The Russian invasion of Ukraine has led to major disruptions in the supply of commodities such as energy and food, of which Russia and Ukraine are major exporters. The war exacerbated existing pandemic-related tensions in commodity markets, which had arisen due to supply chain disruptions, weak investment in energy generation and a rapid rebound of global demand. Most commodity prices have seen strong increases over the past year, with some reaching historic highs, which has contributed to the global rise in inflation.
Wars, pandemics and global recessions have repeatedly impacted commodity markets throughout history. These events can have longer-term consequences, as prolonged periods of very high (or low) commodity prices can trigger permanent changes in consumer and producer behavior, often intensified by poor government policies.
An analysis of two previous episodes of major shocks, the rise in oil and food prices in the 1970s and the general boom in commodity prices in the 2000s, can shed light on how the war in Ukraine may affect commodity markets. During the first oil price shock in 1974, prices quintupled in one year, while they tripled during the oil price spike of 1979, reaching a high of $151 per barrel of crude oil at real prices of 2022 (Figure 1). During the 2000s, oil prices peaked at $171 per barrel in real terms in mid-2008 and averaged $120 per barrel between 2010 and 2014. below these highs, but some other energy commodities have reached all-time highs.
This blog argues that market adjustments alongside certain government policies aimed at improving energy efficiency and boosting energy production can resolve commodity market imbalances, although this process may be protracted. At present, however, government policies have focused on fuel subsidies and tax breaks which can exacerbate price pressures by supporting strong demand.
Figure 1. Real oil price since 1970
Source: Fred; World Bank.
Note: Crude oil, average deflated by US CPI (2022).
Market mechanisms respond to price shocks through three main channels: demand reduction, substitution, and supply response.
Reduction in demand. Between 1979 and 1983, global demand for oil fell by 11%, and in advanced economies it fell by almost 20%. Part of the fall was due to the global recession of 1982, as well as consumers using less oil. Higher prices also led to changes in consumer preferences – in the United States consumers bought more Japanese cars which were more fuel efficient than American cars. Underlying demand growth has been permanently slowed by improvements in energy efficiency and substitution to other fuels. High oil prices in the 2000s also induced efficiency improvements in oil use.
Substitution. In the five years following the oil shock of 1979, the share of crude oil in energy consumption in OECD countries fell by 7 percentage points (Chart 2). This was mainly due to the switch from power plants to oil in favor of nuclear and coal. In the agricultural sector, substitution is common on the production side: high prices for a commodity, such as soybeans, induce farmers to grow soybeans rather than other crops such as wheat.
Figure 2. Shares of oil, coal and nuclear energy in OECD energy consumption
Source: BP Statistical Review, World Bank.
New sources of production. High oil prices in the 1970s encouraged the growth of oil production from high-cost sources, including Prudhoe Bay in Alaska and North Sea fields in the United Kingdom and Norway (Figure 3.A). The production of other fuels, such as coal, has also increased. High and stable prices in the 2000s facilitated the development of alternative sources of crude oil, including US shale oil. For foodstuffs, the high prices of the 1970s brought new supplies from South America, especially Argentina and Brazil (Figure 3.B).
Figure 3. Oil, soybean and corn production
Sources: EIA; IEA; USDA; World Bank.
Rising oil prices during the 1970s triggered a series of policy responses, which interacted with market mechanisms. In the United States, oil price controls (which were first imposed in 1971) contributed to shortages of petroleum products and were followed by the implementation of fuel allowance programs. These likely exacerbated oil shortages and distorted markets.
Some other policies have been more successful. For example, several OECD members created the International Energy Agency in 1974 to protect oil supplies under an emergency oil-sharing system (including the creation of national oil reserves). oil) and to promote the development of common policies and the collection and analysis of data. Other policies included phasing out oil-fired power plants in favor of coal, while the United States also introduced fuel economy standards for cars.
Policies were also implemented in the 2000s. The United States passed legislation in 2005 and 2007 aimed at reducing energy demand and boosting production. Demand-side measures included tax incentives to improve the energy efficiency of vehicles and homes. Supply-side measures included a mandate to increase the use of biofuels, setting standards for renewable fuels, and tax incentives for power generation and loan guarantees for carbon-free technologies. Other countries have adopted similar policies. For food, the G-20 created the Agricultural Marketing Information System in 2011 to improve transparency and policy coordination.
More difficult challenges today
The current commodity price shock has three key characteristics that could make it more difficult to resolve the energy deficit:
- General rise in prices. Price increases were widespread across all fuels, unlike previous shocks, where only oil prices increased. As a result, there are fewer opportunities today to switch to cheaper fuel.
- Lower energy intensity. The energy intensity of GDP is much lower than in the 1970s, so consumers may be less sensitive to changes in relative prices.
- Policy responses. Many countries have responded to the current shock with energy subsidies and tax breaks, with fewer policies designed to address the underlying imbalance between supply and demand. These policies are fiscally costly means of supporting vulnerable groups and, by maintaining demand for energy, they can prolong the imbalance between supply and demand.
Lessons from previous commodity shocks suggest that a combination of appropriate government policies and market adjustments can reduce stress in commodity markets. Measures to promote energy efficiency and boost energy supply helped resolve the imbalance of supply and demand after the oil shocks of the 1970s, while high prices led to lower oil demand and changes in consumer behavior, including the shift to more efficient vehicles. These lessons suggest that countries should focus their policies on promoting energy efficiency and encouraging energy production, preferably using reliable low-carbon energy sources, rather than distorting fuel subsidies. Food milestones could include measures to promote the efficient use of inputs such as fertilizers, as well as reducing food waste and relaxing biofuel mandates.