How to reduce the impact of the war in Ukraine on commodity markets

Russia’s aggression in Ukraine has significantly hampered the supply of goods such as energy and food, with Russia and Ukraine being major exporters. The war has exacerbated existing epidemic-related pressures on commodity markets, caused by disruptions in the supply chain, weak investment in energy production, and a rapid return to global demand. Prices of most commodities have risen sharply over the past year, with some reaching all-time highs, contributing to rising global inflation.

Wars, epidemics and global recessions have repeatedly affected commodity markets throughout history. These events can have long-term consequences, as the price of too many (or too few) products for a long period of time can bring about lasting changes in the behavior of consumers and producers, often exacerbated by weak government policy.

An analysis of the previous two episodes of major shocks, rising oil and food prices in the 1970s and mass-based commodity prices in the 2000s, can shed light on how the Ukraine war could affect commodity markets. During the first oil price crash in 1974, prices increased fivefold in one year, while they tripled during the 1979 oil price hike, reaching a high of $ 151 per barrel of crude oil at real prices in 2022 (Figure 1). In the 2000s, oil prices peaked at 17 171 a barrel in mid-2008 and averaged $ 120 a barrel in 2010-14. Oil prices remain below this peak today, but some other energy products have reached all-time highs.

This blog argues that market coordination along with some government policies to improve energy efficiency and increase energy production can eliminate product market imbalances, although this process can be protracted. Currently, however, government policies have focused on energy subsidies and tax breaks that could increase price pressures while maintaining high demand.

Figure 1. Actual oil prices since 1970

Real oil prices since 1970

Source: FRED; World Bank.
Note: Crude oil, average deflated by US CPI (2022).

Market process

The market process responds to price shocks through three main channels: demand reduction, replacement, and supply response.

Decreased demand. Between 1979 and 1983, global oil demand fell by 11 percent, and in developed economies it fell by about 20 percent. Part of the downturn was the global recession in 1982, as well as consumers consuming less oil. Consumers’ preferences have also changed due to higher prices ্রে in the United States, consumers have bought more Japanese cars that have higher fuel efficiency than US cars. The growth of underlying demand through the improvement of energy efficiency and the replacement of other fuels has been steadily declining. High oil prices in the 2000s also improved oil efficiency.

Replacement. In the five years since the 1979 oil price crash, the share of crude oil in fuel consumption in OECD countries has fallen by 7 percentage points (Figure 2). This was mainly due to the shift from oil-fired power plants to nuclear and coal. In agriculture, replacement in terms of production was common উচ্চ the high price of a commodity, such as soybeans, encouraged farmers to grow soybeans instead of other crops such as wheat.

Figure 2. OECD energy consumption shares oil, coal, and nuclear energy

OECD energy consumption shares oil, coal, and nuclear energySource: BP Statistical Review, World Bank.

New source of production. In the 1970s, high oil prices encouraged an increase in oil production from high-value sources, including the Prudho Bay in Alaska and the North Sea areas of the United Kingdom and Norway (Figure 3.A). Production of other fuels like coal has also increased. High and stable prices in the 2000s helped develop alternative crude oil sources, including U.S. shale oil. For food, high prices in the 1970s brought new supplies from South America, especially Argentina and Brazil (Figure 3.B).

Figure 3. Oil, soybean and corn production

Oil, soybean and corn productionSource: EIA; IEA; USDA; World Bank.

Government policy

The rise in oil prices in the 1970s created a response to various policies, which interacted with market processes. In the United States, price controls on oil (which were first imposed in 1971) contribute to the shortage of oil products and are followed by the implementation of energy allocation programs. These have probably exacerbated the oil shortage and distorted market.

Some other policies were more successful. For example, several OECD members formed the International Energy Agency in 1974 under an emergency oil-sharing system (including the creation of national oil reserves) to protect oil supplies and to promote general policy-making and data collection and analysis. Other policies include phasing out coal-fired oil-fired power plants, while the United States has introduced fuel economy standards for cars.

Policies were also implemented in the 2000s. The United States passed laws in 2005 and 2007 aimed at reducing energy demand and increasing production. Demand-side arrangements include revenue incentives to improve energy efficiency in vehicles and housing. Supply-like arrangements included increasing the use of biofuels, establishing renewable energy standards and tax incentives for energy production, and credit guarantees for zero-carbon technology. Other countries have adopted the same policy. For food, the G-20 established the Agricultural Marketing Information System in 2011 to enhance transparency and policy coordination.

Today is a more difficult challenge

The current product price shock has three main features that can make energy deficits more difficult:

    • Broad-based price increases. Unlike previous shocks, where only oil prices have risen, price increases have spread across all fuels. As a result, the chances of switching to cheaper fuels are lower today.
    • Low energy intensity. The energy intensity of GDP is much lower than in the 1970s, so consumers may be less sensitive to relative price changes.
    • Policy response. Many countries with low policies to address the underlying imbalance between supply and demand have responded to the current push with energy subsidies and tax breaks. By pursuing these policies financially costly ways to support vulnerable groups and maintain energy demand, they can prolong demand and supply imbalances.

Lessons from previous product pushes suggest that the combination of appropriate government policy with market adjustment can reduce commodity market volatility. Measures to promote energy efficiency and increase power supply after the oil crash of the 1970s helped to address demand and supply imbalances, while higher prices reduced consumer demand for oil and changed consumer behavior, leading to more efficient vehicle transfers. These lessons will suggest that countries should focus on policies to increase energy efficiency and encourage energy production using reliable sources of low-carbon energy, rather than distorting energy subsidies. Key feedback measures may include reducing food waste and simplifying biofuel obligations, as well as promoting efficient use of inputs such as fertilizers.

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