What goes up must come down. That's true regarding gravity and it usually holds when applied to markets. The questions that usually remain, then, include how long will it take for market forces to bring prices down? Or, has something fundamental changed that will cause those prices to never decline to prior levels?
Those are the kinds of questions being asked about grain markets these days. Figures 1 and 2 show weekly nearby corn and soybean meal prices. While corn is still trading within the range established in late 2006, this fall's post-harvest rally has pushed prices near the top of that range. Should nearby corn eclipse last spring's high of $4.45, the next technical objective would be the all-time high price of $5.52. The only technical roadblock between yesterday's soybean meal close and the all-time high, $431/ton back in 1973, is the 2004 spike high just above $375/ton.
And, it's only December. Many acreage decisions have been made, but several million marginal acres are still up for bid as we go through spring. I fear that these prices are going still higher -- at least until we see what weather conditions do into the early 2008-growing season.
Fundamentally Changed Corn Market
If pork producers do not have corn and soybean meal already booked, about the only cost-limiting strategy available is buying call options to put a lid on corn and meal costs. Out-of-the-money calls will be more affordable since they have no intrinsic value. Depending on the time period you choose, you could still have substantial time value.
The Renewable Fuels Foundation published a report this week that assures us all that higher corn prices do not cause higher food prices. The study, done by Informa Economics (formerly Sparks Companies), mainly focuses on relationships between corn prices, corn price changes and food price indexes, both contemporaneous and over a number of time lags.
They concluded that relatively small correlation coefficients did not support a conclusion that "rising corn prices are the causative reason behind high and rising retail meat, egg and milk product prices." In addition, they point out that the current "up" trends in these prices began in the late 1990s, well before corn prices began to increase.
These results are correct. Historic correlations are small. The increases in meat, milk and egg prices seen to date are not the result of higher corn prices. They were indeed underway prior to the fall 2006 corn price explosion.
But correct results can be meaningless -- and that appears to be the case here. Historical relationships between corn prices and food prices are just that -- historical. They are useful in predicting the future only if the underlying conditions of the current and future marketplace are similar to the conditions that prevailed in history. That's hardly the case here. Subsidized and mandated ethanol production has fundamentally changed the structure of the corn market.
The corn price increases in the historical data used by Informa were caused by supply shocks either in the United States or elsewhere in the world. Corn users knew this and have always been relatively certain that they were just one growing season away from again having affordably-priced corn. Consequently, high corn prices did not cause large-scale reductions in livestock, milk or egg output and, thus, did not cause increases in food prices.
But the corn and soybean meal price increases shown in Figures 1 and 2 are fundamentally different. They are demand driven. High oil prices, current U.S. energy policy and the very real possibility of higher mandates for ethanol usage indicate that this demand-driven market will be persistent and that livestock producers are not just one growing season away from affordably priced feed. Eventually, higher costs must be paid for by consumers.
Informa correctly points out that the marketing system can effectively absorb shocks. Livestock producers are just part of the grain marketing system. The shock we are experiencing is not just a bump in the road. This shock is of the "fall off the cliff" variety and some reaction will eventually come. Output will be reduced from the level that otherwise would have prevailed. Livestock prices will be higher than they otherwise would have been. Processors, retailers and foodservice establishments will not absorb those price increases. They will be passed along.
New Price Plateaus on the Horizon?
Does this mean that meat, milk and egg prices will rise by as much as corn prices? Absolutely not. The cost of the farm-level output accounts for only a fraction (roughly 30% for hogs, 45% for beef) of the consumer dollar. The remaining portion, the marketing margin, will not change in absolute terms and the marketing system will be quite innovative in finding ways to reduce costs, change products, or whatever it takes to keep the consumer price impact as low as possible. Still, the impact will not be zero, especially when the cost change is persistent or permanent.
It now costs roughly $30 more per head to produce a market hog. Pork producers might eat that increase for a little while, but they won't do it forever. Neither will packers nor processors nor grocery stores. Milton Friedman's statement still applies: "There is no such thing as a free lunch."
Click to view graphs.
Steve R. Meyer, Ph.D.
Paragon Economics, Inc.