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The oil price effect

The longer-term impact of low oil prices on the agriculture sector remains the subject of much speculation, writes Andrew Wood, senior associate at law firm Norton Rose Fulbright.

The longer-term impact of low oil prices on the agriculture sector remains the subject of much speculation, writes Andrew Wood, senior associate at law firm Norton Rose Fulbright. Production costs have fallen but so have prices.  A combination of factors, including the non-luxury nature of many products in the sector, changes in farming strategy in reaction to price reductions, broader macroeconomic factors and (most significantly) existing and potential non-market intervention mean that the ultimate impact is difficult to fully predict. The beneficiaries in the short term will be consumers but whilst the full list of winners and losers is not clear, the economies of many commodity-exporting countries (generally speaking those least capable of absorbing low prices) are likely to be among the hardest hit.

The longer-term impact of low oil prices on the agriculture sector remains the subject of much speculation. Production costs have fallen but so too have prices. A combination of factors, including the non-luxury nature of many products in the sector, changes in farming strategy in reaction to price reductions, broader macro-economic factors and (most significantly) existing and potential non-market intervention mean that the ultimate impact is difficult to fully predict. The beneficiaries in the short term will be consumers but whilst the full list of winners and losers is not clear, the economies of many commodity-exporting countries (generally speaking those least capable of absorbing low prices) are likely to be among the hardest hit.

Low input costs not lifting the bottom line

Most industry specialists agree that oil prices are likely to remain well below historic levels throughout this year. History tells us that low oil prices tend to lead to reduced agriculture commodity prices (and vice-versa) due to a number of factors including the correlation with shipping costs and general energy consumption in farming and the use of feedstocks for biofuels. Producers’ cost savings are being immediately offset by reduced sales revenues, leaving margins unaffected at best and significantly reduced at worst (particularly in relation to the significant volumes of agricultural produce for which, despite many people’s perception, fuel costs represent a small component of the overall production cost).

The exporter/importer divide

History only takes us so far however. Past behaviour tells us that oil price reductions traditionally accompany general economic downturns. Yet on this occasion, the drop in oil prices stems from a unique combination of compounding circumstances (principally a strong dollar, oversupply in proportion to less-than-anticipated demand and OPEC policy) which in themselves are unlikely to hinder economic growth in oil-importing economies.

Accordingly, in Europe and other oil-importing countries, low oil prices in current circumstances mean cheaper fuel on the one hand (benefitting consumers and reducing production costs for businesses) and an increased capacity to consume a wide range of goods on the other. Indeed, one of the consequences is that in Europe deflation is seen as a significant risk.

By contrast, the situation is more difficult for oil-exporting nations. Where, in addition to reduced oil revenues, the local currency of such countries (many of which are heavily reliant on agricultural imports) is falling against a strong dollar (the currency in which most agricultural commodities are denominated), the capacity to spend on agricultural produce is reduced.

The inevitable consequence (in the absences of combative measures at state or international level) is wealth redistribution from the developing nations in favour of the developed.

Despite this, agriculture is unlikely to be central to such a trend on the basis that a significant proportion of agriculture produce is viewed by the consumer as “necessary” or “non-luxury” items. This tends to result in more steady demand: whilst those with fewer resources (broadly, in the current scenario, consumers in those oil-exporting countries with weakening currencies) continue to purchase necessities to the fullest extent possible, those with excess resources look to purchase luxury items rather than additional food, for example. The likely outcome is therefore that the purchase of higher-end goods (generally non-agricultural products save for a few exceptions) will increase in the developed world and reduce in the relevant countries in the developing world.

External forces

Supply and demand continues to be central, with farmers in some countries proposing to reduce planting of many crops next year in response to lower pricing. But a long list of potential non-market forces might also distort the ripple-effect that oil prices has on the agri sector.

We should not ignore the possibility that further governmental, international or other external intervention will interrupt natural forces. OPEC policy has already played a key role in establishing current oil prices and any change in OPEC policy will undoubtedly have wide-reaching effects. Widespread government intervention to combat deflation cannot be ruled out if low food and fuel prices persist. In addition, sanctions will clearly distort natural forces in the areas in which they are operative.

To take the example of external forces and biofuels, where national biofuel quotas exist, biofuel production is likely to remain steady in the relevant country. This is despite the fact that affordable oil would otherwise reduce demand for US biofuels, in turn affecting the demand for corn, sugarcane and other ethanol inputs. We are already seeing a drop in demand from some biofuel-importing countries. The key question for countries with biofuel agendas is how long its political backing will remain as the supporting economics continue to move in the wrong direction.

Whilst it is almost inevitable that agriculture prices will naturally move broadly in the same direction as oil prices, predicting the scope and scale of such non-market intervention all but impossible.