Record high corn prices and the impact on food costs

Wednesday, 12 March, 2008

Recent US trades driven by economic growth in developing countries and favourable exchange rates, combined with tight global grain supplies, resulted in record or near-record prices for corn, soybeans and other food and feed grains in 2007.

For corn, these factors, along with increased demand for ethanol, helped push prices from under US$2 (AU$2.14) per bushel in 2005 to $3.40 (S3.65) per bushel in 2007. By the end of the 2006/07 crop year, 2 billion bushels of corn (19% of the harvested corn) had been used to produce ethanol, a 30% increase from the previous year. Higher corn prices motivated farmers to increase corn acreage at the expense of other crops, such as soybeans and cotton, which saw their prices rise as well.

So what effect do these higher commodity prices have on retail food prices? In general, retail food prices are much less volatile than farm-level prices and tend to rise by a fraction of the change in farm prices. The magnitude of response depends on both the retailing costs beyond the raw food ingredients and the nature of competition in retail food markets. Ethanol's impact on retail food prices depends on how long the increased demand for corn drives up farm corn prices and the extent to which higher corn prices are passed on to retail.

Retail food prices adjust as the cost of inputs into retail food production change and the competitive environment in a given market evolves. Strong competition among three to five retails stores, in the US, has seen a moderating effect on food price inflation.

Overall, retail food prices have been relatively stable over the past 20 years, with prices increasing on average to 3% per year from 1987 to 2007. The main exception occurred when sharply higher farm prices increased retail prices 5.8% in 1989 and 1990. Since then, food price inflation has averaged around 2.5% per year in the US and a modest 1.2% in Australia for the December 2007 quarter.

Retail prices are a function of both consumer demand and the interaction between food manufacturers, distributors and retailers with each group having some pricing power in the supply chain. Ultimately, though, the retailer has a more complicated pricing decision since it is selling a wider variety of products to a more diverse consumer clientele than most manufacturers or distributors. The challenge for the food retailer is to determine how best to distribute the costs of providing food and services to consumers across a wide range of products. The pricing challenge removes some of the direct connection between the costs of a given product and the retail price charged.

When there are cost shocks in the food production system due to changes in the commodity or farm product market, most retailers respond by passing on a fraction of their higher costs to consumers. In Australia, grocers recently warned that the long-running drought, strong export demand and global grain shortages mean that Australian consumers will inevitably have to pay more at the checkout. Among factors affecting this pass-through rate is the level of processing and value-added services that take place between the farm and the grocery store aisle. Products that require more processing and packaging are usually less directly linked to changes in farm prices, while the price of less processed foods follows closely the changes in farm prices. For example, changes in farm prices for eggs, fresh fruit and fresh vegetables show up in more volatile retail prices for these less processed foods.

Currently in the US, ethanol production comes mainly from field corn meaning that the most direct impact of increased ethanol production should be on corn prices and on the price of food products based on field corn. However, even for these the effect of rising corn prices is dampened by other market factors. While field corn is the predominant corn type grown in the US, it is primarily used for animal feed, with less than 10% of the crop used for direct domestic human consumption in corn-based foods such as corn meal, cornstarch and corn flakes. The remainder is used for animal feed, exports, ethanol production, seed and industrial uses.

Continuing elevated prices for corn will depend on the extent to which corn remains the most efficient feedstock for ethanol production and ethanol remains a viable source of alternative energy. Both of these conditions may change over time as other crops and biomass are used to produce ethanol and other alternative energy sources develop.

Even if these conditions do not change in the near term, market adjustments may dampen long-term impacts. In 1996, when field corn prices reached an all-time high in the US of $3.55 ($3.80) per bushel due to drought-related tighter supplies and strong demand from China and other parts of Asia, the effect on food prices was short lived. Also, at that time retail prices rose for some foods, including pork and poultry, but these effects did not extend beyond the middle of 1997. For the most part, food markets adjusted to the higher corn prices and corn producers increased supply, bringing down the price.

Experts have suggested that food producers, manufacturers and retailers adjust to the changing market conditions by adopting more efficient production methods and improved technologies to counter higher costs which would mean consumers would see relatively stable prices at the checkout.

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