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Introduction

Between October 2007 and October 2008 the world witnessed an unprecedented increase in the prices of several crop commodities. Corn, soybeans, and wheat prices all experienced 50-100% gains in roughly nine months, while rice prices increased by nearly 200% (see chart). The only thing more surprising than the magnitude of the price increases was their rapidity, which left analysts struggling to find an explanation for what was quickly termed the 2007/08 Global Food Crisis.

(click to enlarge)US Corn Farm Price Received Chart

US Corn Farm Price Received data by YCharts

The media and analysts proposed a number of explanations as prices increased, although the most oft-repeated one in both sources was the use of a large fraction of the U.S. corn crop as fuel ethanol feedstock (the so-called "food versus fuel" controversy). The basis of this explanation was the very rapid growth in U.S. corn ethanol production between 2003 and 2008 (see chart), the result of multiple protectionist measures implemented by the U.S. government with the goal of replacing foreign with domestic transportation fuels. Between 2007 and 2009 the sharp increase in food prices coincided with almost exponential growth in U.S. ethanol production. The line between correlation and causation was quickly blurred (some might say it was ignored from the beginning), and U.S. biofuels policy was ultimately labeled a "crime against humanity" by a UN official for supposedly making food staples too expensive for many in the developing world to afford, thereby causing chronic hunger on a massive scale.

(click to enlarge)US Fuel Ethanol Production (Annual) Chart

US Fuel Ethanol Production (Annual) data by YCharts

Despite this conventional wisdom regarding the positive correlation between U.S. corn ethanol production and crop prices, those traders and investors who were long grain futures or ETNs (JJG) in mid-2008 on the basis of continued new highs in U.S. corn ethanol production that summer began suffering heavy losses in July and August. These losses occurred because their trading premise was deeply flawed despite the overwhelming support in the media for it: recent research has shown that the 2007/08 Global Food Crisis was actually a panic caused in part, of all things, by Vietnam's inability to accurately count the volume of its rice exports [1]. With a little research, these traders and investors would have discovered that the logical (and popularly accepted) explanation for the rise in crop prices was not the correct one, and could have positioned themselves accordingly.

This article provides an overview of the 2007/08 Global Food Panic and examines the lessons that both investors and traders should derive from it, particularly with regard to the perils of basing one's investing or trading premise on widespread public perception and conventional wisdom.

Food versus fuel

The concern that the use of food crops as biofuel feedstock increases food prices is not a new one; I was told by a professor at a recent workshop on advanced biofuels that she has been discussing the issue as part of her work on the Intergovernmental Panel on Climate Change since the early 1990s. The notion that there exists a zero-sum game between the production of foodstuffs and biofuels did not gain popularity, however, until University of Minnesota economists C. Ford Runge and Benjamin Senauer published an article called "How Biofuels Could Starve the Poor" in the prominent policy journal Foreign Affairs [2]. Using as their starting point a study by the International Food Policy Research Institute predicting a 40% rise in corn prices by 2020 due to biofuel production, Profs. Runge and Senauer calculated that biofuel production would cause 600 million people to be chronically hungry (i.e., starving) by 2025. They projected corn ethanol production to cause a rise in all crop prices, as sustained high corn prices would cause consumers to switch to other crops such as wheat, soybean, and rice (or cause farmers to switch from producing those crops in favor of higher-value corn). The timing of their article could not have been more perfect as crop prices began increasing rapidly a few months later. Public awareness of the food versus fuel controversy became widespread after UN official Jean Ziegler labeled the growth of biofuel feedstocks on arable land a crime against humanity the following October. Media attention reached a peak in the summer of 2008 with wheat prices up 100% and rice prices up 200% over the previous 12 months.

Then the unexpected happened in June and July 2008: crop prices began falling substantially even as monthly U.S. corn ethanol production continued to increase (see chart). This fall in prices has since been attributed to the global financial crisis, which burst upon the scene in September 2008, and subsequent fall in both commodity and equity values. For example, one Reuters headline in March 2009 read "Economic recovery may rekindle food/fuel debate", based on the assumption that renewed economic growth would cause petroleum prices to rise again, thus prompting a new boom in corn ethanol production and a return to skyrocketing crop prices. The problem with this assumption is that the summer of 2008 had exposed a disconnect between crop prices and U.S. corn ethanol production. The central tenet of the food versus fuel controversy is that crop prices are directly linked to corn ethanol production. Were the assumption correct then concerted crop price declines of 20-60%, such as those experienced by corn, rice, soybeans, and wheat in the second half of 2008, should have only occurred if U.S. corn ethanol production had fallen as well (or at least stabilized). But it had not, of course; U.S. corn ethanol production increased by 8% over that same period, and has continued to increase until this day. U.S. ethanol production could therefore not have been the primary cause of the 2007/08 Global Food Crisis.

(click to enlarge)Thailand 100% Broken Rice Price Chart

Thailand 100% Broken Rice Price data by YCharts

If not ethanol, then what?

While commodity price movements after June 2008 called into question the popular conception that biofuels were the primary cause of the 2007/08 Global Food Crisis, there was no doubting that the price increases had been real. IFPRI researcher Derek Headey discovered the explanation while attempting to confirm the IFPRI's previous research on the link between increases in food prices and chronic hunger using a different research methodology (an activity that too few research organizations engage in, at least publicly). What he found was that, according to this new methodology (the initial study used computer simulations while the follow-up used self-reporting in affected regions) chronic hunger actually fell by 60 to 250 million people between 2005 and 2008. In a separate paper he examined the role of trade shocks on the crisis and identified a very different culprit for the 2007/08 Global Food "Crisis": national trade policy [1].

One of the weaknesses of the "food versus fuel" theory as an explanation of the 2007/08 Global Food Crisis is that it fails to explain why the price of rice, a commodity that the U.S. is not a major producer of and which is not a major biofuel feedstock, increased by so much more than that of corn. While the theory suggests that rice prices would experience some increase as rice replaced corn being directed to ethanol production, the 200% increase that actually occurred was far greater than corn prices (up 50% over the same period).

Dr. Headey's research shows that while the increases in crop prices were the result of government policy, U.S. biofuels policy was not to blame. In September 2007 Vietnam restricted its rice exports after its officials discovered that the country had sold more to the global markets than it actually owned (history's first case of naked short selling by a country?). India, which had experienced a poor wheat harvest the year before, quickly followed with export restrictions of its own. These restrictions caused panic within the global community as both Vietnam and India were responsible for 15% of global rice exports at the time. Countries with a high level of rice consumption soon followed with restrictions of their own in an ill-advised attempt to keep rice prices down: Egypt, China, Thailand, and Cambodia restricted exports by April 2008, while India and Vietnam increased the severity of their initial restrictions. Meanwhile, major rice importers enacted policies to lower the import price: Saudi Arabia began subsidizing rice imports in Q1 2008 and Nigeria removed a 100% tariff on rice imports. The Philippines engaged in what Dr. Headey describes as "panic buying" by purchasing its entire annual quota in the first four months of 2008. In short, entire countries behaved as if the global markets were experiencing a severe long-term rice shortage.

(click to enlarge)

Thailand 100% broken rice prices, 2007-2009 ($/ton). Adapted from Reference 1.

A similar situation was playing out in the corn and wheat markets. China and Argentina placed restrictions on corn exports between July 2007 and January 2008. Ukraine banned wheat exports, also in July; Argentina, Kazakhstan, and Russia followed with their own restrictions on wheat exports between December 2007 and February 2008. Whether these were in response to increased global demand for grains resulting from the rice panic or other causes is difficult to say, but it does make clear that U.S. corn ethanol production was not responsible for the increased prices of those commodities at the time; indeed, Dr. Headey shows that U.S. corn exports nearly doubled between 2007 and 2008 in response to the fall in global supply. The media and UN were blaming the extreme rise in global crop prices on U.S. corn ethanol production when the real cause was much more global in nature: changes in trade policy by a dozen countries on three continents.

Lessons for investors and traders

The announcements of these export restrictions were quite public in nature; the chart showing the response of rice prices to changes in trade policy is adapted from Dr. Headey's work, which is in turn based on the collation of media articles and government reports. While the trade policy announcements were undoubtedly obscured by the furor over "food versus fuel" in the international media, they were available to anyone armed with Google News and the proper keywords. Savvy investors and traders only needed to question the conventional wisdom regarding the spectacular rise in crop prices and do their own research to discover that the rise was actually a series of bubbles prompted by widespread panicky government responses to changes in trade policy by a small number of countries. Dr. Headey has used the term "contagion" to describe what I now refer to as the 2007/08 Global Food Panic and this is apt, with one important addendum: unlike the 2008 Financial Crisis, which was a contagion of the financial markets that arguably required some government intervention to prevent their collapse, this was a contagion of government activity that was quickly resolved by the markets. Crop failures are never permanent; as the panic over rice price demonstrates, high prices caused by sudden drops in supply will quickly fall following a successful harvest (particularly when the drop in supply is artificial in nature).

None of this is to say that the recent rise in corn prices is the result of government trade policy or inaccurate information; I live in the Midwest and have seen farmers plowing their crop under in areas that normally yield 150 bushels per acre or greater. Nor is it to say that corn ethanol production has placed no upward pressure on corn prices. Rather, it is to demonstrate to investors and traders the importance of doing one's own research. The media and conventional wisdom can be valuable sources of information but should hardly be depended on as one's primary sources of information, particularly when one's own money is at stake. Profits are to be made (and losses avoided) when market prices are the result of inaccurate public information overwhelming accurate public information, as the 2007/08 Global Food Panic aptly demonstrated.

References

[1] Headey D. (2011) Rethinking the global food crisis: The role of trade shocks. Food Policy 36:136-46.

[2] Runge C.F. and Senauer B. (2007) How Biofuels Could Starve the Poor. Foreign Affairs May/June.

Source: A Look Back At The 2007/08 Global Food Panic: One Possible Lesson For Today