ANNEX A Implications of $100 pbb Oil Price for UK Agriculture by sdfsb346f


ANNEX A Implications of $100 pbb Oil Price for UK Agriculture

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									   ANNEX A: Implications of $100 pbb Oil Price for UK Agriculture
                          January 2008
Research on the impacts of a sustained oil price of $100 on agricultural markets suggests the

Longer-term impacts:

    •   Significant increases in agricultural commodity prices, with the highest increases for crops.
    •   Only relatively small impacts on agricultural output and UK competitiveness as producers
        everywhere face higher energy costs and will eventually be able to pass on increased costs.
    •   Other factors are likely to have more important impacts on farm incomes and

Short-term impacts:

    •   Squeezing of profit margins for producers, leading to a fall in production, exiting of some
        producers and restructuring.
    •   Other factors influencing agricultural markets mean that increased energy prices will be felt
        more or less severely in different sectors. Pigs and poultry producers already facing
        increased feed costs and low output prices will be in a worse position to cope with a further
        squeeze of their margins than, for example, cereals producers.

Earlier this month, the oil price reached an unprecedented high of $100 per blue barrel (pbb).
Although the oil price has fallen back to about $90 again, it is timely to summarise available research
results on the impacts of a sustained oil price of $100 on agricultural markets and put them into
context of other current developments. This note first looks at the drivers behind the increase in the
oil price. It goes on to present results of research into the longer-term impacts of a sustained oil price
of $100 pbb on agricultural prices and output and on the impact on UK competitiveness. It then
discusses some shorter-term impacts before full adjustment to higher costs are made and puts higher
energy prices into the context of other current developments.

Drivers behind the increase in the oil price
Earlier this month, the oil price reached an unprecedented high of $100 per blue barrel (pbb). In real
terms the current nominal oil price of $100 is just below the previous peak in the oil price in 1980.
The oil price has increased fairly steadily since 2003. Increased demand, especially from emerging
economies, that has not been met by an equivalent increase in supply and a lack of investment during
the 1980s and 1990s are the underlying reasons for the increase of the oil price over the last few
The further fairly sharp increase earlier this month which led to oil being traded briefly at $100 pbb
was attributed to several additional shorter-term factors:

    •   speculation;
    •   unrest in Nigeria, Algeria and Pakistan;
    •   weak US dollar;
    •   prospect of cold weather.

Projecting the oil price is difficult but it is worth noting that most analysts expect the oil price to remain
at a historically fairly high level but below $100 as the fundamentals of the markets do not support the
price hike seen at the start of this year. Nevertheless, it is useful to review the research on the
impacts of a sustained crude oil price of $100.
Impacts on agricultural prices and output
Increased input costs will eventually push up prices of agricultural commodities and/or decrease the
margins for agricultural producers. Food products as a group are relatively price inelastic leading to
more significant adjustments in prices than in production and consumption. There will, however, be
some substitution from energy intensive commodities to less energy intensive commodities.

Analysis of the impacts of $100 pbb oil price was carried out by the Agricultural Economics Unit in
Defra last year using the OECD Aglink Biofuels model. The analysis compared projected prices and
production for a baseline scenario where the oil price falls back from $65 in 2006 to $40 in 2013 with
one where the oil price increases to $100 in 2013. Thus the low price scenario assumes a lower oil
price than the actual oil price in the last couple of years. The analysis focused on the EU15 as UK
results are not available from the model. The results confirm that although prices are projected to
increase significantly, the impact on overall production is much smaller. Producer prices in the EU15
for cereals and oilseeds are projected to increase by around 20 and 30%, respectively, as a result of
an oil price of $100 instead of $40. Meat and dairy prices are projected to increase less. Little
change is projected in overall EU15 production. Crop production is projected to fall marginally (a fall
of less than 1%) but some shift away from cereals production to more oilseed production is expected.
Overall livestock production is projected to fall by 4% but with small increases in pig production.

Similarly modest impacts on UK production were reported in a study by ADAS, commissioned by the
Sustainable Development Commission1 using a model that allows separate analysis of UK agriculture.
It found that, following an increase in the oil price from $50 to £100, production costs in the UK are
expected to increase by 13% for crops and by between 3 and 5% for animal products. It concluded
that the impacts on production of agricultural commodities are generally modest. It also reports a
small overall fall in arable production and some shift from cereals to oilseed production. The results
for animal production also reflect the results of the Defra study with falls in cattle and sheep
production but increases in pig production.

An increase in the oil price, other things being equal, could be expected to make biofuels production
more profitable and thus significantly increase the demand and prices for biofuel feedstocks such as
cereals and oilseeds. In current market this is unlikely to be a significant factor because high cereals
and oilseed prices have lead to a significant increase the cost of production of biofuels. The analysis
using the OECD Aglink model confirms that the impact of an increase of the oil price on commodity
prices through increased input costs can be expected to be much larger than any impact through
increased biofuel production.

Impacts on relative UK competitiveness
The increase in the price of energy will affect agricultural producers in all countries. However, if
energy intensity of producers in different countries varies, some impacts on UK producers’
competitiveness can be expected.

The study commissioned by the Sustainable Development Commission looked at the impact of higher
oil prices on the competitiveness of UK producers and their main international competitor for six
commodities using life cycle analysis. The study found that UK wheat, beef and chicken will become
relatively more competitive whilst milk and lamb production will become marginally less competitive.
The largest loss of competitiveness was found for oilseed production as palm oil production is
significantly less energy intensive than rapeseed production.

The analysis above was done under the assumption of a constant exchange rate. Oil is generally
traded in US dollars and therefore the dollar exchange rates influence the price of energy costs in
local currencies. The increase in the oil price over the last two years has been mitigated for British
and European consumers of oil by the weak dollar. While the average price of oil (in $) increased by
9% between 2006-2007, the price both in pounds and euros changed only marginally. However,
since some commodities, such as wheat, are also mainly trade in dollars commodity prices have not
increased by as much in pounds and euros as prices in the US dollars.

 “$100 a Barrel of Oil Impacts on the sustainability of food supply in the UK” available at
                                                   Crude Oil Prices in three main currencies

    Price index (1995=100)













Sources: ECB and EIA

Shorter-term impacts and other developments
The results presented above refer to the longer term implications of an increase in the oil price to
$100. Some of the adjustments that are needed on the way to a new equilibrium in the markets will
take time. Rising production costs, for example, are not immediately rewarded from the market but
lead instead to a reduction in profit margins for producers. As a consequence some producers have
to exit the market leading to restructuring and a fall in production. The time taken for prices to adjust
depends on the structure of the market and other market factors such as global supply and demand
changes and the energy efficiency of the sector/business. These effects will be experienced in
broadly equal measure by UK producers and by their international competitors.

Commodity prices have shown different developments over the last year making the different sectors
more or less vulnerable to further input cost increases. Milk prices, for example, have increased
significantly over the last year, partly as a response to higher production cost. Cereals prices have
increased by more than production costs mainly driven by a global shortage of cereals due to adverse
weather conditions in the main producing countries and continued strong demand for food, feed and
industrial uses. As a result, profit margins for cereals producers have increased despite higher input
costs. By contrast, poultry and pig prices have changed little despite large increases in input costs,
mainly due to increased feed costs but also increased energy costs. As a result many pigs and
poultry producers are currently making a loss. It might take a significant reduction in production
before prices start to rise.2

The study commissioned by the SDC considered the impact on competitiveness for a selected range
of commodities. If this pattern of impact is mirrored across all commodities, then we would expect
decreases in self sufficiency for commodities where we become less competitive to be offset by
increases in self sufficiency for commodities where we become more competitive, leaving the overall
level of self sufficiency broadly unchanged. Other factors will be having a more important impact, with
exchange rates being the dominant factor shaping competitiveness since the early 1990s. The
following chart shows how the pound has depreciated by more than 10% against the Euro over the
last 12 months making imports from the Euro-zone relatively more expensive and the UK more

  For a more detailed discussion of recent market impacts on the different sectors see the note “IMPLICATIONS
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