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What’s Driving Food Prices? March 2009 Update

Despite reversal of conditions, complexity and
drivers of food prices remain unchanged

In July 2008, crude oil prices were at record levels, as were most agricultural commodity prices. Low supplies generated fears of food shortages. The rhetoric of the food-versus-fuel debate rose along with food prices. Today, despite remarkable course changes, the key drivers of food prices and their complex interactions remain the same, according to a new Farm Foundation report, What’s Driving Food Prices? March 2009 Update.

This new report updates the analysis Purdue University economists Phil Abbott, Chris Hurt and Wally Tyner did just nine months ago for the Farm Foundation report, What’s Driving Food Prices? That report, released in July 2008, identified three major forces driving food prices:

World agricultural commodity consumption exceeding production growth, leading to very low commodity inventories;
The decline in value of the U.S. dollar; and
The new linkage between energy and agricultural markets.

In the second half of 2008, each of these driving forces reversed direction. A world financial crisis put the brakes on world income growth. Global crop production returned to more favorable levels for both the 2007/2008 and the

2008/2009 crops, as both production area and yields increased. After July 2008, the exchange rate of the U.S. dollar appreciated against major currencies. Energy prices collapsed, influenced by changes in income and exchange rates. Lower energy prices constrained the profitability of ethanol, contributing to weaker commodity prices.

“The transitions were truly remarkable—almost a 180-degree course change—yet the key drivers of food prices remain the same: supply and utilization of grains and oilseeds; the exchange rate of the dollar and related world macroeconomic factors; and the energy/agriculture linkage,” says Tyner, one of the three report authors. “Our updated analysis verified the role of the key drivers, although they sometimes play out in somewhat different ways.”

Grain and oilseed prices have dropped sharply from record-setting peaks, but remain well above long-term norms. Commodity market prices have declined more rapidly than production costs, yielding tight margins for producers. In the future, agricultural commodity prices will depend greatly on exchange rates and crude oil prices, which in turn are linked to macroeconomic performance. Macroeconomic forces such as global recession and financial crisis generate higher unpredictability—the impacts of these forces have been more quickly reflected in the value of the dollar, crude oil prices, and agricultural commodity prices, than have changes in supply and utilization.
The changes in the value of the dollar, agricultural commodity prices and crude oil prices followed similar relationships leading up to the June/July 2008 peak and afterwards. A weak dollar meant higher dollar prices, stronger exports and weaker imports. Since July 2008, the dollar has appreciated against the Euro and many other currencies—especially those of developing countries—leading to weaker exports and more imports. Appreciation of the dollar also contributed to rapid declines in the dollar prices of agricultural commodities.
Since 2006, energy and agricultural markets have become closely linked as biofuels production surged. Ethanol and biodiesel were linked as energy substitutes for gasoline and diesel, and usage of crops for these biofuels became large enough to influence world prices. In the last half of 2008, crude oil prices fell rapidly, but gasoline prices fell faster and further. Low gasoline and crude oil prices reduced the expected use of corn for ethanol which, in turn, put pressure on ethanol prices and corn prices. By the end of 2008, the ethanol industry’s economic fortunes had deteriorated such that up to two billion gallons of capacity was idled. There have been changes in the way markets are now functioning but the basic relationship between crude oil and corn remains strong.

Farm Foundation’s July 2008 report and this update confirm the linkages of the three key drivers of food prices. “Whether the future takes prices up or down depends on many unknowns—not the least of which are the depth and recovery characteristics of the current global financial crisis and recession,” Tyner says. Other unknowns include the potential for inflation and its possible influence on commodity prices, the direction of the U.S. dollar exchange rate, the price of crude oil and agricultural commodities.

“Understanding the function of the driving forces of food prices is critical in helping public and private leaders make informed decisions about business strategies and public policies,” says Farm Foundation President Neil Conklin. “Farm Foundation commissioned the first report to provide a comprehensive, objective assessment of the forces driving food prices. Building on that analysis, this update further broadens that information base.”

As part of the first report, Abbott, Hurt and Tyner reviewed recent studies on the world food crisis. The March 2009 Update report includes an annotated bibliography of studies released since June 2008.

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