The Russian invasion of Ukraine provoked significant interruptions in the supply of goods such as energy and food products, the main exporters of which are Russia and Ukraine. The war exacerbated existing pandemic-related stress in commodity markets due to supply chain disruptions, weak investment in energy production and a rapid recovery in global demand. The prices of most commodities have risen sharply over the past year, with some hitting historic highs, contributing to global rise in inflation.
Wars, pandemics, and global recessions have repeatedly affected commodity markets throughout history. These events can have long-term consequences, as prolonged periods of very high (or low) commodity prices can cause irreversible changes in consumer and producer behavior, often exacerbated by ineffective government policies.
Analysis of two previous episodes of major shocks, the rise in oil and food prices in the 1970s and the wide-ranging boom in commodity prices in the 2000s may shed light on how the war in Ukraine could affect commodity markets. During the first oil price surge in 1974, prices quintupled in one year, and during the oil price surge in 1979, they tripled, peaking at $151 per barrel of crude oil in 2022 real prices (Fig. 1). During the 2000s, oil prices peaked at $171/bbl in real terms in mid-2008 and averaged $120/bbl between 2010 and 2014. Oil prices remain below those peaks today, but some other energy commodities have hit historic highs.
This blog post argues that market adjustments, along with some government policies to improve energy efficiency and increase energy production, can address commodity market imbalances, although the process may take longer. However, government policy is currently focused on fuel subsidies and tax breaks, which could exacerbate price pressures by sustaining strong demand.
Figure 1. Real oil price since 1970
Sources: FRED; The 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.
Decrease in demand. Between 1979 and 1983, world demand for oil fell by 11 percent, and in advanced economies it fell by almost 20 percent. Part of the fall was due to the global recession of 1982, as well as the fact that consumers began to use less oil. Higher prices also led to a change in consumer preferences – in the United States, consumers bought more Japanese cars, which had better fuel efficiency than American cars. Underlying demand growth has been consistently eroded by energy efficiency improvements and fuel switching. High oil prices in the 2000s also contributed to more efficient use of oil.
Replacement. In the five years since the oil price surge in 1979, the share of crude oil in energy consumption in OECD countries has fallen by 7 percentage points (Figure 2). This was mainly due to the transition from oil to nuclear and coal-fired power plants. In agriculture, substitution has been commonplace in manufacturing: high prices for one commodity like soybeans encourage farmers to grow soybeans over other crops like wheat.
Figure 2. Shares of oil, coal and nuclear energy in energy consumption in OECD countries
Source: BP Statistical Review, World Bank.
New sources of production. High oil prices in the 1970s stimulated an increase in oil production from expensive sources, including Prudhoe Bay in Alaska and the North Sea fields in the UK and Norway (Figure 3.A). The production of other fuels such as coal has also increased. High and stable prices in the 2000s encouraged the development of alternative sources of crude oil, including shale oil in the US. In terms of food, high prices in the 1970s led to new supplies from South America, in particular from Argentina and Brazil (Figure 3.B).
Figure 3. Oil, soybean and corn production
The rise in oil prices in the 1970s triggered a series of policy responses that interacted with market mechanisms. In the United States, oil price controls (first introduced in 1971) contributed to shortages of petroleum products, followed by fuel distribution programs. This likely exacerbated the oil shortage and distorted markets.
Some other policies have been more successful. For example, several members of the OECD established the International Energy Agency in 1974 to protect oil supplies under the emergency oil distribution system (including the creation of national oil reserves) and to promote common policy development and data collection and analysis. Other policies included phasing out oil-fired power plants in favor of coal, while the United States also introduced fuel economy standards for automobiles.
The policy was also implemented in the 2000s. In 2005 and 2007, the United States passed laws aimed at reducing energy demand and increasing production. Demand-side measures included fiscal stimulus to improve the energy efficiency of vehicles and housing. Supply-side measures included a mandate to increase the use of biofuels, setting standards for renewable fuels, and tax credits for energy production and credit guarantees for carbon-neutral technologies. Other countries have adopted similar policies. For food, the G20 created the Agricultural Marketing Information System in 2011 to increase transparency and policy coordination.
More challenging tasks today
The current commodity price shock has three key features that could make it difficult to address the energy shortage:
- Widespread price increase. Price increases were broad-based for all fuels, unlike previous shocks when only oil prices rose. As a result, today there are fewer opportunities to switch to cheaper fuel.
- Low power consumption. The energy intensity of GDP is much lower than in the 1970s, so consumers may be less sensitive to relative price changes.
- Political responses. Many countries have responded to the current shock with energy subsidies and tax breaks, and policies to address the underlying imbalance between supply and demand have been reduced. These policies are a financially costly means of supporting vulnerable groups, and by supporting energy demand, they can prolong the imbalance between supply and demand.
Lessons learned from previous commodity-related shocks suggest that a combination of good government policy with market adjustments can ease commodity market tensions. Measures to improve energy efficiency and increase the supply of energy helped redress the imbalance between supply and demand after the oil shocks of the 1970s, while high prices led to lower consumer demand for oil and a change in consumer behavior, including a shift to more efficient vehicles. These lessons suggest that countries should focus policy on improving energy efficiency and encouraging energy production, preferably with reliable, low-carbon energy sources, rather than distorting fuel subsidies. Key steps for food commodities could include measures to promote the efficient use of resources such as fertilizers, along with reducing food waste and easing biofuel mandates.