You know commodity prices are obscenely high when you breathe a sigh of relief seeing corn futures dip back down to around $6 per bushel, and you utter gratitude that crude oil slid back to around $125 per barrel.
Even as commodity prices lose some of their extraordinary steam, analysts are in the midst of trying to figure out exactly why they got so out of hand so quickly. Demand running ahead of supply, federal policies subsidizing a food and feed product for fuel use and the anemic U.S. dollar are all favorite targets.
Looking at the situation through the lens of escalating food prices, according to a recent study conducted by three Purdue University economists for the Farm Foundation, the run-up has to do with a plethora of interdependent variables.
“We made no attempt to calculate what percentage of price changes are attributable to the many disparate causes and, in fact, think it is impossible to do so,” says Wallace Tyner, the lead author of the report. “But examining the interplay of the forces driving food prices gives a clearer picture of what has been happening.” Tyner is an energy and policy economist, most recently specializing in bio-fuels policies.
Tyner was joined in the study by Christopher Hurt, who works in analysis of commodity markets and Philip Abbott, who works in international trade and macro factors. They reviewed current reports and studies, considering the findings of that literature as they did their own analysis of the situation. Here are some key findings:
• Rapid economic growth in developing countries has led to growing food demand and dietary transition from cereals toward more animal protein. As a result, global consumption of agricultural commodities has been growing rapidly. While many studies focus attention on China and India, neither country is a major trader of most agricultural commodities. However, China's rapidly growing oil imports have had an indirect effect on food prices by impacting world prices for crude oil.
• Demand for agricultural commodities has increased, while growth in agricultural productivity has slowed. Over the past four to eight years, depending on the commodity, this combination has resulted in a change from a surplus to a shortage era, setting the stage for commodity price increases. When weather and crop disease problems occurred in 2006 and 2007, stocks of many agricultural commodities were already low, exacerbating the impact on prices. Policy actions by some countries to isolate their domestic markets through export restraints made the situation even worse, particularly for rice. Increased investment in agricultural research is important, but not a short-term solution.
• The effects of supply and demand on commodity prices are clear. Less clear are the effects of changes in the structure of commodity markets, particularly speculative activity. There is no doubt that the amount of hedge fund and other new monies in the commodity markets has mushroomed. Price volatility has increased, partly due to increased trading volumes. Based on existing research, it is impossible to say if price levels have been influenced by speculative activities.
• Most commodities, including crude oil and grains, are priced in U.S. dollars, but are purchased in the local currency. When the dollar falls, as it has over the past six years, there is a link with rising commodity prices. The link between the U.S. dollar exchange rate and commodity prices is strong and more important than many other studies imply. The decline of the dollar is linked not only to higher demand for U.S. agricultural commodity exports, but also to higher oil prices.
• Some studies conclude that oil prices and rising production and transportation costs have helped drive current commodity price increases. But many of these impacts occur with a significant lag. Higher crude oil prices have pushed up the cost of producing agricultural commodities through increases in the price of inputs, such as fertilizer and diesel, but the long-term impact of these increases has yet to be felt.
• Crude oil's strongest and most direct impact on food prices has been through its effect on the demand for bio-fuels. In the United States and the European Union, public policies, such as subsidies and mandates, led to the development of the bio-fuels industry and its growing demand for corn and vegetable oils. In the last four years, most of the growing global demand for corn has come from its increased use for ethanol production. Ethanol blender credits, tariffs and the Renewable Fuel Standard are factors causing increased corn prices, but quantitatively, most of that price increase is driven by high oil prices.
• Agricultural commodity price increases have a much greater impact on low-income consumers, especially in developing countries, because food is a larger fraction of total expenditures and commodities are a larger share of their food consumption. One side of higher commodity prices that has gotten little attention is the potential for farmers in developing countries to increase production and productivity. Higher prices could induce these farmers to purchase and use such inputs as improved seeds and fertilizer, leading to substantial increases in productivity and economic gains. For this to happen, governments would have to permit higher prices to be transmitted to farmers.
“Today's food price levels are the result of complex interactions among multiple factors. However, one simple fact stands out: economic growth and rising human aspirations are putting greater pressure on the global resource base,” says Neilson Conklin, Farm Foundation president. “The difficult challenge for public and private leaders is to identify policy choices that help the world deal with the very real problems created by today's rising food prices without jeopardizing aspirations for the future.”
Farm Foundation's mission is to work as a catalyst for sound public policy by providing objective information to foster deeper understanding of the complex issues before the food system today.
“We commissioned this report to provide a comprehensive, objective assessment of the forces driving food prices,” Conklin explains. “It is the intent of Farm Foundation that the information will help all stakeholders meet the challenge to address one of the most critical public policy issues facing the world today.”
Fact is the bloom appears to have faded from the commodity rose in recent weeks as it seems more of the speculative money in those markets have bailed out for Wall Street and other investments. Just as that money added to volatility, and arguably the high prices themselves on the way up — an overcorrection beyond market reality — prices on the way down will likely do the same. That doesn't mean a return to the inexpensive commodity prices the cattle industry enjoyed for the better part of five decades. It does mean, the market should become a more reliable indicator of reality.
Further Contraction Without Incentive
“If beef demand—especially export demand—does not increase enough to boost beef and cattle prices high enough to offset the rise in production costs, the industry will shrink in size to the point that fewer pounds of beef are marketed to U.S. and international consumers,” says James Mintert, agricultural economist with Kansas State University. “The rising costs of production have largely been absorbed by livestock producers so far, but that cannot continue indefinitely. Ultimately, higher prices throughout the marketing chain will be required to offset the large increase in production costs.”
As it is, the July 25 mid-year Cattle Inventory report from the National Agricultural Statistics Service (NASS) indicates beef cow numbers are one percent lower than a year ago (33.2 million) and beef replacement heifers are two percent fewer (4.6 million head). The inventory of all cattle and calves July 1 is estimated at 104.3 million head, down slightly from a year earlier—milk cow inventory is one percent higher—and one percent fewer than 2006.
Further reflection of the lack of economic incentive to retain replacement heifers could be found in the monthly Cattle on Feed (COF) report issued that same day. Looking at the percentage of heifers and heifer calves on feed for slaughter, as a percentage of all steers, heifers and heifer calves, 37.3 percent of the COF inventory July 1 was heifers and heifer calves; it was 36.8 percent at the same time last year and 34.3 percent in 2006.
Sluggish to anemic fed cattle sales continue to keep a cap on calf and feeder prices that might otherwise surge ahead given the decrease in corn prices the past month.
“Feed is the largest single cost item for livestock and poultry production -- accounting for 60 to 70 percent of the total cost in most years," says Mintert. “Although energy, labor and other inputs have increased over the last two years, feed costs have jumped 40 to 60 percent, depending on whether a producer is feeding swine, cattle or poultry.”
Reflecting upon record high economic losses in cattle feeding, and the growing negative margins in the cow-calf sector, Mintert points out, “…the losses experienced in the cattle sector were not associated with large cattle price declines. In fact, prices for market-ready cattle in Kansas were record-high in 2007, averaging $93 per hundredweight or 8 percent higher than in 2006. So, the reduced profitability was directly attributable to rising costs, especially feed costs.”
That's why increased demand is key to maintaining or growing the industry.
“Consumers disposable income is a major determinant of their demand for beef. Slow or even negative growth in the U.S. economy during 2008 and 2009 will mean little likelihood in the short run for an increase in domestic beef demand,” says Mintert.
“Looking ahead, the U.S. beef industry could be facing several more years of herd reduction before prices rise sufficiently to offset the new production cost regime.”