What is Driving Food and Oil Prices Higher?

As South Asians, Americans and the rest of the world suffer the impact of doubling of the food and fuel prices in about a year, there is a strong desire around the world to understand and address the underlying causes driving this phenomenon. While conspiracy theories abound, the more serious reasons being explored include imbalances between supply and demand and market speculation by large financial players. Meanwhile, the people continue to suffer in countries such as Pakistan and India where the poor spend as much as 66% of their income on food and fuel.

Increasing demand from the fast growing economies of the BRIC countries is usually acknowledged as a factor. Simultaneously, supply jitters have been caused by "peak" oil theories bandied about Saudi Arabia and crop failures in traditional breadbaskets of the world. In addition, the US and Japan have become the largest hoarders of oil. The Strategic US Petroleum Reserve (SPR) is an emergency petroleum store maintained by the United States Department of Energy. The US SPR is the largest emergency supply in the world with the current capacity to hold up to 727 million barrels (115,600,000 m³) of crude oil. The second largest emergency supply of petroleum is Japan's with a 2003 reported capacity of 579 million barrels (92,100,000 m³). The current US inventory is displayed on the SPR's website. As of June 11, 2008, the current inventory was 704.9 million barrels (112,070,000 m³). At current market prices ($138 a barrel) the SPR holds over $38.7 billion in sweet crude and approximately $50.9 billion in sour crude (assuming a $15/barrel discount for sulfur content). The total value of the crude in the SPR is approximately $89.6 billion USD.

However, it appears that the increased demand, greater national hoarding and limited supply do not completely explain such a steep price rise over less than a year.

It seems the line between financial assets such as stocks and bonds, and essential commodities such as food and oil, is rapidly fading with huge institutional investors including pension and hedge funds looking to increase their returns substantially. Some of them may be buying oil, food and other physical commodities as well as futures contracts to hedge against inflation and the falling US dollar.

Recently, George Soros, the legendary investor and speculator, told a US senate committee that speculation, while not the only contributor to the recent runup in crude oil prices, "reinforces the upward pressure on prices." He said speculation is "distinctly harmful" to the economy.

"We're paying, some believe, as high as a 50% premium to the pockets of speculators that are operating in markets that are completely unpoliced," said Michael Greenburger, a University of Maryland professor and former CFTC official. "At least 70% of the US crude oil market is driven by speculators and not people with commercial interests."

"Americans may be surprised to learn that the oil futures markets were substantially deregulated by the CFTC staff decisions that were made behind closed doors," said Sen. Maria Cantwell, D-Wash. "Now this London and Dubai loophole is keeping important U.S. energy trading in the dark and without proper light ... it can give manipulators free rein in energy markets."

Investigating food prices in India, a government appointed commission concluded that futures trading has nothing to do with the increase in the prices of food products such as wheat and rice. That was the unanimous finding of the four-member committee headed by Abhijit Sen asked to look into the connection between the two.

While the futures trading may not have caused the price rises, there is a strong belief that investors are playing their part in the food chain and may contribute to further price volatility.

Soaring agricultural prices, growing demand for biofuels and the growth of the Chinese and Indian economies are leading top global investment banks to buy farmland in a bid to embrace the physical commodities market, according to Reuters.

Investment banks and hedge funds are buying up vast tracts of agricultural land around the world, hoping to ride the so-called "commodities supercycle" that has lifted prices of everyday agricultural commodities such as wheat, rice, soybeans and corn to record highs, says a Reuters report.

One of the Middle East's largest private equity firms has been quietly buying up farmland in Pakistan as part of plans by the United Arab Emirates to increase food security and to control inflation, according to a gulf website arabbuild.net. Please read prior blog posts on this subject.

US investment bank Morgan Stanley has bought several thousand hectares of land in Ukraine, Europe's grain basin. Reuters says Morgan Stanley declined to comment, but industry executives say many other big banks are looking at land.

A recent NY Times report raises concerns about the commodity speculators jumping into the fray. By owning land and other parts of the agricultural business, the investors, including sovereign funds, are freed from rules aimed at curbing the number of speculative bets that they and other financial investors can make in commodity markets. “I just wonder if they need some sheep’s clothing to put on,” said Jeffrey Hainline, president of Advance Trading, a 28-year-old commodity brokerage firm and consulting service in Bloomington, Illinois in the United States.

If the governments do decide that the futures trading is driving significant price increases rather the fundamental supply-demand equation, then the possible fixes include a range of options. The regulators can just ban futures trading outright (as they have in India) in one or more commodities or, at a minimum, significantly increase margin requirements (from 5-10% to 50%)for futures contracts to dampen speculation. The latter option is better because it does preserve the ability of genuine producers and consumers to hedge against future price volatility. Given the potential for artificially high food and fuel prices causing major disruptions in the global economy, it would be wise for major governments to act now, rather than wait for conclusive evidence.

On the oil speculation front, the US Congress appears ready to act to restrict oil futures trading, under mounting pressure from the airline industry, American consumer groups, the International Monetary Fund and Billionaire investor George Soros. A similar effort will probably be needed to curb food price increases based on speculation.

Here's a video clip of world leaders, including Shaukat Aziz, at the World Economic Forum in Kuala Lumpur talking about Global Food and Energy Crises:


Anonymous said…
Good job! :)

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