Companies and investors are caught between expectations of lower demand growth for energy and raw materials and uncertainties about supply-side risks. Commodities prices have fallen from their peak in 2011 as expectations of a recession in the Eurozone and a slowdown in economies such as China have hit markets and crop production has recovered. However, some inventories remain tight and fuel and commodity prices are still higher than the average for the five-year period to the end of 20101. Average food prices in 2011 were the highest in 20 years.
Supply and demand trends are likely to keep global food prices strong – futures wheat prices for the end of this year are currently more than one-tenth higher than existing prices.2 The recovery in wheat and grain production could help replenish depleted stocks caused by floods and droughts in some producing regions and help meet growing demand for food, feed and biofuels, rather than fully reverse the sharp rise in prices between 2010 and 2011.
High prices for oil and fertilisers such as potash, will feed through into agricultural commodity prices going forwards. The costs of the environmental impacts of production, such as greenhouse gas emissions and water use, could also increase input costs. Environmental costs are increasingly being internalised through regulatory or market measures, and the food industry is particularly vulnerable to the costs of the physical impacts of resource depletion, pollution and climate change.
A recent report by McKinsey & Company into resource trends over the next 20 years shows a potential 50-450% rise in commodities prices if externalities from greenhouse gas emissions and water use were priced. McKinsey points out that rising prices for food and water are increasing input costs for consumer packaged goods (CPG) companies, which also face rising energy and materials prices.
With Trucost’s help, McKinsey assessed how the price of a common basket of consumer packaged goods (CPG) might change if it were to reflect the cost of environmental impacts. Trucost data show that pricing environmental costs for water and greenhouse gas emissions could increase wheat prices by more than 400%. External costs for water use vary by region. For instance, the four top wheat producing countries are China, India, Russia and the United States of America. Different levels of water use per tonne of crop produced and levels of water scarcity in surrounding basins drive variations in water costs in each country. Chart 1 shows how more intensive water use for wheat production in India, combined with greater water scarcity, results in an embedded water cost that is more than 800 times higher than that in Russia.
Chart 1: Wheat production and external water costs in top 5 countries
Food value chains could incur costs through changes in Government subsidies, higher water pricing, changes to abstraction or irrigation licenses or lower productivity. For instance, lost crops due to drought in Argentina could cut export revenues by US$6 billion. Production in parts of China and India could be hit by low rainfall, while other areas face floods and storms caused by ongoing La Niña weather conditions. However environmental costs are internalised, uncertainties and fears of tail risks – low probability events that have a significant impact on prices – are likely to keep markets volatile. Exposure to fluctuations in commodity prices could increase if trading of agricultural commodity derivatives is curbed in response to accusations that it has contributed to food price spikes.
Companies that transform value chains and business models to improve resource efficiency and manage exposure to risks from the interdependence between food, energy and water will be well positioned for an era of greater price volatility.
1 IndexMundi commodity price data
2 FactSet, 24 January 2012