Economic Relationship Between Oil Prices, Food Prices and the Nascent Global Economic Recovery - Research Paper Example

?Economic relationship between oil prices, food prices and the nascent global economic recovery The term ‘inflation’ has become the buzzword in the recent times of global economic turmoil. Inflation basically means change in prices of commodities over time. But definition alone cannot be proof enough of the virility that it has cast on common man’s lives on a global basis. What had started with mere disputes in demand- supply equilibrium in the real estate market has turned out to be the biggest evil, spreading its grasps on almost everything that it has touched. This current inflation has not only limited itself to the real estate sector but it has now been affecting the other basic amenities of a common man’s life, most notably food. So the question arises whether the mankind is headed for a food crisis. Market research shows that developing countries like Yemen, India, Mexico, etc have all witnessed food inflation in recent times. People of Argentina have been seen boycotting tomatoes during the presidential elections as the price of vegetables got dearer to that of meat prices. Another instance shows Italian shop keepers organizing a one-day pasta boycott as an agitation against the rising food prices. So, what is the cause of this food crisis and price rises? Experts identify it as immense rise in oil prices. This project is an effort to gauge the economic relationship of oil price inflation and food price inflation and what is their impact in the nascent global economy (Kingsbury). Inflation and its massive global seriousness In light of the present scenario, the world has been witnessing unlimited rise in oil and food prices which is becoming an increasingly unbearable burden for the consumers and the producers. The United Nations Food and Agricultural Organization (FAO) in 2007, had reported that price of oil at nearly $100 per barrel resulted in huge upshot of the charge of food imports. FAO also predicted rise in the possibility of global hunger with subsequent increase in food prices, and as a result elevation in social unrest. Moreover, FAO reported dip in the worldwide food reserves to be the lowest recorded in the last thirty- five years. This was also another reason for the food prices staying high. FAO estimated rise in global food import bill was $ 745 million in 2007, up by 21% from 2006. In 2008, along with the ongoing inflation the prices of certain other items like that of soybean, corn and meat have also experienced all- time high prices. The oil price experienced a rebound to $ 140 per barrel after a slight slip (Kingsbury; Khor). Countries have been blaming each other for this. In the FAO, 2008 held in Rome several South American countries alleged developed nations for such atrocious results. U.S blamed Indian and Chinese people of increasing their food consumption with rise in income while India lashed back at U.S pointing out that people of West have long been making higher food intake. Most developing nations pointed out that speculation in the commodity markets were raising the food price. The Western countries blamed oil producing nations of not raising their oil supply to meet the rising demand and members of U.S Congress also asking for legislation to mark OPEC (the organization of exporting countries) activities as law defying (Khor). U.S and its massive demand for oil: How are food inflation and oil price rise related? Now amidst such adverse conditions there is an increasing need to assess the participation of United States of America in elevating food and oil inflation. United States is the world’s leading oil user. It contains only 2.9% of the total oil reserves that are proven and a very small percentage of unproven oil reserves. U.S receives about 29% intra-country oil productions and 21% of intra-country natural gas production through offshore drilling, mainly off the Texas and Louisiana coasts in the Gulf of Mexico, an area prone to hurricanes that are rising in intensity. Another 17% of domestic oil is received from the Northern Slope of Alaska by oil tankers using the Trans- Alaska Oil Pipeline. At present, the lifestyle and economy of the oil-dependent nations including U.S is based on supply of cheap oil. U.S contributes to only 9% of global oil production with only 2.9% of oil reserves but requires 25% of world’s oil in which 68% is used for transportation purposes. U.S was the first country to produce oil in 1859. However, oil being an exhaustible resource, by 1947 U.S had spent more than half of its total oil reserves which at one time were abundant. M. King Hubbert was a geologist working in the U.S Geological Survey. In 1956, he was of the view that U.S oil production would be at its peak in 1970. At that time, U.S was the largest oil producer of the world. So his words were not believed at that time and he was also ridiculed by the oil company officers. But U.S saw its oil production reach its peak in 1974, just after four years more from the time Hubbert predicted and has since then declined. From this incident, the half way production line of an oil field has been named as ‘The Hubbert Peak’. Many geologists also predict that U.S oil production will deplete up to 80% within 2055. U.S now produces oil at a very high cost of about $7.50- $10 per barrel, which is very high when compared to the cost of production in Saudi Arabia which is about $1-$2 per barrel. This is the reason as to why in 2005 U.S imported about 60% of oil. Most of the U.S oil comes from non-OPEC countries like Canada which contributes 11% of its oil demands and Mexico, about 10%. The politically unstable OPEC countries supplying oil to U.S are Saudi Arabia, about 9%, Venezuela about 8% and Nigeria, about 7% of its total oil demand. Almost 60% of its oil imports arrive from Houston and Texas regions which are primarily hurricane afflicted areas. So there is a fear that intense hurricanes can inflict serious damage to offshore oil refineries and plants. U.S Department of Energy (DOE) has accorded that in the near future, U.S as well as most other oil- dependent nations will have to rely more on the Middle- Eastern oil producing countries as they have a large reserve of discovered and undiscovered oil (Miller, Spoolman, 361-362). In order to reduce its impending oil insecurity, U.S has made a misguided effort to convert grains into fuels thereby triggering a global food crisis so large the world has never seen earlier. The prices of grain and corn have climbed to its all time highs. The Chicago Board of Trade on December 17, 2008 reported wheat trading, for the very first time breached the $10 per bushel level while in the month of January in the same year the price of corn trading was $5 per bushel which was also high by general standards. The soybean trade reached the mark of $13.42 per bushel which was the maximum price yet recorded. All these prices were just the double of what they used to be two years back. As a result, food products formed directly from these crops like bread, pasta, pizza etc and indirectly formed food products like pork, beef, milk, poultry, eggs etc were also on the rise. In Mexico, meals made from corns were priced at 60% of what it used to cost two years ago. Flour prices had become twice in Pakistan. China and other south Asian countries were facing an extreme form of food inflation that they had never experienced. So how exactly is the food inflation related to the rise in oil prices? One of the main issues on the demand side is that of bio fuels. Bio fuels are basically made from food crops like corn, sugar cane, palm oil, etc. These are seen as substitutes to decrease oil-seeking country’s dependence on diesel and gasoline as well as a strategy that when prices of crude oils are high these alternative sources can be used at market- competing prices. Since 2007, over 2.15 billion bushels of corn, which constituted 11% of total U.S consumption of corn, have been used to manufacture ethanol. More amount of corn is to be utilized in ethanol manufacture over the next few years. With this elevated usage of corn in production of bio fuels like ethanol prices of corn is expected to rise in the future that will be much greater than the average historical prices. As corn use in production of ethanol rises, prices of corn will be much more influenced by the oil prices. Much like corn, gasoline and crude oil are also products and they are also subject to price variability as an impact of the demand supply changes. Since ethanol is extracted mainly from corn, an ethanol user should be ready to pay for corn; this is known as break-even price of corn related in direct correspondence to the price of ethanol. Therefore, there is a positive correlation between the break-even prices of corn and the ethanol price. As the price of crude oil increases, there will be a subsequent rise in the price of gasoline which will in turn raise the ethanol price and the break-even price of corn (Brown, 2008; Crude Oil Price Variability and Its Impact on Break- Even Corn Prices, 2007, 1). Impact of U.S demand for oil on global oil price rises and food inflation In the industrial nations, although better processing and marketing technologies have been used to prevent the hard blow of this price rise, prices of food commodities are showing no signs of depletion. This is evident from the fact that when price of a loaf of whole wheat bread in U.S got 13 percent higher than that of the previous year, milk became dearer by 29 percent, eggs by almost 36 percent and in Italy, prices of pasta raised by 20 percent. World has witnessed rise in the prices of grains three times since World War II, but these price rises were results of weather- related harvest reductions. But in this case, it is due to the demand supply anomaly. In the last seven or eight years, world consumption of grains have outpaced the world production of grains. Some also claimed that the number of hunger-stricken and malnourished people would be decreasing from 800 million to 625 million by 2025 in absence of food crisis, however with food crisis due to bio fuel effects looming large, it is being predicted that number of hungry destitute are going to increase to 1.2 million by 2025, with its effects showing from now on. International food aid agencies set their budgets in advance, so a rise in food prices reduces the level of food assistance. The U.N World Food Program (WFP), which is now in charge of supplying emergency food assistance to 37 poor nations, is now making certain cost cuts as prices rise. Reports of WFP show that 18,000 infants are dying every day from hunger and its related diseases. Social unrest is also an integral by product of this problem of rising food prices like those of tortilla agitations in Mexico, pasta protest demonstrations in Italy and soaring prices of bread in Pakistan. Jakarta has seen 10,000 protesting Indonesians in front of the presidential residence to protest the soybean oil price doubling. Further examples show that when the Government in Chongqing, China, where price of cooking oil have risen, offered to provide cooking oil at a much lower price, there was a huge stampede in a marketplace where three people were killed and 31 were injured. There are also various kinds of political stresses arising from the rise in food prices due to a rise in the price of oil. In problematic countries like Afghanistan, Iraq, Somalia, Sudan, Pakistan, Haiti and Democratic Republic of Congo where there have been political unrest even before the rise in the prices of food began, have now elevated tenfold due to this problem. Moreover this current crop year is showing the lowest stocks of grains till date, with the highest of the prices ever. The food crisis has also opened a new prospect of a much timid U.S harvest of grains as the several hectares of land that previously was shifted from soybeans to corn production last year are being directed back to the soybeans since there is an impending need of providing food to an increased 700 million people and with the U.S distilleries demanding a supply of 33 million additional tons of grain to support the newly established ethanol distilleries that are getting operative from this year on. The market analysts are predicting even more stringent supplies after the next year’s harvest (Brown, 2008). One of the most important impacts of global food crisis that can be noted is the considerable rise in commodity prices since middle of May 2010. Oil prices have increased by almost 40 % with major rise in prices taking place since December. It has also witnessed rise in food and agricultural commodities with prices of metals and minerals showing considerable rise compared to that of the summer of 2008. Greater prices of energy have been operational due to the rising food prices which accounts for more than one-third of the cost of production of grains. Moreover, it is only due to the demand factors that led to the price hike until tensions of geopolitical origination aroused in North Africa and the Middle East. The massive demand for oil outside the OECD region was mainly due to the rapid economic expansions of most of the emerging economies as well as their high- intensity competitive production. There were certain other factors like that of U.S dollar depreciation since the period of global crisis that seemed to have played a significant role. U.S dollar depreciation resulted in decline of proceeds on dollar dominated assets in terms of currencies of other nations. Since crude oil is listed in U.S dollars, dollar depreciation resulted in reduction of ceteris paribus oil prices in other nations, thereby escalating oil demand on a global basis. On supply side, supply distortions like that of production and transport have also played a major impact in driving up of the oil prices. It is clear that the spare capacity of Saudi Arabia would be enough to compensate for the production disruptions in Libya. Saudi Arabia has also assured the world market of oil to compensate for the shortfalls in supply in Libya which has helped to calm the market to some extent. However, if and when the spare capacity of Saudi Arabia comes to a halt, it could result in further oil price hikes and voluntary rise in oil prices around the West as well as other oil-dependent nations (“The Effects of Oil Price Hikes on Economic Activity and Inflation”). There have been various recent climatic and political factors have been adding insult to injury by restraining supply at a temporary basis. Recent series of violent hurricanes acutely damaged U.S domestic production and manufacture of oil with massive destructions to the oil refineries. Amidst such geopolitical pressures, increasing demand of oil from Middle East and OPEC nations has caused an outrage in the production in recent times. This has resulted in curtailing the supply of oil from these countries to the Western countries. OPEC announced its cumulative production cuts in November, 2006. This has resulted in rise of oil prices on a global level with increasing inflationary pressures. The world noticed a sharp decline in the oil prices in late 2008 due to a falling demand of oil, thus reflecting a rapid depression in the worldwide economic activity during the global crisis. However, the situation was just the reverse in the beginning of 2009 when there was a massive oil supply crisis which directed the rebound of oil prices. It was this time that OPEC started tightening its screws on supply norms (Eckhard, Willard & Ollivaud, 12-13) Estimations of inflationary pressures through oil price hike To estimate some of the major effects of oil price hikes on general inflation, OECD (Organization for Economic Co- operation and Development) has come up with a Global Model to measure the effects of rise in oil prices on inflation. According to it, a $ 10 hike in the oil prices could implement a reduction in the activity in OECD region in the second year of the price shock by 0.2 % and increase the rate of inflation by 0.2 % in the first year and an additional 0.1 % in the next year. However, dynamic effects like that of the impact of balance- sheet re modeling due to a fall in real income of people causing households to decrease their rate of savings, have been excluded from the model. Again, higher costs of oil will have a detrimental effect on the potential growth due to rise in input expenses and elevated volatility of pricing portfolio on business environment. Secondly, according to the OECD Global Model multiplier projections, if the $ 25 hike in oil prices that took place during the Tunisian uprising were to be maintained, economic activity could have been halted down by almost 0.5 % and inflation rising by .75 % in the OECD region within 2012. Moreover, since the impact of oil price hikes on inflation is largely dependent on the efforts of monetary authorities to abscond inflationary expectations from moving to uncontrollable levels, at lower levels of inflation and expectations, monetary policies need not react much to the current price rises of oil(“The Effects of Oil Price Hikes on Economic Activity and Inflation”, 2-3). Policy Recommendations to reduce food and oil inflation and initiating nascent economic recovery The main problem of this ongoing global inflation is that of food inflation. But advanced research shows that the problem of food inflation is a direct impact of the developed countries’ unending demand for oil. This problem cannot be altered until and unless the oil crisis is dealt with. In order to dissipate the ongoing global crisis of food stemming from high oil prices, some policy recommendations are required to be structured to reduce oil dependency of West and bring stability to food markets as an initiation towards nascent global economic recovery. This part of the project deals with some of the possible policy recommendations that can be adopted. There are three broad areas that need to be addressed, which are: constructing a proper bio fuels infrastructure, taking methodical steps to prevent manipulation of the oil market by the OPEC countries and also introducing bio fuels to the market. Regarding the policy of bringing proper infrastructure to bio fuels circulation, bio fuels should be priced at rates that can allow every driver wanting to use bio fuels to be able to use it. As of today, only a very meager percentage of U.S cars are able to use bio- fuels and a very small number of U.S service stations are equipped to provide bio- fuels. U.S car manufacturers have been building new cars with flex fuel technology since 2006. Big car companies like Chrysler, Ford, General Motors, etc have now come up to support this and they claim that half of their new models will be equipped with flex fuel technology within 2012. The cost of installation is also very modest, only $100 per vehicle. Although the progress is commendable, yet it is not sufficient enough. Flex fuel technology should be installed in all fresh cars. It is recommended for all new buyers to enquire from the car dealer before buying a new model whether it is flex fuel. There should be a governmental legislation that makes it mandatory for the automobile makers to fasten up the speed with which this new technology should be added to new car models. For example, a legislation requiring half of the new cars sold be equipped with flex fuel by 2012, with requisite levels to rise by 10 % per year from then on. Moreover, E85 pumps are also the need of the hour. At present, only a few U.S service stations have the technological advancement to sell E85. The primal problem lies in the fact that the converting gas tanks are very costly, at almost $4,000 per piece which creates a hindrance for the pumping- station owners to install this new technology. This barrier can be overcome by a legislation that directs the major oil organizations to modify the existing pumps to E85 pumps at 50% of their possessed branded stations. There should also be a legislation that restricts the agreements of the franchisees to limit the number of bio fuels pumps at the service stations. These limitations are not accorded with national interest and such provisions should never be affirmed valid. There should also be legislations to encourage development of ethanol pipelines in bigger corridors (Sandalow, 93-94). The next recommendation is that of preventing market manipulation by OPEC. Currently, American farmers are being hit hard by the external manipulation of global oil prices by OPEC. Policies by OPEC to increase production to reduce world prices on a temporary basis will throw many ethanol producers out of their businesses. The best way to fight this threat would be by adjusting the tax credit of ethanol corresponding to the oil prices. In present context, the subsidy is much higher than what is required to encourage more investment in manufacture of ethanol. The main paradox is that the U.S tax payers are in turn providing finances that would trigger an increase in their own food prices by subsidizing the continuous conversion of grain into ethanol. There is an impending risk that if OPEC does set its prices at investment dampening levels, the subsidy will then become insufficient (Sandalow, 94-95). Considering the third possible recommendation that is introducing bio- fuels in the market, there have been several arguments in its favor. First of all, U.S bio fuel manufacture has resulted in an enhancement in protein supply as well as making it cheap which otherwise would have been quite expensive. Soybeans are the prime requirement for U.S bio fuel and each grain of soybean has around 80 % protein and 20 % oil. This soybean oil is needed for production of bio fuels. Thus with increase in soybean production, more oil can be extracted for bio fuel purposes, and with increasing soybean production, prices of soybean will definitely fall thereby providing cheap protein rich meals to U.S people. Moreover, bio fuel production will be encouraging growth in the U.S soybean industry, thereby allowing provision of varied soy products needed for food and fuel. Thus, this will in turn serve a dual purpose of producing more bio fuels on one hand and providing more food materials with nutritional contents at much cheaper rates which can help to remove food crisis to a large extent. Thirdly, the FAO has been able to find out possible opportunities for small farmers throughout the world that the presently booming bio fuels market have in store for them. FAO has called for a strict set of plans to develop policies of bio energy which ensures benefits for everybody and has also recommended small scale assistances for encouraging farmers of poor countries to contribute in bio fuels production. With opportunities of some additional income, these poor people can also use this money for ensuring food for them and their families. Reduction of this food crisis would indeed act to start progression towards an economic recovery (“Biodiesel Brings a Lot to the Table”, 2-5; United Nations Economic and Social Commission for Asia and the Pacific, 11-12). Conclusions The world is standing at a very crucial juncture of time with global economic meltdown, after a very long span is starting to slow down a bit. However, oil prices and food prices are going to remain high and there is still no change in the scenario predicted as of now. The economy at this stage is going through a period of transition. With increasing investments in bio diesel manufactures, ethanol production will continue to remain a profitable prospect. The likely growth in the capacity of ethanol industry will also not allow the corn prices to fall below average. Oil price variability will most certainly lead to corn price variations. Open contracts are also of the view that corn prices are going to remain high. Higher prices of corns will also drag the prices of other related food grains up. People need to be a bit more patient and smart at this point of time. Risk management will be of great significance to farmers in order to get an insight into the future. Cash rents as well as land prices are to be needed to adjust the higher prices of food crops. Such cost regulations will help to provide the equal per acre margins before prices of products that are ethanol- induced start increasing again. Last, but not the least, farmers still will be required to guard themselves from the continuous price changes in the market. References: 1. Kingsbury, Kathleen. ”After the Oil Crisis, A Food Crisis?” Time, November 16,2007, May 20, 2011 from: http://www.time.com/time/business/article/0,8599,1684910,00.html?iid=sphere-inline-sidebar 2. Khor, Martin.”Oil and food prices continue to rise” Third World Network, June 23,2008, May 20, 2011 from: http://www.twnside.org.sg/title2/gtrends/gtrends211.htm 3. Miller, G. Tyler & Scott, Spoolman. Living in the Environment: Principles, Connections, and Solution. Belmont, CA: Brooks/Cole Cengage Learning, 2011. 4. Brown, Lester R.” Why Ethanol Production Will Drive Food Prices Higher in 2008” Earth policy Institute, January 24,2008, May 20, 2011, from: http://www.earth-policy.org/plan_b_updates/2008/update69 5. “Crude Oil Price Variability and Its Impact on Break- Even Corn Prices” Farm Business Management, 7.11, 1-5, May 30,2007, May 20,2011, from: http://www.farmdoc.illinois.edu/manage/newsletters/fefo07_11/fefo07_11.pdf 6. “The Effects of Oil Price Hikes on Economic Activity and Inflation” Organization for Economic Co- operation and Development. 1-4, n. d, May 20, 2011, from: http://www.oecd.org/dataoecd/9/3/47332660.pdf 7. Wurzel, Eckhard, Willard, Luke & Patrice Ollivaud. “Recent Oil Price Movements- Forces And Policy Issues” Organization for Economic Co- operation and Development.1-30, December 4,2009, May 20, 2011, from: http://www.oecd-ilibrary.org/docserver/download/fulltext/5ks5ljvswzvh.pdf?expires=1305943843&id=id&accname=guest&checksum=B6CFEEDF8B64BCF07D5E0B2A3FE7DCA5 8. Sandalow, David. Freedom from Oil. New York: Mcgraw-Hill, 2008 9. “Biodiesel Brings a Lot to the Table”.1-5,April, 2008, May 21, 2011, from: http://www.biodiesel.org/resources/sustainability/pdfs/Food%20and%20FuelApril162008.pdf 10. United Nations Economic and Social Commission for Asia and the Pacific. Economic and Social Survey of Asia and the Pacific 2008. New Delhi: Academic Foundation, 2008 Read More