Thursday, 16 Jun 2022
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The Treasury

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Special Topic - Commodity Update

Russia’s invasion of Ukraine has worsened strains in global supply chains and caused significant increases in the prices of many commodities, particularly those exported by Russia and Ukraine. Globally, the sharp rise in commodity prices, especially food and energy, is adding to inflation and to the effects of other pre-existing headwinds to growth including reduced fiscal and monetary support. How long prices remain high depends on the course of the war and how quickly supply and demand can be rebalanced. This Special Topic concludes that the risks to global commodity prices are skewed towards further rises. 

Commodity prices rose further in May…

The economic effects of the war in Ukraine are being felt through many channels, but particularly through food and energy commodity prices. Together, Russia and Ukraine account for about 30% of global wheat exports, 15% for corn, 20% for mineral fertilisers and natural gas and 11% for oil. In addition, global supply chains are dependent on Russian and Ukrainian exports of metals and inert gases. The prices of many of these commodities increased sharply after the onset of the war, even in the immediate absence of any significant disruption to production or export volumes.

Commodity prices rose further in May, up 3% on April’s average, led by energy and agriculture, while metals prices declined (Fig 1).

Figure 1: Commodity prices

Figure 1: Commodity prices

Source: Haver/S&P GSCI

…as weaker agricultural production…

In agriculture, grain exports from Ukraine have been severely disrupted by the blockade of shipping in the Black Sea, although much of the 2021 season’s harvest   has already been exported. The chief concern is how the war will affect planting in the coming season. Recent forecasts from the US Department of Agriculture (USDA) assume Ukraine’s wheat and corn production will be around 30% lower than in the 2021 season.

At the same time, rising input costs including fertilisers and energy, and export restrictions are weighing on global supply prospects. India’s bans on sugar and wheat exports in May added to limits in other countries that have taken global food export restrictions higher than in the 2008 food crisis, on some measures (Figure 2). On the positive side, Indonesia allowed exports of palm oil to resume after a three-week ban intended to stabilise soaring domestic prices, but progress has been slow despite ample supply.

In its June update, the Food and Agricultural Organisation (FAO) of the United Nations forecast world production of major cereals to decline in 2022, the first fall in four years. However, food consumption is not anticipated to be impacted, but the use of cereals for animal feed is expected to fall. The FAO expects modest declines in global corn and wheat production, reflecting lower output in Ukraine and some other countries, but partly offset by higher production elsewhere. Global oilseed production is also forecast to contract in the year ahead and demand rationing is anticipated in some markets owing to high prices and export restrictions. Meanwhile, global rice production is forecast to be flat to higher and supplies to be ample. 

Figure 2: Food export restrictions

Figure 2: Food export restrictions

Source: IFPRI

…and rising input costs, keep markets tight…

Turning to the outlook for prices, it is important to note that agricultural prices were high prior to the war. Agricultural prices have been on an upward trend since mid-2020, as strength in demand has outpaced supply growth and inventories have fallen.

In January 2022 the FAO’s Food Price Index, which measures monthly changes in a basket of food commodities[1] was just 1.5% below its 2011 peak. With markets already tight, Russia’s invasion of Ukraine and the shock to grain supply generated a spike in prices that sent the index to a record high (Fig 3).

Figure 3: FAO Food Price Index

Figure 3: FAO Food Price Index

Source: FAO

In this context, the question of how long prices will remain high depends partly on how the war evolves but also on how the underlying supply-demand imbalance is resolved.

The FAO observes that agricultural sectors are exposed to supply limitations due to rising input costs, in particular fuel and fertilisers, that could spur further price rises. Over the past year the FAO’s measure of global input prices for food production has risen more rapidly than food prices and is currently at an all-time high. This points to falling real returns to farmers and suggests that if production is to increase either input prices need to fall or output prices need to rise or some combination of the two. The FAO concludes that the current environment “does not augur well for a market led-supply response that could conceivably rein in further increases in food prices for the 2022/23 season and possibly the next” .

The demand destruction effect of high prices has given rise to concerns around who bears the burden of adjustment, both within and between countries. International efforts, including those led by the G7 and World Bank, have provided a range of financial support measures to help low-income countries meet the higher costs. Meanwhile, a number of high-income economies have used fiscal policies to help address affordability concerns for low-income households.   

…including meat and dairy

Internationally, meat and dairy producers are both heavy users of grains for feedstock and higher crop prices will eventually flow through to meat and dairy markets. However, in the short-term the rise in input costs will incentivise farmers to reduce production.

Global dairy supply is already tight as supply has not kept pace with demand over recent seasons. The global dairy herd, outside India, has been static for a number of years and growth in supply has primarily come from higher yields. Consequently, an expansion of the herd size is needed to catch up with demand, but rapidly rising input costs will mitigate against this and, as with crops, may result in lower yields.

In New Zealand, dairy producers Fonterra and Synlait have both announced an initial forecast of $9 per kg of milksolids for the current season. This follows Fonterra’s expected record payout of $9.30 kg/ms in the just completed 2021/22 season. Westpac analysts view the $9 figure as the “new normal” for payouts.  

Global meat production rose strongly in 2021, driven by a recovery in China’s pork industry. Production is expected to expand further in the current year, driven by increases in Brazil, Australia and China, although high input costs will likely be a constraint. Overall, meat prices, which have been on an upward trend since mid-2021, are expected to remain high reflecting robust demand and constrained supply.

Oil prices may need to rise further…

Energy supply remains tight as expectations of increased demand to meet US domestic travel and international travel, and expectations of recovery in China’s demand lifted prices to around US$120 in recent weeks (Fig 4). On the supply side, the European Union’s move to ban seabourne imports of Russian oil by the end of the year, was partly offset by OPEC’s agreement to a faster pace of supply increase and by the International Energy Agency’s release of strategic reserves.

Figure 4: Oil and oil product prices

Figure 4: Oil and oil product prices

Source: Haver

The rise in crude oil prices is having an even greater effect on refined products such as petrol and diesel. Refined product inventories were declining prior to the Russia-Ukraine war as refining capacity trailed the increase in global demand as pandemic disruptions eased. Sanctions on Russian exports have led to increased competition for refined product barrels from other markets in the Middle East, US and Asia. Refining capacity is expected to increase as maintenance is completed, but the phase out of Russian supply means the market will remain tight and provide support for high prices. Goldman Sachs analysts believe that oil prices will need to rise further to bring demand back into line with supply.   

Natural gas prices also remained high, but eased somewhat over May, particularly in Europe, reflecting weaker demand and a steady supply, which has helped Europe to rebuild its inventories. The rise in stocks came despite Russia cutting supply to Finland and uncertainty around payment for contracted supplies as Russia insists on payment in roubles.

In Australia, outages at coal fired power stations saw domestic gas prices surge higher. Consequently, the Australia Energy Market Operator intervened to ensure adequate gas was available for electricity generation in east coast markets. Meanwhile, Australian coal prices have increased to near-record levels.  

…but metals prices have eased

Metals prices have been sensitive to China’s economic fortunes. Steep falls in household consumption and industrial production have been reflected in lower prices over the month. The government has responded with a range of policy support measures, but the effectiveness of these measures depends importantly on the path of the pandemic, which remains highly uncertain. 

  1. [1] The basket consists of the average of five commodity group indices: cereals, vegetable oils, dairy, meat and sugar. For more detail see FAO Food Price Index .