Chicago, 26 January 2010

Violent protests in Tunisia and Algeria this month announced that food inflation has reared its ugly head again. But, while rising food prices may be universally unwelcome, especially in low-income regions, they may be a necessary evil if global food production is to rise to the sustainably high levels required to feed the planet's growing population.

Those who vilify speculators for inflating the cost of wheat, cattle and sugar risk opening the door to a far worse fate -- a world in which food is so cheap that more farmers can't afford to produce it. When adjusted for inflation, agricultural markets are just barely coming back to their relative cost in the 1980s, and are less than half their 1970s peaks.

In contrast, markets like copper and oil have recently traded at their highest ever on an inflation-adjusted basis. Even with increased efficiency, that suggests prices should be moving higher -- not lower -- if the world is to improve the security of its food supply.

THE DIFFERENCE BETWEEN THE COST AND PRICE OF FOOD

For most Developed World consumers, food represents only a small fraction of total household expenditures, so price changes in grocery cart staples tend to go largely unnoticed. (This is especially so when retailers pull sneaky tricks such as reducing carton sizes as a way to pass on rising costs without increasing sticker prices.) Hefty government subsidies to producers also help shield consumers from food price increases in many advanced economies.

But in developing nations, where food can account for upwards of 50 percent of a household's purchases, food price volatility can prove to be both glaringly obvious and panic-inducing. Indeed, the recent riots in North Africa and the subsequent flurry of comments from Western World policy makers about fighting food inflation are testament to how sensitive an issue food prices from a consumer's perspective have become.

Graphic of share of income spent on food:

Graphic of food share over time:

Despite this heightened awareness of the rising price of food, little focus has been placed on the equally important issue of the cost of producing food, even though the burden of feeding the planet lies squarely at the feet of the world's farmers and food processors over the coming decades.

This distinction between the price of food faced by consumers and the cost of producing it goes to the heart of the food security story set to unfold over the rest of this century, which will be defined by how well governments can keep food prices in check for the consumer while at the same time ensuring producers remain motivated to continually escalate food output.

LOWER FOOD PRICES NOT NECESSARILY THE BEST THING

The recent chatter about food price increases was sparked in part by news this year that an index of global food prices tracked by the United Nations had hit an all-time high in December. This revelation reignited policymaker debate over the plight of low income nations, and sparked comparisons with the crop price surges of 2008, when riots over food shortages plagued many emerging market economies.

The recent debates also unleashed a wave of government-initiated studies into what measures may be taken to roll back the prevailing high food prices in order to avoid a repeat of the 2008 food crisis.

But such moves, however welcomed by consumers over the short term, may prove to be detrimental over the longer term, if global food output is not incentivized to the maximum degree. This issue is complicated further by the fact that rising material and input costs have eaten into farmer profitability even as improved technology and heightened efficiencies have lowered overall production costs.

INFLATION-ADJUSTED PRICES REVEAL PRODUCER DILEMMA

This theme of producers not being able to fully realize the "benefits" of higher overall retail food prices is best captured by stripping out the effects of inflation on current crop prices. As can be seen in the charts below, once crop prices have been adjusted for inflation, it is clear that current values -- although well above the low prices seen during most of the past decade -- remain well below their inflation- adjusted highs seen during the mid-1970's.

These graphics show that, while consumers may be faced with nominal crop prices that may be at or close to their highest levels ever, producers are to a large degree presented with real prices that remain well below such elevated levels.

This situation for crop producers contrasts strongly with the economic environment facing the producers of industrial commodities, such as crude oil, copper and gold, where inflation-adjusted prices have coincided with the ascent in nominal prices to multi-decade high levels in recent years.

Graphic of inflation-adjusted commodities prices:

These contrasting producer landscapes mean that, while copper miners and oil refiners may be faced with one of the most economically attractive environments on record -- and therefore should be fully incented to boost output wherever possible -- crop growers have theoretically seen much better days in terms of economic returns, and so may not be receiving the same signals to expand output aggressively.

What's more, these same producers are faced with rising fuel, fertilizer and seed prices, as well as increasingly expensive land and labor costs, which have served to squeeze profit margins and promote a more cautious outlook with regard to crop output expansion.

Expansion opportunities will be pursued, if the crop economics make sense, but it may require a sustained period of high prices before meaningful commitments to output increases take effect.

GOVERNMENT SUPPORT KEY TO SUCCESS

In order for any nation's food production potential to be fulfilled, government support in terms of infrastructure development and tax incentives is critical. South American powerhouses Brazil and Argentina are examples of what can be achieved when governments and corporations commit themselves to a shared goal designed to maximize natural efficiencies.

Despite having less nutrient-rich soils and more primitive transportation infrastructure than U.S. growers, Brazilian and Argentine producers have been able to match their U.S. counterparts in terms of soybean productivity in recent years, thereby securing themselves a key role in international crop trade.

And, given the scale of continuing investments and improvements in the region, further impressive food output gains can be expected from South American growers in the years ahead.

Huge promise also exists in India, where massive amounts of land are dedicated to each of the world's top crops. Indeed, in terms of harvested area, India is the world's top "grower" of rice and wheat, and the world's fourth largest planter of corn and soybeans.

However, due to the prevalence of small-scale farming operations and infrastructural inefficiencies, India's total production of each crop falls behind that of other nations. In rice production, for instance, Indian output is roughly 45 percent less than China's, despite Indian harvested area being more than 45 percent greater than China's. India's wheat production total also belies its stature as the world's top planter.

Interactive graphic of World's top crop growers

http://graphics.thomsonreuters.com/10/04/TopGrowersByCrop.swf

Over time, India's output totals have the potential to rise dramatically from current levels, should more intensive farming practices be adopted and genetically modified crops become more widely used. But such progress would come at a cost in terms of both the environment and the number of people employed by the agriculture industry, which would present fresh and complex challenges to a nation openly committed to sustainability and under clear pressure to find work for its massive population.

Nonetheless, India's potential to play a major role in food production is real, and given the right domestic and market-related conditions, could well be unlocked in time to diffuse any food shortage crises before they occur.

In all, the current flare-up in crop and food prices has rightly sparked concern about potential further unrest in low-income regions where rising food costs directly threaten lives. But in order for the world's top food producers to be fully incentivized to pursue expansion opportunities in the years ahead, higher prices may need to be accommodated regardless of the discomfort they may induce over the near term.

Ends --

By Gavin Maguire, Reuters market analyst – for Commodities Now.

The views expressed are his own.