In the past, when the price of a barrel of oil rose, its impact on farmers was limited to direct production costs such as increased prices of fertilizer, diesel or transport.

Recently, however, the agricultural sector has become part of the energy-supply equation. With the introduction of energy policies, particularly in the US, this has provided more demand for commodities that are used to produce biofuel.

Renewables

From 2007-2011, an average 20% of renewable energy production in the US was derived from biofuel. This compared to less than 1% from 1981-1985. The US has been the leading producer of biofuel since 2006, followed by Brazil, then the EU-27. Meanwhile, global production of biofuel was over 29bn gallons in 2011, six times the amount produced in 2000. The US has increased its corn crop by 100m tonnes annually on the back of this increased demand.

This biofuel demand has played a key role in creating a stronger relationship between oil and agri-commodity prices. While it has created a new market for crops, it has also created more complex market situations.

As an energy-intensive sector, agriculture plays a big role on the demand side of the equation. Some reports suggest the direct energy component of agriculture is four to five times higher than for manufacturing sectors.

Energy, although mainly in the form of natural gas, is a large input cost in the manufacture of fertilizers. Over time there has been a close relationship between the price of oil and that of raw fertilizers. For example, the price of nitrogen fertilizer has increased almost fourfold since 1999, while the price of oil has increased by a similar amount.

The increasing cost of inputs such as fertilizer sometimes also influences the choice of crop to be planted, particularly in the countries such as Brazil. For example, due to lower use of fertilizer, soyabeans are cheaper to grow than grains.

Economic theory

Economic theory suggests decreasing oil prices directly affect agricultural prices through lower input and transportation costs. And in an oversupplied market, the lowest-cost producer will ultimately determine the price.

In a recent global study, it was found that when oil prices fall to $70/barrel, maize corn production costs fall by between 3% and 8%. The smallest cost reduction was in the EU and the greatest in Brazil. Changes in wheat costs are similar to those of corn with an average fall of 4%.

Soyabean producers see the largest average cost decline of 21%, with Brazil topping out at 31%.

Analysis How low oil prices affect production

Production decisions are not solely dependent on oil price. Other factors such as futures markets, demand, exchange rates and weather do play a role.

Assuming these factors remain the same and oil remains at current levels, the graphic above illustrates how soyabean and wheat production would rise by a total of 3% across the three regions.

At the same time, the production of sugarcane, ethanol and biodiesel would fall by a total of 5%. The greatest percentage biofuel declines occur in Brazil and the US, the two regions with the largest production.

In the EU, wheat production with low oil would rise by 1.4 million tonnes (0.9%) due to lower input costs. Ethanol production would fall due to reduced demand for blending, as it becomes less competitive.

In Brazil, production of soyabeans and wheat would increase by a total of 1.2%. Sharper declines in sugarcane, ethanol and biodiesel would be seen due to lower energy prices.

Unlike in Brazil and the EU, crop production in the US is likely to be relatively unaffected (less than 1%) by low oil prices.

Wheat will be the largest mover with a 0.3% increase projected. However, ethanol and biodiesel production is expected to decrease by almost 1% as it becomes less competitive.

This will mean that less of the US crop will be used for biofuel production, leading to an increase supply for export markets and this could put further downward pressure on commodity prices.

Why is oil falling?

In recent weeks, the price of oil has fallen by 40% to a five-year low of $66/barrel. The main cause of this is increased oil supply due to fracking in the US. It has increased its production by one-third in the last two years to 9m barrels per day (b/d).

This is largely due to the advancement of drilling technology which is allowing oil speculators in Texas and North Dakota extract shale oil, which was previously seen as unviable. In a short space of time the US has become practically self-sufficient (85%) while the world has gone from an oil shortage to a surplus.

On the demand side, the stagnation of the eurozone along with a slowing Chinese economy, the world’s second largest oil consumer, means that global demand for oil is less than anticipated.

Unusually, OPEC has decided to maintain current production levels in order to keep prices low in a bid to put these new high-cost US shale producers out of business. There is some speculation that oil prices could fall as low as $40/barrel.

Market pressure

While cheaper oil is good news for Irish farmers in terms of falling fuel and other direct inputs, it is also good news for farmers in the US and Brazil. Effectively everyone is allowed produce more with less.

However, if oil prices remain low in the longer term, the potential knock-on effects for Irish farmers could be very significant.

One of the largest drivers of biofuel production outside of policy was high oil prices. This effectively created a new market for crops such as corn and sugarcane. It helped bolster prices of these commodities around the world.

Corn is the most widely produced crop in the US and almost one-third of it is used in the ethanol industry. If biofuel becomes uncompetitive relative to oil, governments may come under pressure to review their energy policies.

Any drop off in demand for the 100m tonnes of corn that the US currently produces for the biofuel industry will lead to increased supply in more traditional feed grain and export markets.

For Ireland, cheap grain is not good. The obvious losers are tillage farmers. Less so are dairy and beef finishers.

Cheap grain will increase productivity in the US meat and dairy sectors, heavily reliant on intensive feedlot systems, as it becomes cheaper to feed cattle and cows.

Already this year, low grain prices have helped fuel a 4% production increase in the US dairy sector. This is having the effect of reducing global dairy prices.