Biofuels and Commodity Turbulence

By Dennis Rogoza - President, Rogoza Consulting Group Inc., Victoria, BC

For the past year, the negative headlines in the mass media about biofuels have been akin to supermarket tabloids.  These headlines have screamed about biofuels causing food riots, mass starvation and environmental destruction.  Most people in the biofuels industry were blindsided by this turn of events, given that the industry barely exists, at least in Canada.

A major theme of this debate has been the impact that biofuels’ feedstock prices have had on retail food prices.  But, like many issues, one has to get behind the headlines to better understand the factors affecting retail food prices.

There is nothing new about what drives the long-term fundamental prices of agricultural commodities – supply versus demand.  For the past 50 years, the green revolution in agriculture has resulted in large commodity surpluses, keeping prices of crops like wheat so low that many farmers stopped growing it.  While consumers benefited from these low prices, the impact on farmers changed the face of rural Canada, with many farmers going bankrupt or scaling up and diversifying into other crops to maintain their viability.  Governments responded to this new economic reality by encouraging crop diversification and value-add developments so as to help increase farm incomes.  Like in the U.S., this is a key rationale behind the Alberta government’s support for biofuel development. 

World population growth has increased food demand and helped narrow the inventory carryover of crops, making these crops vulnerable to large price increases in the event of supply disruptions.  This is what happened with wheat, where crop failures in Australia and Asia reduced supply, driving up commodity prices. Another impact of global economic growth has been a dramatic increase in the consumption of animal protein.  When tens of millions of people decided to eat more meat, the market for feed grains escalated, putting upward price pressure on feed commodities such as corn and soybeans.  These global trends will influence long-term agricultural fundamentals and likely result in higher average commodity prices for years to come.

Yet another factor in soaring food prices is speculation.  Traditionally, agriculture future markets act as a risk-transfer mechanism, allowing buyers and sellers of commodities like wheat and corn to fix their supply and price risk.  But recently, large financial players – such as index, commodity and mutual funds, with hundreds of billions of dollars to invest – reasoned that the combined fall of the U.S. dollar and changed fundamentals of agricultural commodity markets would lead to a rise in food price, providing a hedge against inflation and the value of the dollar.  Price rises became almost self-fulfilling, with more purchases of futures contracts giving rise to ever higher prices.  In effect, the futures market became disconnected from agriculture fundamentals and became an investment strategy.

Given the current conditions in the financial markets, this party is likely over, with many funds retreating from or closing their investment positions.  This will lead to reduced price pressures.  Palm oil prices have already fallen by about 50 per cent from their peak in March 2008.  This, in turn, will impact world biodiesel prices, as palm oil is a major biodiesel feedstock.

While biofuels have been blamed for all food price increases, not all major food stocks are used in biofuel production.  For example, rice – which soared in price from $360 a tonne last October to $1,000 in April, causing riots in some countries – is not used to produce ethanol or biodiesel. By September, the price had retreated to about $700, reflecting demand and supply fundamentals.

Biofuels like ethanol and biodiesel do create added demand for corn, wheat, soybeans and canola.  But while biofuels have been principally blamed for increases in prices of these commodities, it’s worth noting that the 2007 increase in U.S. corn production exceeded the total demand from the ethanol industry, allowing the U.S. to achieve record corn exports. 

The key issue in this whole debate is the actual impact the price of an agricultural commodity has on the retail price of a food product.  The answer is not much.  There is only about four cents of corn in a typical box of corn flakes.

Brent Searle, special advisor to the Director of Agriculture in Oregon, says that of the 12 factors affecting food prices, biofuels has had the least impact. The primary factor is the large increase in oil prices, raising costs in every sector of the world economy.  Other major factors include the decline in the U.S. dollar, weather, speculation, higher labour costs and increased demand for meat from global markets. 

Record global wheat, corn, soy, canola and rice harvests are forecast for 2008, as farmers respond to high prices.  As this supply reaches the market, agricultural commodity prices will likely decline even further.  This will reduce input costs for biofuels and, assuming the weather cooperates, the world will get fed at a reasonable price.