Ideally, the price of a product would reflect production and delivery costs plus a
reasonable profit. If this were the case, crude oil would be selling for about $50 a
barrel and corn would be selling for about $4 a bushel.
But the actual price of a barrel of crude oil is closer to $130 while the price of a
bushel of corn is nearing $6.50. Why? The conventional wisdom is that the
former is a result of price manipulation by oil companies and the latter is a result
of corn ethanol.
The correct answer, as is so often the case, is more complex. Three factors
explain the disparity between the ideal and the actual.
Supply and demand. Surprisingly, supply and demand seems to have little to do
with rising oil prices. Oil supply continues to outpace increases in demand.
In the case of crops, supply and demand plays an important role. In the case of
wheat, whose price has risen faster than that of corn, droughts reduced the
supply, accounting for a part of the run-up in price. The global supply of rice has
increased, but the rising price of rice in 2007, largely a result of speculation (see
below) led rice-exporting countries in the first few months of 2008 to curtail
exports in order to dampen inflation and protect domestic customers. This quickly
led to a doubling of rice prices and food riots in a dozen countries.
For corn, biofuels have indeed played a significant role in price increases. Global
corn production has gone up, but effectively about half the
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increase has gone to produce ethanol. Some estimate that government
promotion of biofuels may have increased the price of corn by about $1 a bushel.
One more comment about supply and demand may be in order. The massive
increase in biofuels has also effectively increased the supply of oil. The head of
Merrill Lynch's commodities division estimates biofuels have reduced the price of
crude oil by about $15 a barrel. A recent study by two Iowa State economists
concludes that biofuels have lowered the price of a gallon of gasoline by more
than 30 cents.
Devaluation. Global oil sales are denominated in dollars. When the dollar
declines in value against other currencies, the effective price the oil producer
receives also declines, prompting the producer to compensate by raising prices.
Since the dollar has fallen about 25 percent to 30 percent, up to $30 of the
current price of crude oil may reflect this decline.
In the case of grains, the impact is more indirect and less pronounced. The
dollar's decline makes U.S. grains less costly for many countries, leading to a
higher demand and higher prices.
Speculation. Oil and corn prices have soared by about 50 percent since the end
of 2007. Most experts see massive speculation as a significant factor.
Futures markets have been around for many decades. But until recently
producers largely used them as a hedge against a possible collapse in prices.
Speculation existed, but it added liquidity to the market because speculators sold
as well as bought futures. But the collapse of the stock market in 2001 and the
collapse of the financial derivatives markets after 2006, coupled with the decline
in the dollar, created a tsunami of commodities investment by hedge companies
and institutional investors.
Investments in commodity indexes have increased from $13 billion in 2003 to
$260 billion in March 2008, with more than $50 billion of that invested in just the
first two months of this year.
In June 2006, when speculative markets were much smaller, the U.S. Senate
Subcommittee on Investigations found that "there is substantial evidence
supporting the conclusion that the large amount of speculation in the current
marketplace has significantly increased prices."
By pushing up futures prices, speculators also create a financial incentive for oil
companies to store rather than sell the oil. Over the past two years, crude oil
inventories have been steadily growing. Today they are at a 10-year high. In
effect, this reduces the supply, which further increases prices.
One might argue that speculators are simply making a sound investment based
on their conviction that oil production will soon peak, driving up prices much
further, and that speculation plays a useful role in sending an early warning
signal to markets about impending shortages.
Be that as it may, there is no current shortage of oil that accounts for the $50 runup
in its price over the last eight months.
What then is the answer to our original question: Why are crop and oil prices so
much higher than can be explained by their production costs? For oil, speculation
and the decline of the dollar largely explain the soaring price. For grains, supply
and demand are the main factor, aided and abetted by speculation. For corn,
biofuels have reduced supply, thereby lifting the price, although at the same time
biofuels have effectively increased the supply of oil, thereby reducing its price.
David Morris is vice president of the Minneapolis-based Institute for Local Self-
Reliance and is author of "Driving Our Way To Energy Independence." His e-mail
address is [email protected].Minnesota Pioneer Press
