Volatile grain prices

Is bad weather the only cause?

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1001 F Mgrain

The interaction between world grain supply and demand resulted in a wild swing in grain prices in the last two years as corn prices first rose 400% to record high levels and then plummeted 66% before ending up at levels about double those of earlier years. This unusual and destructive volatility was caused by four factors which combined to bring outsized changes in the supply and demand of grains: the drought in Australia, the sudden increase in ethanol production, China and the worldwide economic boom and bust.

The world supply of grain was limited in the period 2006 to 2008 by a severe drought in Australia and other areas. This supply restriction came at the same time as demand soared due to the rapidly increasing use of corn by the ethanol industry in the U.S. combined with the overall increase in grain use caused by a rapidly rising world economy. In particular, China was and is continuing to use increasing amounts of grain. To complete the picture, loose credit allowed commodity speculation to run rampant.

Production increase in 2008

From crop year 2004-2005 to crop year 2006-2007 the world produced less grain and consumed more each year. The gap between production and use was the greatest in 2006-2007. In 2008 grain prices reached their record high levels provoking a feed and food crisis before easing back as world grain production increased in response to high prices.

Table 1: World production and use of grains

 

There was no shortage of culprits for this crisis. Some blamed China. Feed use in China is indeed growing at a rapid rate. However, even more important than China was the sudden increase in the use of corn for ethanol in the U.S. Corn use for ethanol increased from 40 million metric tons in 2005 to 100 million metric tons in 2008.

 

Tables 2 & 3: US ethanol and Chinese commercial feed

 

Since this increase came at the time of reduced world grain production, it led to higher grain prices and bankruptcies in the livestock and poultry industries including that of the largest U.S. poultry company at the time, Pilgrim’s Pride (now majority owned by JBS of Brazil). Despite protests to the contrary, the ethanol policies of the U.S. are far from blameless for this food and feed debacle.

Meat consumption plummets

Meat consumption is, of course, extremely sensitive to both the cost of grain and the ability of consumers to purchase meat. High grain prices and lower world disposable income had a predictable effect on world meat consumption per capita. Total meat consumption per capita fell by a half a kilo, one pound, worldwide this year and will only recover slowly in the next two years.

Table 4: World meat per capita consumption

 

What can be expected going forward? Droughts and recessions come and go but one thing is certain, ever greater amounts of corn are mandated (and subsidized) to be used in producing ethanol. If less than the mandated amount is blended into gasoline, U.S. oil companies would be penalized.

Ethanol hikes corn price

Given the rising importance of corn in making ethanol, the prices of corn and oil have become tightly linked. The Center for Agricultural and Rural Development (CARD) in Iowa has made the following predictions about the long run equilibrium price of corn at various prices of oil. It is interesting to contrast the price of corn with and without subsidies for ethanol. According to CARD, if oil is $70 per barrel, corn will be $4.70 rather than the $3.20 it would be without ethanol subsidies. Corn farmers should be glad that their lobbying efforts have been so successful.

Table 5: Ethanol from corn mandate 2008-2015

 

The correlation between oil and corn price is uncanny, mirroring each other through 2008 and 2009. As reported in the Wall Street Journal, as of December the two prices are both exactly 10% less than two years ago.

Events pushed all of the supply and demand factors in reverse at the end of 2008. Australia and others had a good wheat harvest increasing the supply of grain, demand for corn to make ethanol slowed temporarily and the demand for meat production dropped as well. Finally, speculators found that their lines of credit disappeared.

Table 6: Long-run corn price per bushel

 

In 2010 corn prices are headed up again. Oil prices increased 100% in the last year putting upward pressure on corn prices. As the world economy gains speed, the direction for both oil and grain prices is likely to be up.

U.S. ethanol policy origin

The origin of the U.S. corn-based ethanol policy can be found in the energy crisis of the 1970s when efforts were made to reduce U.S. dependence on foreign sources of oil. Policy initiatives in the 1970s included significant increases in the fuel economy of cars combined with a subsidy for the use of gasohol, the mixture of ethanol and gasoline. The subsidy never led to any significant production of ethanol because of the drop in the price of petroleum in the 1980s. Even the word gasohol disappeared. What did not disappear was the subsidy; it remained on the books even if there were few takers.

It was difficult for the ethanol industry to become established in the 1980s, even with the subsidy, because of the low price of fossil fuel energy. When oil became more expensive in the last decade, the subsidy began to provide an incentive for the expansion of the industry. As the price of oil rose higher and higher, the incentive became compelling. For this reason the ethanol industry experienced explosive growth in the last few years.

U.S. agricultural policy toward corn production has been characterized by extreme positions over the last several decades. One extreme, that of subsidizing the production of corn regardless of the quantity produced, led to artificially low prices. It was low corn prices (combined with subsidies) that attracted the attention of the energy sector. That led to the other extreme, the recent unusually high prices.

Finding a middle ground

The abrupt swing in corn prices from one extreme to the other raises the question of a middle ground. Among practitioners of agricultural policy, the piece of advice most often heard is to “get prices right.” A U.S. agricultural policy that gets prices right would be one that avoids policy extremes.

There are numerous middle ground suggestions. These include such ideas as variable subsidies, an end to the tariff on imported ethanol, and a limit to the amount of corn that can be used to produce ethanol. If cellulosic ethanol becomes feasible, that could replace corn ethanol. However, it appears that at least another decade will be required before cellulosic ethanol approaches the cost of corn-based ethanol and it is easy to forget that corn-based ethanol is not economically feasible without subsidies.

Weather challenges crops

Despite the new importance of crude oil in prices, crops still have to be planted and harvested and those activities still influence the price of grain. Crop production was difficult last year in the U.S. A late spring followed by a cool summer and perhaps the worst October ever for field work resulted in a late harvest and less corn than was expected.

The corn crop reached its peak potential in October and began to decline as it sat in the rain unharvested. Although losses were cut short by a perfect November, a blizzard in December ended the harvesting season with 10% of the corn left in the field. As a result, the harvest was less than expected and the consequences of wet corn and corn stranded in the field are still being resolved.

The world ending stock of corn is projected to be down by 10 MMT this year due to lower production in Brazil, Europe and Russia and higher world use including sharply higher use in the U.S. due mostly to ethanol production. Lower ending stock is usually an indication of higher prices.

Wheat balances corn shortage

Lower corn stocks are balanced somewhat by higher wheat stocks. Wheat substitutes for corn in many instances and the ending inventory of world wheat is projected sharply higher this year.

Table 7: World ending stock of corn and wheat

Oil boosts soy value

Soybean meal was relatively expensive last year due to the fall in the price of soybean oil combined with the drought in Argentina. Soybean oil prices are rising which will allow oil to make up more of the value of the beans. Help is also on the way in the form of the good harvest in the northern hemisphere last fall followed by a potentially better southern hemisphere harvest this year.

There is likely to be a plentiful supply of soybeans this year. Given a favorable climate in South America, the total world production increase of 35 MMT this crop year will be a record large. Ending inventories should also be much improved. Soybean meal prices should therefore be lower this year.

Biodiesel made from soybean oil does not yet play as great a role in soybean prices as ethanol does for corn. The biodiesel use of soybean oil actually fell in the last two years. Nevertheless, a renewed interest in soybean oil is expected. Brazil, for example, is mandating a 5% biodiesel inclusion in 2010. Unlike corn ethanol, as the use and value of soy oil increases, it helps the animal industries that use soybean meal since the meal becomes relatively less expensive as the oil assumes more of the total cost of producing the beans.

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