The cure for high/low prices

by Robbin S. Johnson
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The record-high prices for many commodities years ago are a major cause of today’s lower prices. An important question is whether this cycle will soon repeat.

In the world of commodities, there is a well-known aphorism: “The cure for high prices is high prices, and the cure for low prices is low prices.” The record-high prices for many commodities three or four years ago are a major cause of today’s much lower prices. An important question for agriculture — both for inputs and outputs — is whether this cycle will soon repeat.

Food prices are largely market-driven, but oil and gas prices are not. Ever since 1973, the Organization of Petroleum Exporting Countries (OPEC) has tried to override this lesson, and they are expected to want to try again. What is likely to happen?

High price cures

When prices rise to high levels, several things change in response. New production emerges, both through expansion of the resources devoted to output and through intensification of inputs. At the same time, consumption drops, and consumers search out substitutes; such changes in consumption patterns may persist even after prices come back down, turning a cyclical instability in demand into a chronic change in usage. And, where possible, consumers put off buying high-priced goods. More supply and less demand leads inevitably back toward lower prices.

Because food demand is relatively inelastic, the option of deferring consumption is not very successful. But output growth and substitution effects may be quite pronounced. Moreover, once additional production is put in place, it often remains even after prices come down. Likewise, when substitutions occur, it may be costly — or impossible — to attract users back, as they become accustomed to their new consumption patterns. For example, some of America’s reduced beef consumption per capita in recent years of high prices may prove permanent, reinforced by other societal and dietary trends.

Low price cures

When prices fall, high-cost producers may scale back or shut down. Low prices also induce additional usage, and they may encourage stockpiling. Food, again, is constrained in its responses because marginal production costs usually are low compared to fixed costs, enabling output to continue even at the new, lower prices. Stomach size, social trends and health concerns may limit usage growth, dampening the demand response. Many foods also are subject to spoilage, limiting the effect of stockpiling in response to low prices. As a result, while periods of high food commodity prices tend to be brief, periods of low prices may persist much longer.

Energy markets

The attempts by Saudi Arabia to rally a sufficient number of large oil producers to cut output, as OPEC has done in the past, seem not to be gaining the same degree of traction. If not enough other major oil producers are willing to cut back production, Saudi Arabia’s oil minister has pledged to keep its own production running at a high level. Will this situation end up keeping oil and gas prices low for a more prolonged period? There are a number of reasons for thinking that low energy prices will persist for some time.

First, energy consumption is being pushed toward rising levels of efficiency by forces beyond price. For example, Corporate Average Fuel Efficiency standards for U.S. automobile and truck fleets are rising. Even as consumers shift back toward larger vehicles, the effect on increased energy usage is blunted.

Second, a key driver of high oil and commodity prices earlier in this century was the seemingly insatiable appetite of China. China’s slowing growth and its past tendency to overbuild infrastructure have certainly slowed that engine of demand.

Third, stockpiling energy is much more feasible than for food. Storage tanks may be pumped full, new facilities may be built for anticipated future returns, and fossil fuel supplies may be left in the ground but ready to flow at the first signs of rising prices.

Particularly interesting is the effect of production costs on price response. There already is substantial evidence that producers using “fracking” techniques have found ways to lower their operating costs. Moreover, many of the less well-financed companies in this industry are likely to end up in stronger, better-capitalized hands after their sale or bankruptcy. In the natural gas world, large investments have been made in the infrastructure for shipping liquefied natural gas. Low prices are unlikely to drive this sector out of business.

Finally, many of the producers of fossil fuels are state-owned corporations, for whom normal economic forces may not fully apply. And many major producing countries depend on oil and gas revenues for much of their national budgets. They can ill afford to cut back in the face of low prices, making them less willing to cooperate to reduce production. The entrance of post-sanctions Iran into global energy markets adds yet another strong supplier with reasons to keep pumping.

There seem to be many reasons to believe that $100+ per barrel oil prices may have been more of an aberration than a future certainty. If so, agriculture can, on the one hand, look forward to more attractive input costs and, on the other hand, a less promising biofuels prospect.

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