and generous government subsidies and incentives, ethanol continues to proliferate.

Today, every car built in the U.S. is capable of burning gasoline mixed with ethanol. And with the government passing stringent legislation mandating ethanol use to double by 2012, production is likely to surpass 10 billion gallons within the next few years and continue climbing.

Not surprisingly, a good chunk of American farmland has been re-directed toward the production of biofuels. According to the Department of Agriculture, nearly one-quarter of the 93 million acres of corn planted in the U.S. is currently used to make ethanol. And with ethanol refineries popping up all over the country, that percentage could continue rising.

The Meat of the Matter
Meanwhile, rising incomes in places like China have caused a shift in dieting patterns, allowing more people to supplement their diets with meat. Obviously, it takes a good deal more grain to feed a cow than a person, and mountains of livestock feed are also exerting upward pressure on prices. Finally, from droughts in Australia to poor conditions in Argentina, Mother Nature has also played a role in increasing prices.

With all this in mind, it's easy to see why corn prices have doubled over the past couple of years and currently stand at 10-year highs near $6 per bushel. And with many farmers cashing in by devoting more space to corn, prices for wheat and other crops have also been driven sharply higher. For example, U.S. soybean acreage declined -16% in 2007, causing futures prices to climb to $13 per bushel -- from just below $8 this time last year.

Reap What You Sow
This surge in commodity prices has been a boon for farmers, with farm income jumping +26% in 2007 to hit a record of $87 billion. More importantly though, this trend has also brought in billions in revenues for agricultural companies. Flush with cash and the prospect of a bountiful payoff for their crops, those farmers have been more than willing to buy needed inputs.

For example, demand has been strong for fertilizers like potash, phosphate and nitrogen, which boost crop yields. Over the past three decades, the use of these nutrients has helped average yields rise from 80 bushels of corn per acre to more than 150. With the rising commodity prices, the potash market has enjoyed a growth rate of +20% between 2001 and 2006 -- and sales have only accelerated since then.

Whether it's fertilizer suppliers, equipment manufacturers, seed growers or food processors, nearly everyone in the group is feeling a brisk tailwind. But as agriculture stocks hit new highs, the fundamental laws of supply and demand look to carry them higher.