[Paper Review] UPDATE July 2012 | The Food Crises: The US Drought

Marco Lagi, Yavni Bar‐Yam+1 more|arXiv (Cornell University)|Sep 27, 2012

Market Dynamics and Volatility4 references3 citations

TL;DR

This paper updates a validated model showing that financial speculation and corn-to-ethanol conversion amplify food price volatility, predicting that the 2012 U.S. drought will trigger an early, severe food price spike due to speculative feedback loops. Without intervention, prices may surge above prior peaks by year-end, but curbing speculation or ethanol use could prevent the crisis.

ABSTRACT

Recent droughts in the midwestern United States threaten to cause global catastrophe driven by a speculator amplified food price bubble. Here we show the effect of speculators on food prices using a validated quantitative model that accurately describes historical food prices. During the last six years, high and fluctuating food prices have lead to widespread hunger and social unrest. While a relative dip in food prices occurred during the spring of 2012, a massive drought in the American Midwest in June and July threatens to trigger another crisis. In a previous paper, we constructed a model that quantitatively agreed with food prices and demonstrated that, while the behavior could not be explained by supply and demand economics, it could be parsimoniously and accurately described by a model which included both the conversion of corn into ethanol and speculator trend following. An update to the original paper in February 2012 demonstrated that the model previously published was predictive of the ongoing price dynamics, and anticipated a new food crisis by the end of 2012 if adequate policy actions were not implemented. Here we provide a second update, evaluating the effects of the current drought on global food prices. We find that the drought may trigger the expected third food price bubble to occur sooner, before new limits to speculation are scheduled to take effect. Reducing the amount of corn that is being converted to ethanol may address the immediate crisis. Over the longer term, market stabilization requires limiting financial speculation.

Motivation & Objective

• To assess the impact of the 2012 U.S. drought on global food prices using a validated model of price dynamics.
• To evaluate whether speculative trading and ethanol production are primary drivers of recent food price volatility.
• To determine whether current policy interventions—especially speculation limits and ethanol reforms—can prevent a third price bubble.
• To quantify the amplifying role of speculation in turning a supply shock into a global price crisis.
• To compare the global impact of U.S. versus Australian grain production shocks, given differing correlations with world supply.

Proposed method

• Uses a quantitative model of food price dynamics that incorporates both corn-to-ethanol conversion and speculative trend-following behavior.
• Employs a system of differential equations with parameters for speculation ($k_{sp}$), ethanol conversion ($k_{sd}$), and financial asset returns ($\mu_{equity}, \mu_{bonds}$) to simulate price evolution.
• Applies a shock to equilibrium prices (+3%) in July 2012 to represent the drought’s impact on corn and wheat supply.
• Compares model outcomes under three scenarios: full speculation, reduced speculation ($k_{sp} = 0.3$), and no ethanol conversion.
• Calibrates model parameters using historical FAO Food Price Index data up to July 2012, with optimized values: $k_{sd}=0.089$, $k_{sp}=1.25$, $\mu_{equity}\gamma_0=-0.074$, $\mu_{bonds}\gamma_0=-15.4$.
• Validates model performance by comparing simulated prices to actual FAO index data and assessing predictive accuracy for post-2012 trends.

Experimental results

Research questions

• RQ1 To what extent does financial speculation amplify the impact of the 2012 U.S. drought on global food prices?
• RQ2 Can the observed price spikes in 2007–2008 and 2010–2011 be explained by corn-to-ethanol conversion and speculation, rather than supply-demand fundamentals?
• RQ3 How does the U.S. grain production correlate with global production, and what does this imply for the global impact of a U.S. drought?
• RQ4 Would reducing speculation or eliminating ethanol mandates prevent the predicted third food price bubble by end-2012?
• RQ5 How effective are the upcoming Dodd-Frank position limits in curbing speculative bubbles, given market resistance and potential regulatory dilution?

Key findings

• The 2012 U.S. drought, combined with existing levels of financial speculation, is projected to trigger a third major food price spike earlier than anticipated—potentially before the new Dodd-Frank regulations take effect.
• The model predicts that without intervention, food prices will rise above previous peaks, reaching levels capable of triggering social unrest and food riots.
• Reducing speculation from $k_{sp} = 1.25$ to $k_{sp} = 0.3$ after July 2012 would limit the price increase to a modest, non-crisis level, avoiding a speculative bubble.
• The U.S. grain production has a strong correlation ($\rho = 0.71$) with global production, unlike Australia ($\rho = 0.17$), making U.S. droughts a major global price driver.
• The model successfully predicted the 2012 price surge based on data available before the drought, confirming its predictive power for future crises.
• Eliminating the government-mandated ethanol quota could cause a sudden price drop, but this may trigger speculative bandwagon effects, potentially destabilizing markets.