Chapter 2: Price volatility
Defining price volatility
22.Price volatility in the agricultural sector is generally understood to mean excessive variations in agricultural commodity prices over time. It refers specifically to price fluctuations, upwards and downwards, around an expected level. According to Tim Lloyd, Professor of Economics, Bournemouth University, “volatility will include some high prices and some low prices, but it is distinct from the state of high prices or low prices.”4
23.A number of witnesses, including Defra,5 David Gardner, the Chief Executive of the Royal Agricultural Society of England,6 and Jared Greenville, Senior Agriculture Policy Analyst at the Organization for Economic Co-operation and Development (OECD),7 pointed out that price volatility is an intrinsic feature of markets, including agricultural ones, as prices adjust to changing circumstances. Agricultural markets tend to exhibit high levels of volatility for a number of reasons, as explained in a report for the G20 by the Food and Agriculture Organization of the United Nations (FAO), the OECD and others8:
(a)Agricultural production is vulnerable to natural disasters, such as bad weather and pests, as well as to policy changes and international incidents, such as the 2014 Russian embargo on imports of a range of agricultural products from the EU.
(b)The inelastic nature of demand and supply of the market, particularly in the short term, means that a large change in prices is required to balance supply and demand after a shock.
(c)There is a lag in the supply response to price changes as the agricultural sector requires a considerable time to make changes to production, which can cause cyclical adjustments that add an extra degree of volatility to the markets.
24.Defra agreed that while demand for agricultural commodities tends to be steady, supply depends on natural factors including seasonality and weather.9
25.Professor Tim Lloyd, Steve McCorriston, Professor of Agricultural Economics, University of Exeter; and Wyn Morgan, Professor of Economics, University of Sheffield, argued that agricultural markets are additionally prone to occasional spikes, such as those that took place in food markets in 2007–2008 and 2011. They noted, though, that farmers are sometimes able to benefit from this phenomenon.10 These spikes can be clearly seen in Figure 1 below, which demonstrates price movements in UK price indices for selected agricultural products.
Figure 1: Real indexed prices for selected agricultural commodities (UK)
Source: Defra, ‘Agriculture in the United Kingdom’: https://data.gov.uk/dataset/agriculture_in_the_united_kingdom
26.Figure 2 demonstrates price movements for all agricultural outputs with respect to the long-term average price. It also shows the extent of annual percentage changes in the price index.
Figure 2: Real indexed prices for all agricultural outputs (UK)
Source: Defra, ‘Agriculture in the United Kingdom’: https://data.gov.uk/dataset/agriculture_in_the_united_kingdom
27.Professor Lloyd noted that there were different ways of measuring price volatility. The most common measure is the ‘coefficient of variation’, which measures variation of price relative to its average value over some sample period.11
28.There appeared to be no consensus, however, over what constitutes excessive volatility. The report for the G20 by the FAO, the OECD and others argued that the answer depends on individual or national circumstances, with small, resource-limited farmers being particularly vulnerable to a fall in prices:
“Suffice it to say that volatility becomes an issue for concern and for possible policy response when it induces risk averse behaviour that leads to inefficient investment decisions and when it creates problems that are beyond the capacity of producers, consumers or nations to cope”.12
29.Price volatility is an inherent feature of agricultural markets, and it will remain a normal risk to be managed by farmers as part of their business strategies.
A historical perspective
30.Recent years have seen a more volatile period in agricultural commodity prices. The evidence, however, suggests that this current episode is not an anomaly, and that volatile periods have generally been followed by periods of more stable prices.
31.According to the Price Volatility in Food and Agricultural Markets report, “there is little or no evidence that volatility in international agricultural commodity prices, as measured using standard statistical measures is increasing in the long term.” Nevertheless, it noted that volatility had been higher during the decade after 2000 than the previous two decades.13 Professor Lloyd, Professor McCorriston, and Professor Morgan agreed that, despite the price spikes of 2007–2008 and 2011, research did not point to any general increase in the volatility of prices on world agricultural markets.14
32.Professor Lloyd said:
“Volatility tends to cluster in periods of time and in between each cluster of volatility there is relative stability. If we look at the recent burst of volatility compared to the previous 10 years, which was a relatively stable period, volatility has increased. However, if we go further back and include the 1970s, which was a much more volatile period than we have just been through, we can see the positive trend that we might observe over a short period of time disappears.”15
33.Domestic price variations may differ from those seen in international markets depending on how integrated domestic markets are with global prices. Defra used the development of EU dairy market prices to make this point. It argued that the EU milk market was relatively shielded from the world market until 2006 due to import tariffs and the milk quota, with prices hovering above the EU support price. After the liberalisation of the market and the relaxation of the quota, EU milk prices had “begun to align with the more volatile world milk price”.16
34.Indeed, the Price Volatility in Food and Agricultural Markets report argued that trade measures such as import duties, export taxes, non-tariff barriers or domestic policies, such as price support, “all influence the extent to which price changes in domestic markets mirror those on international markets”.17
35.Despite increased volatility in agricultural prices in recent years, we conclude that the overall level of price volatility is no higher than at other times in the past.
Factors influencing volatility
36.The drivers of price volatility can be numerous and affect both demand and supply. They range from extreme weather events disrupting agricultural production to countries’ trade policy responses. Dr Philip Dawson, Reader in Agricultural Economics, Newcastle University, Professor Lloyd, Professor McCorriston and Professor Morgan, provided a helpful summary of the main drivers for recent price spikes.18 Their evidence is summarised in Box 1.
Box 1: Drivers of recent price spikes
|
Sources: Written evidence from Dr Phil Dawson (RPV0007), Written evidence from Professor Tim Lloyd, Professor Steve McCorriston and Professor Wyn Morgan (RPV0029)
37.Dr Phil Dawson told us that “Explanations of higher future price volatility include low stocks, increasing speculation, and the current financial crisis. There is no consensus about the relative weights of each explanation.”19
38.Exchange rate fluctuations also influence price volatility. Defra noted that a strong pound made imports to the UK market cheaper, depressing UK prices.
39.Professors Lloyd, McCorriston and Morgan noted that storage played an important role in mitigating the impact of price spikes. When stocks of commodities were adequate, they smoothed out changes in supply or demand in agricultural markets. Inadequate stocks, however, would exacerbate the situation and lead to more marked price variability.20
40.Moreover, the perishability of agricultural produce contributes to levels of price volatility in various commodities. Professor Lloyd argued:
“We tend to observe, other things remaining equal, very high volatility in fruits, simply because they are perishable products that we cannot store. Wheat, on the other hand, is storable and its volatility tends to be less than others.”21
41.Export subsidies to farm products were also highlighted as a source of price volatility on world markets. His Excellency the Rt Hon Sir Lockwood Smith, the High Commissioner of New Zealand to the United Kingdom, commended the World Trade Organization (WTO) commitment in December 2015 to abolish such subsidies, arguing that it had “helped to lead to normal market mechanisms having greater impact on stabilising prices”.22 Defra agreed that “the EU’s move away from the use of export subsidies also contributes to the stability of world markets.”23
42.In the EU, the evolution of the CAP from commodity price support towards decoupled income support and environmental payments has increasingly exposed EU farmers to market prices. According to Defra, “greater market orientation in the EU farming sector can improve efficiency and productivity, but also bring more exposure to price volatility on international markets.”24 The Agriculture and Horticulture Development Board (AHDB), the statutory levy board, concurred:
“Historically, when many of today’s farming businesses were in their infancy, the CAP provided much of the price risk management required meaning the business could focus purely on optimising the physical attributes.”25
Why does volatility matter?
43.While variations in prices provide important market signals to steer farmers’ production and investment decisions, excessive price volatility caused by transient influences can undermine the economic validity of these signals. For instance, farmers face the risk of losing their productive investments made in times of high prices if prices subsequently drop significantly. This uncertainty may lead to sub-optimal investment decisions.
44.In addition, periods of low prices pose significant problems for farm incomes. The House of Commons’ Environment, Food and Rural Affairs Committee’s recent report on Farmgate prices, which investigated farm gate prices for dairy, lamb and pork industries in the UK, found that the most recent period had seen prices fall, leading to many farmers suffering financial difficulty.26
45.The AHDB noted that farmers tended to struggle with adjusting to low prices:
“Essentially, many businesses still take a very physical rather than a business approach to periods of low prices. This prevents the business from identifying and responding to market signals—for example it is often said that dairy farmers will ‘milk through’ low prices to maintain short-term cash flow—rather than making and taking more challenging business decisions.”27
46.Both price volatility and low prices present challenges for farmers. In our opinion, adverse effects at farm level are caused more by unanticipated periods of sustained low prices than by an increase in levels of price volatility.
Normal vs. excessive volatility
47.The OECD argued that producers should be facing some price volatility as part of “normal business risks that they undertake”. Such limited volatility provided signals to make appropriate investments into the sector, guided by supply and demand:
“A certain amount of risk should be present in the industry, so when we think about price volatility we should really only be thinking in terms of where governments start to … play a role in helping to overcome these catastrophic and extreme events.”28
48.Sir John Marsh, Emeritus Professor at the University of Reading, gave an example of “the traditional pig cycle, where a period of high prices would lead to excessive investment and a subsequent market crash”. He argued that such behaviour would misdirect real resources and increase the cost of technical innovation. Excessive volatility could also have social consequences by pushing marginal producers out of business, which might lead to consequences such as a gradual depopulation of regions.29
49.The Price Volatility in Food and Agricultural Markets report argued that:
“Not all price variations are problematic, such as when prices move along a smooth and well-established trend reflecting market fundamentals or when they exhibit a typical and well known seasonal pattern. But variations in prices become problematic when they are large and cannot be anticipated and, as a result, create a level of uncertainty which increases risks for producers, traders, consumers and governments and may lead to sub-optimal decisions.”30
50.Some witnesses stressed the potential benefits that farmers could derive from price volatility. Paul Wilson, Professor of Agricultural Economics, University of Nottingham, noted that the temporary high prices which resulted from the volatility experienced in 2007–08 was a positive event for cereal farmers, allowing them to reinvest in depreciating assets. He concluded that farmers were able to make a profit on the upswing of prices, and that it was only the downswing that presented a problem.31
51.Philip Bicknell from the National Farmers’ Union (NFU), said: “When we saw higher prices, we saw investment in plant and machinery, perhaps stuff that has a shorter lifespan.” He added, however, that investment in farm buildings and storage needed to maintain an appropriate level of capital stock might not materialise because volatility made longer term forward planning difficult.32
The impact of speculation
52.The evidence on the impact of speculation on price volatility was inconclusive. According to Dr Dawson, limiting speculation on agricultural futures markets “may lead to increasing volatility, may mitigate against the important roles of traders who provide liquidity and absorb risk, and may drive funds into international futures markets that have fewer regulations”.33
53.On the other hand, Professor Morgan argued that some speculation in the futures market was “a response to volatility, not necessarily the cause, although it could reinforce some of the volatility”.34
54.A 2010 report for the OECD found that increased participation of index fund investments in agricultural commodity markets had not increased price volatility in agricultural futures markets: “There is no statistically significant relationship indicating that changes in index and swap fund positions have increased market volatility.”35
Volatility as a driver of productivity
55.Price volatility can also drive productivity gains on farms, as farmers adopt strategies to improve their resilience to unexpected price swings and protracted periods of low prices. The New Zealand High Commissioner, for example, reported “staggering” productivity improvements in New Zealand’s agricultural sector after the removal of subsidies that had shielded farmers from global market forces.36 Other witnesses cautioned that there were particular circumstances in New Zealand, which they felt played an important role in the changes that took place, such as currency devaluation.37
56.Indeed, many witnesses argued that free trade could have a stabilising influence on prices, while protectionist measures were considered counterproductive. Defra noted that policies such as import bans aimed at shielding the domestic market from price rises could “export instability onto the world market”.38
57.Douglas D. Hedley, former Assistant Deputy Minister in Agriculture and Agri-food of Canada, argued that volatility in commodity prices was not a concern, as long as “open and fair trade rules and non-distorting domestic programs are in place.” He added that “a considerable degree of volatility in prices stems from governmental action in both trade distortions and distorting domestic programs”. As an example, he noted that China’s decision to alter its state purchases of feed grains, dairy products and meats, had “a considerable effect on the recent declines in prices for these commodities”.39
58.The evidence we received suggested that farmers being prepared for price variations of both inputs and outputs and periods of low prices, would assist farmers in making decisions on investment and business strategies. Such preparedness would not, however, eliminate the risk arising from unexpected price movements. Managing this risk is complicated by, in particular, the time lag between the decision to produce and the time when marketable output is generated and revenue realised. Dr Dawson argued:
“Higher volatility (and therefore higher price risk) may lead farmers, traders, input supply firms and food processors to implement better financial management strategies which include the use of futures and options, insurance, storage, and diversification or collaboration to share costs.”40
59.A degree of price volatility sends crucial market signals, which inform production and investment decisions. It also provides incentives for innovation and efficiency gains.
60.Preparedness for price movements will assist farmers in their investment and business decisions, but it will not eliminate risk.
61.Public policy should not aim to control prices but to help farmers develop resilience mechanisms to manage the risks posed by volatility.
Input prices
62.Though price volatility, as we have used the term, refers to farm gate prices paid to producers, variations in input costs, such as fertilisers, seeds, animal feed and energy, are also affected by price variations. These may be different from variations in output prices. As an important component of production costs, they affect farm incomes and profitability and can either mitigate of exacerbate the impact of output price volatility.
Impact on different farm groups
63.The EU agricultural sector is very diverse, involving a wide range of farm types from intensive to conventional and organic, and various types of produce from livestock, to grain and horticulture. Farmers also face different conditions, with additional payments available to those farming in designated ‘areas with natural constraints’, where agricultural production is more difficult due to factors such as soil, slope and climate.
64.The impacts of price volatility differ depending on the type of farm, the ownership and the age of the farmer. Young farmers and tenant farmers are likely to face specific challenges. Young farmers may be particularly vulnerable to price volatility, because they often lack the financial resources required as a buffer during periods of low prices. Difficulty in accessing credit is compounded by the difficulty that many young farmers face in securing land ownership.
65.The OECD outlined the challenge for young farmers, explaining that “what [they] would be particularly vulnerable to are the shocks where they do not have the financial reserves to deal with it”. They were consequently more likely to exit the market “if they enter at the wrong time and there is a sudden shock”.41 Sir Peter Kendall, Chairman of the AHDB, agreed that young farmers were less resilient, as they might lack land ownership or reserves in the bank.42
66.According to Lynsey Martin from the National Federation of Young Farmers’ Clubs, access to finance is a major concern for young farmers when they have limited capital or a limited credit record: “Without a secure form of contract for whatever you are producing, whether it is arable or livestock, young farmers find it very difficult to get some sort of finance.”. She added that because few young farmers can entertain any prospect of land ownership in the current financial climate, innovative ways of farming, such as share farming or joint business ventures, could help them get into the industry.43
67.Other witnesses argued that young farmers had an advantage, because they were more capable of adapting to changing circumstances and possessed different and more contemporary skillsets, giving them resilience in the face of shocks. For instance, the European Commission’s Directorate General for Agriculture (DG AGRI) argued that young farmers were more educated and more open to new technologies than the rest of the farming community:
“Young farmers tend to be better trained … [The] latest research confirms that, indeed, young farmers are more eager than the rest to develop all entrepreneurial and managerial skills such as marketing, financial, communication, networking and management skills. These skills are essential to guarantee the long-term viability of their farms and cope with the economic challenges that [they] will face in the future.”44
68.The AHDB told us that young farmers could help older ones adapt to available technology:
“The training that is now being given in agricultural colleges is equipping them to understand the markets as well as the technology that will play a fundamental part in our being competitive in the future.”45
The Royal Agricultural Society of England agreed about the value of work done in the colleges, and added that there was an opportunity to work more closely with young farmers’ clubs, to turn them into a vehicle to help “upskill people coming into the industry”.46
69.Some of the challenges facing tenant farmers are similar to those that young farmers grapple with, including access to finance and a lack of land ownership. Tenants have the additional burden of paying rent: Professor Wilson noted that higher prices tended to drive rents up, but told us that when prices moved to a downward path, some tenants would be paying relatively higher rents than was the case historically.47
70.George Dunn, from the Tenant Farmers Association, said that fixed rents and the expense involved in renegotiating tenancy contracts were a major concern for farmers operating in a volatile market. He added that, compared to farmers who own their land, tenant farmers were more constrained when trying to diversify by combining farming with other economic activities to develop resilience.48
71.Mr Dunn added that tenant farmers did not have access to the capital value of the land, and that this could become a problem when they needed to borrow to sustain themselves through a volatile period, particularly when prices were low.49
72.Mr Dunn also flagged up the length of tenancies as an issue:
“For people who are on farm business tenancies—we call them the new style of tenancies, but they have been around … since 1995—a big issue in managing volatility is that they are incredibly short in length. The average length of term is just over three years. In a volatile market, that gives you no time at all to have the ability to manage the highs with the lows.”50
73.Oliver McEntyre, National Agriculture Strategy Director, Barclays Agriculture, identified short tenancies as a potential barrier to obtaining the credit needed to make long term investments:
“If we have only a five-year tenancy or an eight-year tenancy, that is all we can look to lend money over. We will lend money into agriculture for 25 years, and even up to 30 in some instances, but if we have only an eight-year tenancy it is not very responsible to lend someone money over 15 years because, after eight years, that business could cease to exist.”51
Table 1: Changes to farm tenancy agreements
Full Agricultural Tenancy |
Farm Business Tenancy |
|
Legislation |
|
|
Agricultural Holdings Act 1986 (AHA 1986) |
Agricultural Tenancies Act 1995 (ATA 1995) |
|
Effective date of origin |
|
|
All new tenancies starting before 1 September 1995 and some starting after in accordance with the provisions of ATA 1995. |
All new tenancies starting from 1 September 1995, bar exemptions set out in the Act |
|
Security |
|
|
Normally lifetime of tenant. Tenancies starting before 12 July 1984 may have rights of succession. |
Determined in the agreement with average now below 4 years in practice. |
|
Notice |
|
|
Most notices to quit require tribunal consent, but the landlord has the ability, in specific circumstances to serve incontestable notices to quit for reasons including non-payment of rent, bad husbandry or death of the tenant. Notice to quit on death of tenant is stopped by an application for succession. |
Tenancies of two years and less will come to an end automatically. Tenancies of more than two years must be ended by either party serving notice to quit corresponding with the termination date of the tenancy. The minimum notice period is 12 months. The agreement may also include a break clause for either side to terminate the tenancy early. |
|
Rent reviews |
|
|
The landlord or tenant has the right to a rent review 3 years after either the start of a tenancy or a previous rent review. The act contains a “rent formula” which takes into consideration the earning capacity of the farm. |
Landlords and tenants can negotiate their own rent levels and decide whether they want to have rent reviews. Any rent formula used must not preclude a reduction. In the absence of contractual provisions, either the landlord or the tenant can demand a rent review every 3 years. |
Sources: Tenant Farmers Association; UK Government
74.There was, however, no consensus over whether volatility affected some farming sectors more than others. Ross Murray, President of the Country Land and Business Association (CLA), argued that all sectors were currently vulnerable to volatility, with no particular sector more affected than others. What would be more interesting, he argued, would be to differentiate between farms with good or bad management within sectors, farm types and tenure types.52
75.The NFU, on the other hand, saw differences across sectors, some of which related to the tools that different farm types had at their disposal to manage volatility. He suggested that the dairy and red meat sectors, for example, did not have the options available to the pig and poultry sectors (such as feed price ratchets) or cereals (such as futures prices).53
76.Price volatility may also affect different regions to a different degree. In the case of the devolved administrations, Professor Wilson noted that such regional differences “come down to the farm types that are typically operating in those areas”. He added that there were still significant differences in the way the CAP was implemented in the different regions, potentially creating an uneven playing field. In Scotland, for example, some subsidies were still linked to production in the beef and sheep sectors, providing support which other sectors did not enjoy.54
77.Various sub-groups of farmers experience volatility to different degrees and therefore require different strategies and support to strengthen their resilience. We recommend that the UK Government encourages tenant farmers seeking to diversify and strengthen their resilience. The UK Government and the devolved administrations should also investigate the impact of short-term tenancies on the ability of farmers to make necessary investments.
8 FAO, IFAD, IMF,OECD, UNCTAD, WFP, the World Bank, the WTO, IFPRI and the UN HLTF, Price Volatility in Food and Agricultural Markets: Policy Responses (2 June 2011): https://www.oecd.org/tad/agricultural-trade/48152638.pdf [accessed 5 May 2016]
10 Written evidence from Professor Tim Lloyd, Professor Steve McCorriston, and Professor Wyn Morgan (RPV0029)
12 FAO, IFAD, IMF,OECD, UNCTAD, WFP, the World Bank, the WTO, IFPRI and the UN HLTF, Price Volatility in Food and Agricultural Markets: Policy Responses (2 June 2011): https://www.oecd.org/tad/agricultural-trade/48152638.pdf [accessed 5 May 2016]
13 FAO, IFAD, IMF,OECD, UNCTAD, WFP, the World Bank, the WTO, IFPRI and the UN HLTF, Price Volatility in Food and Agricultural Markets: Policy Responses (2 June 2011): https://www.oecd.org/tad/agricultural-trade/48152638.pdf [accessed 5 May 2016]
14 Written evidence from Professor Tim Lloyd, Professor Steve McCorriston, and Professor Wyn Morgan (RPV0029)
17 FAO, IFAD, IMF,OECD, UNCTAD, WFP, the World Bank, the WTO, IFPRI and the UN HLTF, Price Volatility in Food and Agricultural Markets: Policy Responses (2 June 2011): https://www.oecd.org/tad/agricultural-trade/48152638.pdf [accessed 5 May 2016]
18 Written evidence from Dr Phil Dawson (RPV0007) and written evidence from Professor Tim Lloyd, Professor Steve McCorriston, and Professor Wyn Morgan (RPV0029)
20 Written evidence from Professor Tim Lloyd, Professor Steve McCorriston, and Professor Wyn Morgan (RPV0029)
26 Environment, Food and Rural Affairs Committee, Farmgate prices (Third Report, Session 2015–16, HC474)
30 FAO, IFAD, IMF,OECD, UNCTAD, WFP, the World Bank, the WTO, IFPRI and the UN HLTF, Price Volatility in Food and Agricultural Markets: Policy Responses (2 June 2011): https://www.oecd.org/tad/agricultural-trade/48152638.pdf [accessed 5 May 2016]
35 Irwin, S. H. and D. R. Sanders (2010), The Impact of Index and Swap Funds on Commodity Futures Markets: Preliminary Results, OECD Food, Agriculture and Fisheries Working Papers, No. 27, OECD Publishing. http://www.oecd.org/trade/agricultural-trade/45534528.pdf [accessed 5 May 2016]