Heat and crop yields in 2010

This may be premature, but I'm very tempted to award a gold star for clairvoyance to Michael Roberts, whose research on the effect of heat on crop yields I've blogged here and here. Here he is on August 12:

[Current temperatures] are still rising fast. If this keeps up for a few more days I'd say yields will get hammered.

(to give credit where credit is due, the market may have seen the same thing)

Anyway, fast forward to last week, the October forecasts for wheat, corn and soy are all well below the September forecasts (although USDA puts a bizarrely positive spin on it). As Michael's chart below shows, the September forecast is almost always very good, and revisions are generally upward, not downward, so something funny happened this year, and late heat seems to be a very strong hypothesis.
Michael is investigating the more detailed data and I hope will post any findings as they arise. As I mentioned before, if it was the heat, it will be very valuable to prove and communicate this to stakeholders in agriculture, some of whom have taken very skeptical views toward climate change and its impact on them specifically.

More food price volatility drivers

Upon further reflection on Chris Blattman's rare dud, here are a few more (slightly overlapping) potential drivers of food price volatility in the future. Please note that I'm not saying these will definitely cause higher food price volatility in the future, only that it is very easy to believe that they might.

• Biofuels and bioenergy: An additional source of demand growth - potentially very large - that could keep demand at the very edge of supply capacity.


• Stronger links to energy prices: Energy prices have always been linked to agricultural input costs since the most widely used fertilizer (nitrogen) is generally made from natural gas. More recently ethanol has become at times the marginal buyer of corn (Bruce Babcock at CARD did some nice research demonstrating that ethanol was the marginal buyer from late 2007 to mid 2008; I couldn't find a link to the paper, but all you need to do is look at the high correlation between actual corn prices and break-even prices for ethanol production). If this continues - and it may well, particularly when oil prices are high - then volatility in oil prices will be transmitted to food prices more than in the past.


• Speculation: That old bugbear; I personally am more skeptical about this one, as longtime readers will know, but the former head of IFPRI isn't, and objectively I'm no more likely to be right than he is.
  

Update: Michael Roberts responds and reprimands:

Here Chris seems to talking as much about climate science as economics or politics. He has also stepped onto a pet peeve of mine, common among some economists, which is ascribing personal views as truisms stemming from the branch of social sciences in which one specializes. It's not quite as bad as Steven Levitt pontificating about global cooling, but it reeks of that kind of professional arrogance. If you're an academic and are going to start asserting scientific truisms you need to be more specific about the underlying science.

He also points out a few factors not yet on my list, which I'll paraphrase here:

• Globalization is not irreversible: Think about how surprisingly globalized the world became during 1870-1914, only to regress drastically following World War I and the Great Depression.


• Shifts in comparative advantage due to climate change, which Michael is "convinced" of:
  

  That is, [climate change is] going to shift where things are grown. A lot. It's also likely to change global quantities, but that's hard thing to put a finger on (i.e., model convincingly). With that much change going on, we should worry at least a little bit, and probably a whole lot, about how the kind of turmoil these changes will cause. Loss of comparative advantage is just the kind of thing that brings about bad policy response.

• Uncertainty itself can exacerbate market volatility, and uncertainty about the future is high, not just about long-term commodity prices, but also about the direction of the world economy and shifts in agricultural production due to climate change.

Do food prices cause "food riots"?

The usually outstanding Chris Blattman has posted some spotty analysis of the recent journalistic coverage of food riots in Mozambique, which he finds "shallow and alarmist." I would have commented, but many have already done so, so rather than pile on I'll just articulate my own take here. Like commenter @Jonomist, I think his punchline that we should be more careful attributing causality is probably defensible, but some of his arguments are not.

Here’s what a closer look at your economics and political science can tell you.

Expect price volatility to fall over time. Globalization and growth should reduce price spikes in future. More countries are producing crops. Climate shocks in Argentina are not that tied to climate shocks in Russia or China, and so price volatility from supply shocks should be going down. Falling transport costs also mean that more substitutes are available, further reducing price volatility. So things should be getting better over time, not worse, especially if trade allows countries to diversify their diet. Envision a future of diminishing instability.

This is a dangerously superficial argument, reminiscent of arguments that a more integrated global financial system would mitigate systemic risk - remember how that turned out? It's what a textbook analysis would say, but lacks grounding in the realities of these markets.

• Empirical data (most recently the price spikes of 2008 and now 2010) don't bear this out, at least in retrospect to date.


• Many agricultural stakeholders - including private companies both producing and buying food, as well as multi-laterals such as the FAO and the World Bank - are deeply concerned with price volatility in the future. (My own view is that we can't yet tell if average volatility will increase to a higher permanent plateau, but most players believe this is much more likely than the opposite.)


• Growth in both population and income is driving strong growth in agricultural demand that is unlikely to abate soon, and pushing the world toward the edge of its current supply capacity. Production can grow too (Ehrlich and Malthus were wrong) through increasing yields through research and bringing more land under cultivation, but the former is longer-term and the latter runs into seriously diminishing marginal returns. My personal belief is that we will be able to feed 9 billion people a more modern diet by 2050, but there will be bumps along the way, and any time demand nears supply capacity, the potential for price volatility increases significantly.


• Climate may become more unstable as climate change progresses, and climate change could also adversely affect baseline agricultural productivity, as Michael Roberts' excellent paper has shown and the market seems to believe.


• As several commenters noted, national policies play a substantial role in agricultural prices (notice how the wheat market responded to the Russian wheat export ban), and this intervention seems unlikely to diminish (especially in light of the above factors) - if anything it is likely to exacerbate any increases in underlying volatility caused by long-term demand growth and short-term supply shocks.

A few smaller nits:

Look to local policy, not global markets, for the real instability. Bread prices climbed 30% in Maputo, apparently due to Russian wildfires. But global wheat prices have only risen 5%. Why the disproportionate effect? I wish I knew, except I haven’t a single report from the ground that points out the disparity, let alone one that searches for an answer.

Yes, global wheat prices have risen 5% "during August" - and more than 50% since June, as commenter Bernhard Brummer points out. Some of the blame goes to the NYT writer for not picking a better baseline, but it's not a hard thing to double-check.

Chris: For riots, look to poor policing, not poverty.
@Jonomist: Are fires caused by insufficient fire marshaling?

Exactly.

Chris' track record is too strong for him to need to redeem himself, but he does so anyway (I'm not sure if intentionally) through his next post on the quality of his commenters (who came through rapidly here).

Blaming and curbing food speculators

With wheat prices up 50% since June and Russia banning grain exports, the media is all over "the next food crisis." I'm disappointed that former IFPRI Director-General Joachim von Braun appears to lay much of the blame on those evil speculators.

The setting of prices at the main international commodity exchanges was significantly influenced by speculation that boosted prices. Not only are food and energy markets linked, but also food and financial markets have become intertwined – in short, the “financialisation” of food trade. There are increasing indications that some financial capital is shifting from speculation on housing and complex derivatives to commodities, including food.

von Braun is right to call for "accelerated public investment in agriculture." But I believe it's misleading to imply that speculation-curbing measures such as requiring larger capital deposits of traders will really help moderate either prices or volatility. For prices, note how prices also rose in non-speculatable food commodities in 2008, and for the impact of speculation (a.k.a. liquidity) on volatility, just remember the onions.

I'm not 100% sure I'm right on this, but I would have appreciated a more robust substantiation of the claims about speculation's impact from someone of von Braun's stature.

Price rises in non-speculatable food commodities

I recently had a contentious discussion over the extent to which financial speculation caused the food price run-up of 2008 (and prior years). I am skeptical that speculation was a major culprit, and I was unable to remember the specifics of the argument that prices rose similarly in commodities which are not index-traded. For future reference (my own as much as my readers'), I tracked it down in this paper recently released by the OECD. (emphases are mine)

If index fund buying drove commodity prices higher then markets without index fund investment should not have seen prices advance. Again, the observed facts are inconsistent with this notion. Irwin, Sanders, Merrin (2009) show that markets without index fund participation (fluid milk and rice futures) and commodities without futures markets (apples and edible beans) also showed price increases over the 2006-2008 period. Stoll and Whaley (2009) report that returns for Chicago Board of Trade (CBOT) wheat, Kansas City Board of Trade (KCBOT) wheat, and Minneapolis Grain Exchange (MGEX) wheat are all highly positively correlated over 2006-09, yet only CBOT wheat is used heavily by index investors. In a similar fashion, Commodity Exchange (COMEX) gold, COMEX silver, New York Mercantile (NYMEX) palladium, and NYMEX platinum futures prices are highly correlated over the same time period but only gold and silver are included in popular commodity indexes. Headey and Fan (2008) cite the rapid increases in the prices for non-financialized commodities such as rubber, onions, and iron ore as evidence that rapid price inflation occurred in commodities without futures markets. While certainly instructive, the limits of these kinds of comparisons also need to be kept in mind. Bubble proponents have pointed out that commodity markets selected for the development of futures contracts may be naturally more volatile than those commodities without futures markets.

The paper also includes more far more statistical including the latest Granger causality analysis, which is more rigorous, but also in my view less effective than anecdotes like the above in many informal discussions. Their overall conclusion is unequivocally in line with my view that

... at this time, the weight of evidence clearly suggests that increased index fund activity in 2006-08 did not cause a bubble in commodity futures prices.

In related reading, here are previous posts citing Thomas Malthus and Darrell Duffie on the benefits of speculation in food markets, and here is Scott Irwin (one of the OECD paper co-authors) last year on why index speculators didn't break the wheat market.

Reminders of the crop yield treadmill

Recent journalistic pieces on wheat rust and brown streak (a virus which infects cassava) remind us that agriculture is a constant battle against evolving pests of many kinds. So when we think about declining funding for agricultural research and try to assess induced innovation, we need to keep in mind that a certain level of research and progress will be required to maintain yields at their current level, let alone improve them. We are on a treadmill, not standing still.

Map of the day: Access to markets in Ethiopia

From Roving Bandit, these striking graphs show how close a given point in Ethiopia is to international and domestic demand centers, respectively, in terms of travel time. If you're a farmer, living in a green area means your end markets are very far away, and transport will eat up a big chunk of the end price of whatever you're producing.

Transport times like this give you large import/export parity price wedges like this:

... which obviously leads to a lot of price volatility, which is bad for producers and consumers alike.

(the latter graph is a favorite of mine from the World Development Report 2008 on agriculture and development.)

Algerian cereal harvest triples

A report issued by the Algerian Agriculture Ministry showed that the country has produced nearly 6 million tons of cereals in 2009, almost three times more than last year, APS reported.

This year's production rise was made possible by good rains and new financial incentives from the government, the ministry said. Those incentives have included soft loans for farmers and subsidies for fertilizers and high-yielding seeds. Last year, the government also said it would almost double the price it pays farmers for their grain as part of efforts to boost domestic output.

I find this news interesting because it illustrates the availability of additional food supply with high enough prices (or in this case, high enough subsidies). We really aren't butting up against Malthusian/Ehrlichian resource constraints on food production yet.

Creating markets is hard

William Easterly's Aid Watch blog cites an interesting project in Ethiopia as an example of the impossibility of assessing development projects on a binary scale:

This month, while the G8 continued their vague pledges of billions in food aid, Eleni Gabre-Madhin was busy bringing a market-based solution to the problem of food security in Ethiopia, as the CEO of the Ethiopia Commodities Exchange (ECX). After years of studying Ethiopia’s agricultural markets, Gabre-Madhin hit upon a central commodities market as a way to end the country’s deadly boom and bust cycle, which has seen overproduction and low food prices one year and famine the next.

The ECX has been running for a little over a year now, and lists five commodities traded on its website—coffee, sesame, beans, maize and wheat. With a central trading pit in Addis Ababa, eight warehouses throughout the country, and market data being transmitted through a network of electronic display tickers, text messages, TV, internet and radio, the ECX is designed to reduce the burden of high transaction costs and excessive risk on farmers and traders, and increase access to information for small-scale farmers in remote areas.

In 2008 when the ECX was launched, the Economist called it a “bold experiment to improve the efficiency of agricultural marketing,” and Eleni Gabre-Madhin herself has been lauded as a visionary and a pioneer.

Sounds great, right? There is certainly much to be said for transparency and liquidity in agricultural markets. But interference by the corrupt and untrusted government has apparently damaged ECX's credibility, highlighting the challenge of building markets in countries with weaker legal and institutional frameworks than we're used to here in the developed world.

Academia: indices DIDN'T break the wheat market

A few weeks ago the Senate released a report blaming speculation and specifically index funds for high wheat prices and non-convergence of the futures and spot markets. It was interesting reading but received mixed reviews. At the time I stated:

It's very complicated to prove anything in this arena - my hunch is that the indices did play a large part in non-convergence of wheat contracts at the least, and maybe higher volatility as well, but I haven't seen anyone prove it to my own satisfaction.

Well, turns out I was wrong, according to Scott Irwin, a professor of agriculture at the University of Illinois. In a recent post on Econbrowser, he assembles the academic work on the topic and points the finger at two other culprits:

Our research at the University of Illinois pinpoints two major factors contributing to the lack of convergence between cash and futures price in wheat. The first factor is the tendency for spreads in the futures market to reflect a relatively high percent of full carry (contango) since 2006. The second factor is long-term structural deficiencies in the delivery system for CBOT wheat.

I won't do more than summarize (you should read his whole post if you're interested), but on the latter, the basic idea is that because of non-negligible delivery costs and an oligopoly controlling delivery locations, the market isn't entirely efficient (for reasons not yet understood).

It is not clear why these firms have apparently left so much money on the table by not arbitraging the very large differences between cash and futures prices. Understanding the motivation and strategies of these firms would be a far more informative line of inquiry than the current obsession with index funds.

As for the former, the following chart is worth a thousand words:


Days 5-9 are when the so-called "Goldman roll" takes place, i.e. where we would expect to see the impact of the influx of money into long-only commodity indices. And we see a bump... but the effect is not persistent (it subsides immediately in Days 10-13) and it dates back at least a decade. In light of this evidence, it's hard to believe the Senate report's assertion that index rolling was responsible for the recent and persistent widening of spreads.

The enduring importance of wheat

Great quote from the Levin-Coburn report on speculation in the wheat market:

“No man qualifies as a statesman who is entirely ignorant of the problems of wheat.”
--Socrates (469-399 B.C.E.)

Who knew Congress had a sense of humor?

P.S. The report itself is lengthy and conflates correlation with causation (as do many others), but nevertheless makes for fascinating reading, particularly the historical evolution of the wheat futures market. Speculation is clearly not a new issue:

The CBOT Annual Report for 1864 reflects how the nature of trading already had shifted from strictly cash transactions to speculative trading:

“It is true that speculation has been too much the order of the day, and buyers and sellers of ‘long,’ ‘short,’ and ‘spot,’ have passed through all the gradations of fortune from the lower to the higher ground, and in many instances have returned to the starting point, if not to a step lower, but it is to be hoped that with the return to peace this fever of speculation will abate and trade will be conducted on a more thoroughly legitimate basis.”

P.P.S. Another footnote reminds me of the hilarious and instructive case of onion futures.

Did commodity indices break the wheat market?

The Senate's newly published Levin-Coburn report thinks so. CME has promptly "refuted" the charges. Felix Salmon buys it (and makes the connection to the USO oil ETF's exacerbation of oil contango).

It's very complicated to prove anything in this arena - my hunch is that the indices did play a large part in non-convergence of wheat contracts at the least, and maybe higher volatility as well, but I haven't seen anyone prove it to my own satisfaction.