The price of oil has long had an influence on the price of food. The recent rapid expansion of biofuel production has made the relationship both more significant and more complex.
Effect of an Increase in the Price of Oil
Oil is a source of energy for mechanised agriculture and food processing, and an input in the production of pesticides. An increase in the price of oil has a direct effect on the price of internationally-traded food commodities through its effects on production costs.
There is also an increasingly important indirect effect via the markets for those food crops which have alternative uses as biofuel feedstock. Examples are corn (maize) and cane sugar, food crops now also used on a large scale to produce ethanol for use as a petrol substitute. In the US, 40% of the corn crop is now used to produce ethanol (1).
Given free markets, two conditions are necessary for production of biofuels by profit-maximising farmers and processors:
1. The overall production cost of a unit of biofuel must be below the price of its energy-equivalent in oil.
2. The return from growing crops as biofuel feedstock must be at least as high as that from growing crops for human or animal consumption.
Whether these conditions are met at any particular time and place will depend on various circumstances including soil, climate, labour costs, processing capacity, and market conditions. An IEA study in 2007 estimated Brazilian sugarcane-based ethanol to be competitive with oil, based on an oil price of $40-50 per barrel (2). US corn-based ethanol, which costs more to produce, was not then competitive without subsidy, but is probably now competitive at the current oil price of c $120 per barrel.
A sustained increase in the price of oil will lead to:
a) an increase in the share of corn and sugarcane production used for biofuel production, with a corresponding reduction in the proportion used for human and animal consumption;
b) a shift in the pattern of cultivation towards growing crops suitable for biofuel production.
Thus there will be a reduction in food production and an increase in the price of food. Admittedly, conflict between biofuel and food production can sometimes be mitigated by bringing more land into cultivation. However, this is often precluded by the lower productivity of marginal land, water scarcity, or conflicts with forest conservation or urban requirements.
Effect of an Increase in the Price of Food
What of the converse – the influence of the price of food on the price of oil? This used to be fairly small. A sustained increase in the price of food encourages an expansion of agriculture, raising demand for agricultural inputs including oil. This tends to increase the price of oil. But the effect is small because scope for expansion of agriculture is limited and because the demand for oil for use in food production is only a fraction of the total demand for oil.
However, an increase in the price of food will also increase the relative profitability of growing corn for food. This will lead some farmers to switch back from biofuel to food production. Thus a food price shock would send the substitution process into reverse, reducing the supply of biofuels. This would increase demand for oil, raising its price.
Should the possibility of such a reversal of substitution be viewed with concern? In terms of food supply it seems benign. Switching corn from biofuel production to food would dampen the initial increase in the price of food. From an energy perspective, however, it represents a new risk factor, implying that poor harvests could drive up the price of oil.
(1) The Economist, 4th February 2012, p 27
(2) International Energy Agency, Energy Technology Essentials, Brief ETE02 January 2007 p 1 http://www.iea.org/techno/essentials2.pdf