Why Are Food & Fuel Prices Soaring?

Kurt Brouwer July 7th, 2008

The soaring cost of food and fuel has generated lots of heat in the media, but often the information we are given sheds very little actual light on the subject. That is, we read and hear and see countless articles about the high price of gas or corn products, but seldom do we see any solid economic explanations that demonstrate why these costs are going up. However, with a little digging, we can find solid information in the media that helps us understand what is going on.

In this piece in the Wall Street Journal [registration may be required; emphasis added], Harvard economics professor, Martin Feldstein, explains why these costs are soaring and he also demonstrates how the market will respond — is responding actually –in a rationale manner:

We Can Lower Oil Prices Now (Wall Street Journal, July 1, 2008, Martin Feldstein)

Although most experts agree that financial speculation was not responsible for the surge in the global prices of food and energy, many people remain puzzled about the source of these remarkable price rises. Economics offers a simple supply-and-demand explanation and reason for optimism about the future of commodity prices. In the case of oil, economics also suggests how policy changes today that affect the future could quickly lower the current price of oil.

We all know that rising incomes in China, India and the Gulf states have increased the demand for oil and many other commodities. But how could the modest, one-year rise of these demands lead to 100% increases in the prices of oil and other commodities? Let’s take a look first at perishable agricultural commodities.

In the short run, there is little scope for increasing the supply of corn in response to a global increase in demand. For demand and supply to balance - for the market to clear - the price of corn must rise.

If the demand for corn were very price-sensitive, a relatively small increase in price would reduce global demand by enough to offset the initial rise in demand. However, since demand is actually quite insensitive to price in the short run, it takes a very large price rise to bring global demand into line with supply.

In a few paragraphs, Mr. Feldstein has given us some crucial information about market forces for commodities such as gas or corn. First, prices go up (or down) in relation to imbalances in supply and demand. Second, demand for some products like food and fuel is, in economic jargon, relatively inelastic. This means that demand for corn or gas does not respond quickly to price increases or decreases. In the short run, those who eat corn products or drive cars are going to keep doing so in spite of prices increases. As a result, if there is a supply shortage of such a product (corn or oil products), the price increase has to be very large in order to reduce demand enough to get supply and demand back in balance.

Feldstein continues:

Here is a simplified picture of what happened in the past year. The quantity of corn demanded by high-growth countries rose gradually, increasing eventually by an amount equal to, say, 10% of the previous total global level of corn consumption. Since the supply of corn did not increase, the price had to increase enough to reduce corn consumption in other countries by 10%. If it takes a 10% increase in the price to reduce the quantity of corn demanded in the first year by just 1%, it would take a 100% increase in the price of corn to offset the initial 10% rise in the quantity of corn demanded.

Yikes. A 100% increase for a food product such as corn seems outrageous, but if demand goes up, it takes a while for supply to catch up. After all, farmers can’t just pop out some more corn overnight. It takes an entire growing season. When it comes to oil, the process is similar. While producers such as Saudi Arabia can quickly ramp up production a bit, the development of new oil fields to implement large increases in production can take years. But, there is one advantage oil has over perishable commodities such as corn.

Feldstein continues:

…The situation for oil is more complex, but the outcome for prices is potentially more favorable.

Unlike perishable agricultural products, oil can be stored in the ground. So when will an owner of oil reduce production or increase inventories instead of selling his oil and converting the proceeds into investible cash? A simplified answer is that he will keep the oil in the ground if its price is expected to rise faster than the interest rate that could be earned on the money obtained from selling the oil. The actual price of oil may rise faster or slower than is expected, but the decision to sell (or hold) the oil depends on the expected price rise.

…If the price of oil is expected to rise faster, they’ll keep the oil in the ground. In contrast, if the price of oil is not expected to rise as fast as the rate of interest, the owners will extract more and invest the proceeds.

Expectations. Producers of oil are pretty rational and if they think the price of oil is going up quickly, then they might be tempted to hold off on production increases. But, expectations can work the other way too. If the high price reduces consumer demand for oil products enough, then producers will begin to forecast falling prices. As a result, they may want to ramp up production now before prices fall much further.

Feldstein continues:

The relationship between future and current oil prices implies that an expected change in the future price of oil will have an immediate impact on the current price of oil.

Thus, when oil producers concluded that the demand for oil in China and some other countries will grow more rapidly in future years than they had previously expected, they inferred that the future price of oil would be higher than they had previously believed. They responded by reducing supply and raising the spot price enough to bring the expected price rise back to its initial rate.

…Once this relation is understood, it is easy to see how news stories, rumors and industry reports can cause substantial fluctuations in current prices - all without anything happening to current demand or supply.

…Now here is the good news. Any policy that causes the expected future oil price to fall can cause the current price to fall, or to rise less than it would otherwise do. In other words, it is possible to bring down today’s price of oil with policies that will have their physical impact on oil demand or supply only in the future.

…Any steps that can be taken now to increase the future supply of oil, or reduce the future demand for oil in the U.S. or elsewhere, can therefore lead both to lower prices and increased consumption today.

Here is a piece from the Los Angeles Times that demonstrates one example of changing behavior in response to high gasoline prices:

Harley-Davidson might be wishing it made a scooter about now. In fact, most motorcycle manufacturers without one in their lineups have got to be feeling the pain. Motorcycle sales are down this year.

Scooters, on the other hand, are selling as fast as their little wheels can carry them from showroom floors. Sales have jumped 23.6 percent in the first quarter of 2008 compared with the same period in 2007, and they’re likely to continue their quick and upward trajectory.

Daily headlines and the signs at your nearest service station already give the reason, but I’ll spell it out: G-A-S. Depending on the displacement, a scooter gets 40 to 120 miles per gallon, compared with 27.5 mpg for the average car and about 50 for a motorcycle…

Here’s another example in a piece from the New York Times:

Soaring gas prices have turned the steady migration by Americans to smaller cars into a stampede.

In what industry analysts are calling a first, about one in five vehicles sold in the United States was a compact or subcompact car during April, based on monthly sales data released Thursday. Almost a decade ago, when sport utility vehicles were at their peak of popularity, only one in every eight vehicles sold was a small car…

The market is operating rationally on all sides. Consumers are changing their behavior and producers are doing so as well. We really do not know where the price of fuel will settle, but we do know that the price of fuel (or food) will reflect rationale factors such as supply and demand. And, the price mechanism is the key. High prices signal us to reduce demand and also signal producers to increase supply. The answer to the soaring prices for food and fuel is demand and supply. If we want lower prices, then we have to increase supply and reduce demand.

The answer to the question posed in the title of this post is that commodities are produced and consumed in a market that responds to changes in supply and demand of those commodities. But, the time horizon is both short-term and long-term. For example, demand for gas is falling slightly, but because such demand is relatively inelastic, it takes time for consumer behavior to change. Driving habits and commutes are pretty fixed in the short run, but over time they will change if high gas prices persist.

Eventually, reduced demand will bring about a better balance between supply and demand and prices will fall — from that level. However, we do not know where prices will be when supply finally catches up to demand.

Update: For more on higher prices for fuel and food see World Oil Reserves Growing, Yet Prices Are Soaring, GASENFREUDE and High Food Prices — Why Are They Rising?.

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