The price of oil has been rising for the past several months. Historically, there has always been a strong positive correlation between the prices of crude oil and the prices of food.
In the past year the price of Brent oil has maintained an upward trend and now stands at about USD75 per barrel (an increase of over 50 per cent y/y). Moreover, in May the price of oil reached the highest level since November 2014. This is due to the strong demand for oil associated with the consistently high level of activity in the global economy and the slower increase in its supply.
The increasingly marked supply-side constraints on the oil market stem from a number of factors. One of them is the consistent policy of curbing oil extraction pursued by the countries belonging to OPEC (Organization of the Petroleum Exporting Countries) and several other oil producers which do not belong to that organization, including Russia.
After two years of very low — against historical levels — oil prices resulting from oversupply in the global market, in November 2016 the above-mentioned states reached an agreement in which they undertook to reduce the daily extraction of oil by a total of 1.8 million barrels (about 1.9 per cent of the global oil output in 2016) starting from January 2017.
The OPEC countries were supposed to reduce supply by 1.2 million barrels, while the non-OPEC countries which had agreed to join the agreement pledged to reduce their output by a total of 0.6 million barrels. These countries adopted a goal of reducing oil stocks in the OECD countries to the average level observed in the last five years. This was achieved in early 2018.
The agreement was originally supposed to last till June 2017. However, due to its effectiveness in stabilizing the world oil market, it has already been extended twice (in May and November 2017).
In June the parties to the agreement decided to increase the daily production limit by a total of 1 million barrels starting from July. However, the current daily extraction limit is still below the level recorded before the first agreement entered into force.
Another factor that is also conducive to a limitation of the global supply of oil is the collapse in oil production in Venezuela. For years, the extraction of oil was the dominant source of Venezuela’s export revenues. This led to the emergence of the so-called Dutch disease in that country. That term describes a situation where the development of other sectors of the economy is inhibited due to the concentration of factors of production in the oil sector. During the government of Hugo Chaves, the Venezuelan oil sector was largely nationalized, and the revenues from this industry became — to an even greater extent — the source of financing for the government’s expansionary fiscal policy. However, the oil sector itself remained underinvested. After the collapse of oil prices at the turn of 2014, Venezuela’s economy, which was dependent on high oil prices, was plunged into recession.
The social unrest arising amid the crisis and the accompanying hyperinflation exposed the Venezuelan oil sector to an even greater pressure from the government of Nicolas Maduro. Due to low oil prices, mounting pressure from the government and years of insufficient investment, the state-owned PDVSA group developed problems with liquidity.
The oil extracted in Venezuela is dense and in the production process has to be diluted with lighter oil, which Venezuela has to import. This is difficult considering the liquidity problems. At the same time, due to its financial problems PDVSA is not able to meet the requirements related to the transport of oil through international waters, which hinders its exports. As a result, since September 2017 we have observed an uncontrolled decline in oil production in Venezuela, which has already dropped well below the levels established within OPEC.
Donald Trump’s decision to withdraw the United States from the nuclear agreement with Iran which was concluded in 2015 (between the USA, the EU, Germany, Russia, France, the United Kingdom, China and Iran) will also negatively affect the global supply of oil. In exchange for Iran curtailing its nuclear program, the signatories of the agreement had suspended the economic sanctions imposed on that country.
This had allowed Iran to return to the global oil market. As a result, since the conclusion of the agreement, it had increased its production by over 1 million barrels a day (an increase of 37 percent).
United States’ withdrawal from the nuclear agreement means the restoration of sanctions that the Americans imposed on Iran, including the sanctions on its oil exports. Although other signatories did not withdraw from the agreement, the American sanctions constitute an effective barrier to Iran’s oil exports. That is because not only American companies, but also all enterprises that are economically linked to the United States will have to stop imports from Iran. Otherwise they could be covered with secondary sanctions by the United States.
More expensive oil means higher costs
Historically speaking, there has always been a strong positive correlation between the prices of crude oil and global food prices. Such an assessment is supported by the strong positive correlation between the prices of Brent crude oil and the FAO food price index, which amounted to 0.91 in the period from January 1990 to May 2018. The relationship between oil prices and food prices stems from three factors.
First of all, oil prices have a significant impact on production costs in the agricultural and food sector. Natural gas, the price of which is strongly linked to the price of crude oil, is used in the production of mineral fertilizers. Meanwhile, higher fuel prices increase the costs of transportation throughout the entire food supply chain, starting from agricultural machinery and ending with trucks delivering food products to the stores. In turn, an increase in the prices of energy carriers boosts the costs of food processing. Due to the relatively low price elasticity of food demand, its manufacturers are to a large extent able to pass the higher production costs on to the consumers by raising the prices of their products.
Secondly, agricultural raw materials can be used not only for the production of food but also for the production of fuels. For example, it is possible to produce bioethanol from oilseeds, cereals and sugar cane. As a result, when the prices of oil increase, it becomes more profitable to use the above mentioned raw materials for the production of biofuels. As a consequence, the lower supply of agricultural raw materials allocated for food production leads to an increase in its prices.
Thirdly, the growing financialization of commodity markets, and in particular the popularization of investment in raw material indices (commodity indices), is conducive to an increase in the covariability of food and oil prices. Raw material indices represent the weighted average of futures contracts for the raw materials selected by the issuer. The composition of a raw material index often simultaneously includes various groups of raw materials, such as energy raw materials, precious metals, industrial metals and agricultural raw materials. In a situation when the price of one of the raw materials increases, the issuer proportionally purchases more contracts for the other raw materials in order to maintain the constant weights in the index. One example of a commodity index is S&P GSCI.
As a result, an increase in oil prices is conducive to an increase in the prices of other raw materials. Although the commodity markets have become increasingly regulated in recent years, the flows of speculative capital remain an important factor of covariability of commodity prices, including the prices of crude oil and the prices of agricultural commodities.
Due to the stable relationship between oil prices and food prices, it can be expected that the increase in oil prices observed in recent months will be reflected in higher food prices. Such an assessment is supported by an increase in the FAO index observed since the beginning of this year – in the period from January to May it rose by 3.2 per cent.
Further development of the situation will be of a key importance for the global food prices outlook. Despite the decision made by OPEC and some other oil producers to raise the daily production limit by 1 million barrels per day, the likelihood that such production growth will actually be achieved is low. Assuming that the increase in the output limit will be allocated proportionally among all the signatories of the agreement, some countries, and in particular Venezuela and Iran, will not be able to achieve production levels matching the new limits. As a result the final increase in supply from OPEC members and countries cooperating with that organization will be clearly lower than the increase in global oil consumption observed in recent years.
The policy of curbing extraction pursued by OPEC and some of the other oil producing nations, led by Russia, will probably continue to act as a factor conducive to further increases in its prices. In turn, the higher supply of oil from the United States, especially when the current level of prices ensures the profitability of shale oil production, will be conducive to a decline in oil prices. It can be expected, that the price of Brent crude oil will follow an upward trend in the coming quarters, reaching the level of USD75 per barrel at the end of 2018 and USD78 per barrel at the end of 2019.
The main risk factors for such a scenario include further changes in the volume of oil production in Iran and Venezuela. An increase in oil prices will be conducive to an increase in global food prices. As a result, it can be expected that the FAO food price index will reach the level of 182 points at the end of 2018 and will increase to 186 points in 2019.
Although food prices in Poland are closely linked with the prices on the global markets, it can be expected that the growth of domestic food prices will continue to follow a downward trend in the coming quarters. This will be due to the impact of the high base effects from last year, and in particular those caused by local factors (including, among others, last year’s high fruit prices resulting from spring frost damage, as well as the sharp increase in the prices of egg resulting from fipronil egg contamination in Western Europe). There is a high probability that a slight deflation in food prices could be recorded in Poland in the fourth quarter.
In 2019, however, we can expect a gradual acceleration in the rate of growth of food prices which will be supported by faster growth of the prices of sugar, meat and dairy products.