Price Volatility, Reserves and Public Policy

Brian WrightChair, Agricultural and Resource Economics

UC Berkeley

ICABRRavello Italy June 19, 2013

Post- “Inside Job” I perceive a need for disclosure:

Recent or current grant support:• AMIS initiative of G20 • Energy Biosciences Initiative (UC Berkeley, UIUC, LBL, BP,

funded by BP) – researches cellulosic biofuels• USDA• NIH• NSF• USPTO• Giannini Foundation

Disclosure (contd.)• Current consulting relationships:

– World Bank– FAO

• No recent positions in commodity markets• No investments in agricultural input or service providers, or significant

commodity market or energy market participants.• In past 2 years, I was a consultant/expert witness engaged by an entity that

produces and exports agricultural products. I was recently an expert witness in a case involving generic drug entry in pharmaceuticals

• I recently made a presentation at a major agricultural bank• Last month I was compensated by a leading investment firm for a presentation

at their head office• I am happy to identify any of the firms involved in the above activities, should

any audience member request that I do so.

Global Grain Markets: Assumptions for a simple model

1. Production is seasonal, most often with one grain harvest ht per year. – positive trend due to productivity increases.

2. There is an inevitable one-year lag between the investment in planting an area At and the harvest. – within-year planned supply can be approximated as pre-determined.

3. Expected harvest at planting, Et-1 ht, is roughly proportional to planted area.4. The realized harvest is subject to random shocks proportional to expected

harvest, due to variation in the weather, the prevalence of pests, and other shocks.

5. Grain consumption is a negative function of price. – Positive trend due mainly to (exogenous) population increase.– Other demand shifters such as income and tastes and tend to be slow-acting, not

“shocks”

– So we can write the inverse consumption demand as pt = F(ct).

Simplest S-D model is consistent with long run increasing production trend

• Obvious (linear?) uptrend in production

• Obvious downtrend in price in long view

Index of World Detrended Price vs. Index of Detrended Production for Rice (1961-2012)

After detrending, simplest S-D model cannot explain rice price volatility

• No consistent relation even before 2005• Simplest Marshallian S-D model fails if applied to rice alone

Try Adding Storage to the Marshallian Market Model

Assume stylized facts of major grain markets: 1. Grains can be stored from period to period

without cost, waste, or “shrinkage”2. Grain stocks cannot be negative. 3. Consumption cannot be negative.

Available supply is used in two ways:

1) for consumption in year t, ct and for carryout stocks, which become carryin stocks xt for the next year.

2) for carryout stocks, which become carryin stocks xt for the next year.

Available supply at time t, at, for a given year comes from the current harvest ht and from stocks xt-1 carried in from the previous harvest:

• at = ht + xt-1

Available supply is used in 2 ways:

• Consumption• Carryout stocks

ct = at – xt.

Sources of available supply

• Available supply at for a given year comes from the current harvest ht and from stocks xt-1

carried in from the previous harvest.

• at = ht + xt-1

If storers are competitive and aim to maximize expected profits, and the only cost of storing is the (constant) opportunity cost of capital r, then their behavior will result in the following complementary conditions for equilibrium intertemporal arbitrage:

Nonlinearity of Inverse Total Demand Function and Price Dynamics

Does Storage Dynamics Explain Prices?

Rice: Index of Detrended Price versus Observed Stock-to-Use Ratio

• No consistent relation even before 2005• Adding storage to the rice market model does not make it fit

Try Aggregation of Rice, Maize, and WheatCalories price and grain prices

Index of World Detrended Price vs. Index of World Detrended Production for Calories

• Simple S-D model fails even for aggregate grains

Was there a perfect supply storm?

Weather and Global Warming?Really?

US Corn Harvest

0 1 2 3 4 5 6 790%

100%

110%

120%

130%

140%

150%

Ratio of Index of Prices Received for All Crops to Index of Prices Paid for Production Items, Interests, Taxes and Wages Rates

U.S., 1972-1979 vs. 2005-2012

2005-20121972-1979

Cost push?

1990/1991

1991/1992

1992/1993

1993/1994

1994/1995

1995/1996

1996/1997

1997/1998

1998/1999

1999/2000

2000/2001

2001/2002

2002/2003

2003/2004

2004/2005

2005/2006

2006/2007

2007/2008

2008/2009

2009/2010

2010/2011

2011/2012

2012/2013-4%

-2%

0%

2%

4%

6%

Corn Rice Wheat Total

Consumption Surge in India and China?Consider their net exports:

Let’s try: Aggregation Plus Storage

Calories of 3 major grains:Index of Detrended Price versus Observed Stock-to-

Use Ratio - maize, wheat and rice: Now it works!

But are stocks consistent with the naïve model?

19611963

19651967

19691971

19731975

19771979

19811983

19851987

19891991

19931995

19971999

20012003

20052007

20092011

0.6

0.9

1.1

1.4

1.6

1.9

2.1

2.4

2.6

price implied by stocks data detrended observed price

Detrended Price-implied Stocks Data vs. Detrended Observed Price Index for Calories

19611963

19651967

19691971

19731975

19771979

19811983

19851987

19891991

19931995

19971999

20012003

20052007

20092011

0.10

0.15

0.20

0.25

0.30

0.35

actual stocks data stocks implied by price and estimates

Calories: Actual Stocks vs. Stocks implied by Price Data and commodity model

19611963

19651967

19691971

19731975

19771979

19811983

19851987

19891991

19931995

19971999

20012003

20052007

20092011

0.10

0.15

0.20

0.25

0.30

0.35

0.40

actual SUR SUR implied by price and estimates

Actual SUR vs. price-estimates-implied SUR for Calories

(why good fit only through 2004?)

Calories: Index of Detrended Price versus Observed Stock-to-Use Ratio

Transfer to Farmer Wealth:Financial crisis plus biofuels

Permanent Mandate Anticipated and Imposed

Shifts due to a Temporary Mandate versus Permanent Mandate

Implication of Storage Model

• Relation highly nonlinear due to influence of stocks levels

• Cannot calculate “percentages of blame”

• Marginal effect is the key: Relevant for policy• Linear SR time series irrelevant

Policy Options• Self sufficiency:• Strategic reserves• Virtual reserves (IFPRI 2008)• Subsidize storage• Ban Export Bans (if you can)• Limit biofuels use of grains and sugar• Farmer risk management• Acquire foreign farmland and grow the national staple • Biofuels diversion contracts• GM crops?

Policy Options: Tools for Execution?

• Strategic reserves

Subject to political interference - almost always against security and in favor of pressing political interests

Acquisition and disposal rules contentious (see e.g. commodity fund rules)

Policy Options: Tools for Execution?

• Strategic reservesUS strategic petroleum reserve as example

But substitution reduces effectiveness inevitablySpeculative attacks look bad, but actually can increase

efficiencyUS silver reserve as cautionary tale (among

others)

Public and Private Stocks: Interactions

Policy Options: Tools for Execution?

• Strategic reserves

US silver reserve as cautionary tale (among others)

Policy Options: Tools for Execution?

• Virtual Reserves (IFPRI 2008)

Naked short positions where necessary to convince markets that their price expectations will not be fulfilled?

What would have happened if adopted in 2007/08?

Ban Export Bans?

• Prisoner’s dilemma• Export bans can prevent hunger in weak regimes

• Fundamental trade problem:Biofuels as classic (but huge) price discrimination

Divert grain from inelastic (food) to elastic energy) demand market

Acquire foreign farmland and grow the national staple

• Acquire foreign farmland and grow the national stapleGood deal for all? Capital or oil for land output

and supply security?Sovereign risk?Political commitment durability?

Policy Options: Tools for Execution?

• Acquire foreign farmland and grow the national stapleBuy-in from private sector?Buy-in from resident peasants?“terra nullius??”

Policy Options: Tools for Execution?

• Subsidize storage?

– Advantage: depoliticize buy-sell decisions

Policy Options: Tools for Prevention/Amelioration?

• Political alliances, naturally

• Reduce incentive to use biofuels by moderating oil prices?

• Support transparency in grain markets– AMIS initiative– Reduce ignorance that generates panic

Policy Options: Tools for Execution?

Impact of Biofuels: Limit biofuels use of grains and sugar

• Not just in EU and US

• Huge transfer to landowners and farmers

• Huge transfer from poor consumers

Transfer to Farmer Wealth:Financial crisis plus biofuels

Relevance of GM for poor?

• Depends on biofuels policy• Increase RFS continually?• If so GM can do nothing for poor• Not North/South issue but

Landowner/Consumer

Summary

• Nonlinearity of response• Huge distributional effect of biofuels• Will it continue?• If US RFS expansion leads, others including

LDCs will follow• More redistribution away from poor than any

development policy• The “GM for poor” is red herring

What are the sources of insecurity?

① Price spikes like 2007/8? Wealthy countries are minority consumers – can

tolerate a doubling of farm gate food prices Poor countries (and especially the poorest non-

farmer citizens of such countries) are vulnerable Spikes force government intervention,

suppression of private sector development?

What are the sources of insecurity?

① Price spikes like 2007/8? Expect continued grain market pressure and

instability if biofuels use of grains continues to expand as US farmers expect (or hope)

E10 to E85!

What are the sources of insecurity?

① Price spikes like 2007/8? Expect continued grain market pressure and

instability if biofuels use of grains continues to expand as US farmers expect (or hope)

E10 to E85!

What are the sources of insecurity? :

②Export bans like 2007/08? Really bans?? May be exacerbated by state trading, lack of

decentralized private initiative Let’s get real!-no exporter government will starve its citizenry and hope to live to enjoy the rewards of trade Can be fatal: Niger drought disaster after neighbors

reneged on commitment to open borders

What are the sources of insecurity?

③Credit market failure like 2008? Problems financing stocks and trade?

What are the sources of insecurity?

④Interruption of physical access?blockade? Sea lanes interruption? (Persian Gulf?) Landlocked may face closed borders

What are the sources of insecurity?

⑤Obligation to neighbors in distress?

Saudi Arabia and Gulf states?Serious topic: Blockade of Straits of Hormuz?No oil outNo grain in to Gulf States

Whether all or most of these factors will continue to impact markets for food and agricultural products in the years to come is difficult to say. It does, though, appear that extreme weather events have become more likely as a consequence of ongoing climate change. That factor alone may mean that markets may continue to exhibit a marked degree of volatility in the future, even larger than the 'traditional' volatility that has always plagued agricultural markets. Also

Nonlinearity of Inverse Total Demand Function and Price Dynamics

References:• Bobenrieth, E., Wright, B. D. and Di Zeng. “Stocks-to-use Ratios and Prices as

Indicators of Vulnerability to Spikes in Global Cereal Markets.” Agricultural Economics (forthcoming).

• Cafiero, Carlo, E.S.A. Bobenrieth, J.R.A Bobenrieth, and B.D. Wright. 2011.“The empirical relevance of the competitive storage model.” Journal of Econometrics, 162: 44-54.

• Wright, Brian D. and C. Cafiero. 2011.“Grain reserves and food security in the

Middle East and North Africa.” Food Security, (Suppl 1): S61–S76DOI: 10.1007s12571-010-0094-z.

• Wright, Brian D. 2011. “The Economics of Grain Price Volatility.” Applied Economic Perspectives and Policy, Vol. 33, No. 1: 32-58. DOI:10.1093/aepp/ppq033.