The Impact of Energy Prices on the Agricultural Sector

Introduction

Undeniably, there is a link between the energy and the agricultural sector. Traditionally,

the agricultural sector uses energy directly for fuel and electricity and indirectly through

the use of energy-intensive inputs such as fertilizers and pesticides. These activities

constitute a sizeable portion of total agricultural production costs and despite energy

efficiency efforts, increases in energy costs increased production costs and consequently

lead to lowered farm incomes. An additional consequence of rising energy costs is the

rising cost of ground water extraction. The US agricultural sector is also somewhat

dependent on groundwater for irrigation in some areas. A one dollar per million btu

increase in energy prices can decrease ground water extraction by 5.89 acre-feet per

year (Pfeiffer and Lin, 2014). It is also surmised that these higher production costs can

feed into higher agricultural commodity prices.

Rising energy prices and concerns about global warming has resulted in an increased

effort by many countries to reduce their reliance on fossil fuel energy and has renewed

efforts to increase the use of renewables in the energy mix. This sparked a new dynamics

between the agricultural sector and the energy sector. The demand for biofuels as an

alternative source of energy has increased the demand for agricultural products as an

input to this process. In 2012 the US transportation fuels used 42% of US corn and 1%

of US soybean production (Beckman et al., 2013; Sands et al., 2011). This demand for

biofuel feedstock not only placed upward pressure on agricultural commodity prices but

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also somewhat altered the mix of crops planted as farmers intensified production of high

priced corn at the expense of other crops. This in turned inflated the prices of the crops

with lowered production. However, given that energy prices are now significantly lower

and there is some uncertainty about climate change policies under the Trump

administration, there are even more pertinent questions of whether the previously

observed relationship between energy prices and the agricultural sector is still valid and

will be sustained.

This paper presents a succinct literature review on the above mentioned links between

the two sectors. Section one examines the dynamics of energy prices on the agricultural

sector on the demand side and section two examines the pass-through of oil prices to the

agricultural commodity prices through the increased use of biofuel feedstock (including

corn, soybeans, oil seeds) into energy production.

Agriculture as a user of energy

The agricultural sector uses energy directly in the form of fuel and electricity and also

indirectly in the form of energy intensive inputs such as fertilizers and pesticides.

Operations at all levels of agricultural production demands energy. These operations

range from operating vehicles and machinery to drying crops and irrigating fields.

Electricity is also needed for lighting and normalizing the temperature in homes and barns

and for example in dairy production for milking system and providing hot water for

sanitation (Schnepf, 2014). Therefore, increases in energy prices would naturally

translate into higher agricultural input costs. Individual farmers are incapable of affecting

market prices and as such, with higher production costs they are unable to pass these on

to consumers. Consequently, net cash farm income falls.

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The spike in oil prices in the 1980s did trigger energy efficiency efforts in the agricultural

sector but despite the declining rate of energy consumption, energy input is still a

significant portion of the total agricultural production costs. In 2011, corn, sorghum and

rice farmers spent over 30% of the total production costs on energy input (Beckman et

al., 2013). In 2007-2008 similar trends were observed for oats, sorghum, corn and barley.

They all had energy input costs greater than 50% of total operating costs with sorghum

being the highest and wheat the lowest (Sands et al., 2011). However, the share of energy

use by agricultural sector with respect to the overall economy is very modest. In 2002,

the agricultural sector consumed approximately 1% of total energy demand in the USA in

comparison to the transportation sector (27%) and the industrial sector (32%) (Schnepf,

2014). For livestock operations, the share of direct energy costs are modest. For 2007-

2008, milk production was 5% and cow and calf operation was 10% (Sand et al., 2011).

Indirectly, these operations are affected by the cost of energy through higher feed prices.

In the same period, feed cost was 11% of operating cost for cow-calf operations, 58% for

hog production and 76% for milk production (Sand et al., 2011).

Through the use of fertilizers and pesticides, the share of energy use in the agricultural

sector is even more significant. Fertilizers and pesticides account for roughly 9% of total

farm costs and the agricultural sector accounted for roughly 56% of nitrogen use in the

2002 and 67% of all expenditure on pesticides in 2001 (Schnepf, 2004). Since natural

gas is a major input in nitrogenous, phosphate and potash fertilizers and also anhydrous

ammonia( and represents 75% to 90% of the production cost of nitrogen fertilizers), it is

intuitive to disentangle from its total consumption the end use in agriculture. If we do so,

and divide fertilizers and pesticides in their natural gas and petroleum components,

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natural gas would account for about 26% of energy consumption in the agricultural sector.

If the price of natural gas rises, fertilizer prices will follow suit. With increases in fertilizer

prices, farmers can respond by either lower the rate of fertilizer application or plant crops

that are less dependent on fertilizers. The crops that requires the greatest use of fertilizers

per acre are corn, wheat, rice and cotton. These links suggest a significant relationship

between agricultural prices and energy prices, particularly natural gas.

Farmers are responsive to higher production costs. The USA is somewhat dependent on

imported energy, with the share of imported energy expected to reach 70% by 2025

(Schnepf, 2004). This heavily dependence makes the US quite vulnerable to changes in

oil prices globally and agricultural production at its mercy. If farmers anticipated

permanent increases in energy prices, they may very well adjust types of crops planted

to compensate for expected losses in income (Sands et al., 2011). Sands et al. (2011)

further note that cropping decisions are somewhat determined by per-acre operating

costs since these determine producer net returns. However, if farmers think that that price

changes are temporary they may only employ energy efficient strategies.

Food prices are not immune to these changes in fuel prices. If there are sustained

increases in energy prices, food prices may increase as well. Food prices are affected in

three ways. Food that is produced with energy-intensive methods will inflate, there will be

additional costs to transport foods to markets and there will be additional costs for the

storage and distribution of food. It is estimated that 3.5% of cost of food arises from energy

expenses and 4% from transportation. Higher energy costs will increase the dollar amount

of these percentages.

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Energy prices also affect the agricultural sector through groundwater extraction. On

average, 70% of all extracted groundwater is channelled into irrigation, and this can be

as high as 95-99% in many groundwater basins (Pfeiffer, 2014). Energy is a very

important ingredient in this process. As energy prices rise, groundwater extraction costs

rise as well (Zilberman et al., 2008, Pfeiffer, 2014). This in turns affects the type and

quantity of crops planted. Pfeiffer (2014) used both OLS and a simultaneous equation

model to estimate the marginal effect of energy prices on groundwater extraction

decisions in the High Plans Aquifer system of Central USA. The results suggest that a $1

per million btu increases in energy reduces the acres allocated to corn, sorghum,

soybeans and wheat by 1.3, 0.83, 2.21 and 0.8 acres per farmer respectively. On the

hand, areas allocated to alfalfa increases by 0.03 acres per farmer. Therefore, increased

energy prices not only affects the demand for water but also crop selection and crop

acreage allocation.

Agriculture as a producer of energy

Concerns about the imminent threats of climate change have resulted in an increased

effort by many countries to reduce their reliance on fossil fuel energy and increase the

share of renewables in their energy mix. A source of such renewable energy is biofuel. In

the USA, the Renewable Fuel Standard (RSF) and the Energy Independence and

Security Act of 2007 are the policies that lead this charge. In 2014, the EPA suggested

targets of 17 million gallons for cellulosic fuel, 1.8 million gallons for biomass based diesel

and 2.2 billion gallons for advanced biofuel. RSF has a target of 136.3 billion litres of corn

ethanol equivalent fuel by 2022. Naturally, these demands for bioenergy will have to be

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met by the agricultural and forest sector. Herein lies the new dynamics between the

agricultural and energy sector.

The agricultural sector has evolved beyond being a user to being a supplier of energy

leading to linkages between the energy and agricultural sector. Tyner and Taheripour

(2008 p.387) considers this “the most fundamentally important change to occur in

agriculture in decades”. When crude oil prices are high, the demand for corn and soybean

biofuels increases as these are substitutes for gasoline and diesel. Between 2006 and

2007, the share of feedstock used for biofuel production increased from 13.7% to 20%

(Beckman, 2012). But, with the increasing use of agricultural products for bioenergy there

may be upward pressure on agricultural commodity prices, a change in the agricultural

landscape and increased food insecurity for developing countries since low income

consumers use a larger share of their income for food consumption (Koirala et al., 2015;

Abbott et al., 2009). The change in agricultural landscape is evidenced by the 8 largest

exporters of wheat increasing the areas planted in rapseed and sunflowers by 36% from

2001 – 2007 and area planted in wheat fell by 1%. In the US, the production of corn grew

(23%) at the expense of soybean (fell by 16%) (Mitchell, 2008). Undoubtedly, biofuel

feedstocks have evolved beyond being just for food and feed (Trostle, 2008).

Energy prices and agricultural commodity prices are highly correlated (Beckman et al.,

2012; Tyner and Taheripour, 2008; Hertel and Beckman, 2010; Hertel, Tyner and Birur,

2010; Abbott, Hurt and Tyner, 2009). There are various explanations of the nature of this

dynamics. Mitchell (2008) used an ad hoc (not a structural model) to identify keys factors,

including indirect difficult to measure short term effects, that influenced the prices of corn,

wheat, rice oilseeds and the food commodity price index in 2002. He surmises that high

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energy prices resulted in a 15-20% increase in US food commodity production and

transportation costs. Baffes (2007) had similar conclusions about the relationship

between oil prices and agricultural commodity prices. His reduced-form econometric

model, used OLS to regress individual commodity prices on crude oil prices accounting

for inflation and technology change. He admitted that such a method may be overly

simplistic and lacking in its ability to sufficiently reflect the complex nature of commodity

prices, but it still has the ability to indicate the nature of the pass-through of oil prices to

commodity prices. He places this pass through at 0.17. This means that a 10% increase

in the price of crude oil will result in a 1.7% increase in the agricultural commodity price

index in the long run. The fertilizer index has a pass-through coefficient of 0.33. However,

both Mitchell (2008) and Abbott et al (2009) share the view that the demand for biofuels

has influenced agricultural commodity prices the greatest.

Mitchell (2008) believes that food price increases between January 2002 and June 2008

were largely in part influenced by increases in biofuel production (due to policy change)

in the USA and Europe that decreased corn and wheat stocks. Without this dynamics,

prices may have increased by other factors, but only moderately. By the latter half of

2008, crude oil prices fell and gasoline prices fell even further. Considering that biofuels

are attractive as an alternative source in the face of high gas prices, one would expect

the demand for biofuels to pummel and prices to follow suit with excess supply. While

gasoline prices fell ethanol prices held firm resulting in prices higher than gasoline. Abbott

et al. (2009) in their “data-driven approach” surmise that corn price increases was mostly

due to higher oil prices rather than subsidies that induced increased ethanol production.

Subsidies refer to a 51 cent per gallon fixed subsidy. In the absence of the subsidy, corn

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prices will only fall if oil prices decline as well. This view is reinforced with the observation

that a tripling of crude oil prices triples corn prices while the presence of a subsidy has

only about a quarter of the effect of oil prices. Their belief is contrary to other documented

studies that attribute much of the rise in corn prices to the US subsidy and mandate

programmes.

Beckman et al. (2012) examined the role of energy policy on the link between energy

prices and agricultural prices using the GTAP-B10 computational general equilibrium

(CGE) model. They estimate that with the continued sale of biofuel feedstock for ethanol

production the transmission mechanism of energy price volatility to agricultural prices will

be strengthened, possibly double between 2006 and 2020. However, demand is relatively

elastic and as such the sensitivity of agricultural commodity prices to supply shocks are

moderate. If instead the mandates are binding, commodity prices will be more volatile

and more responsive to supply-side shocks. Using the same GTAP-B10 model, Hertel

and Beckman (2010) made similar observations. Additionally, they highlighted that the

nature of the relationship between the energy and agricultural sector also depends on

whether oil prices are low or high. At prices below $75 per barrel, the correlation is 0.32

but at prices above the correlation jumps to 0.92. However, with an ethanol blend wall

(10%), in face of falling oil prices, they see some divergence in the corn prices and oil

prices as corns prices remains at levels that are not competitive with oil.

Recent literature suggests that the role of biofuels has been overplayed in the rise of

agricultural prices (Baffes and Haniotis, 2016). Evidence indicates that biofuel has mostly

influenced the prices of corn, and even this impact has been exaggerated. Baffes and

Haniotis (2016) believes that some of the previously assumed links between agricultural

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commodity prices and energy have been broken and other relationships are being

observed. Amidst all this, agricultural prices have even experienced declines independent

of changes in these causal factors, for example biofuels. The link between crude oil prices

and natural gas in the US has somewhat dissipated and there is a stronger co-movement

between natural gas and the price of coal. However, the energy and agricultural link

important and energy prices was the driver of rises in food prices. This relationship is

complex and spans direct energy costs and indirect energy costs such as transportation.

Conclusion

Energy prices do feed into agricultural commodity prices. The agricultural sector uses

energy for lighting and transportation and also indirectly through pesticides and fertilizers.

In addition to this, energy policies to reduce energy import dependence and to reduce

carbon footprint have increased the use of agricultural feedstock in energy production.

This creates a new channel through which changes in the energy market can pass-

through to the agricultural market. Even with recent decreases in energy prices, this link

between the two sector remains.

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