Article - Russia’s invasion of Ukraine and its impact on food prices

The unexpected impact of the invasion on prices.

On the 24th February 2022 Russia invaded Ukraine. This was in one sense expected - The US government had been very publicly stating that Russia was planning to invade for months, and were unusually open with intelligence on Russia’s next moves. Troops were massed at the border, and even if some Russian commanders were apparently in the dark about the nature of their involvement right up until the invasion¹, few expected that conflict could be avoided.

However, once underway the war has also led to the profoundly unexpected, and attempts to predict its course have made fools of many commentators. Russia clearly expected a swift victory, and banked on it with confidence given their early actions. They were not completely alone in this, and even some western commentators with solid pedigrees shared their expectations². Instead, their military seriously underperformed and were forced to withdraw from much of their early gains, experiencing heavy losses³. Meanwhile, despite being thrust into a war they did not choose, the Ukrainian people have not been found wanting, and have held together rather than falling apart as Russian planners clearly hoped. Finally, the conflict and public response globally caught many leaders by surprise, leading to some prior expectations concerning energy and security policy shifting overnight.

In some weeks a lot of history can occur. Nuclear risks have not gone away, and the invasion has centered them in a way not seen since the cold war. While it still appears to be unlikely that nuclear weapons will be used in the current conflict, we really cannot roll the dice here forever and tensions create room for miscalculations. In addition, the global political and economic system is tightly coiled, and the invasion has set off a chain of events that we are still dealing with today.

Crop prices rose sharply following the invasion, hitting heights in real terms not seen for over a decade. In my recent interview with this magazine, I commented about the surprise this presented on its surface. Global agricultural markets are sophisticated, traders have a lot of information and there is a serious amount of money to be made by making accurate predictions. If the invasion was of high probability to all rational observers and not already priced in, who was leaving billions of dollars on the table? 

Noticing that I was  confused, I thought I should investigate further. Naturally, it turns out that the story is a bit more interesting than an aversion to money amongst our best informed traders. So what happened?

Futures at their core are very well capitalized prediction markets, with a few key elements. They allow parties to trade a certain well defined commodity (for example hard winter wheat of a certain quality), for delivery at a certain time (like July 2022) and a certain designated place (for example Chicago or Rouen). For each commodity there will be many different expiration dates in a given year, allowing you to trade or speculate based on what you expect will happen at any given time. For example, the diagram below shows the price of July 2022 Chicago hard winter wheat over the first quarter of 2022, with the price updating constantly based on the information available at each point in time, and the impact of the invasion is clearly visible.

July 2022 Chicago Hard Winter Wheat contract - prices over Q1 2022

Source: Bloomberg

A huge amount of the bulk commodities that we use and consume daily are sold under these contracts, as they are very useful for both buyers and sellers in managing their exposure to fluctuating prices and choosing what to buy, sell and transport. Speculators can also make profits by being good at predicting harvests or what will happen to demand by the time a contract expires⁴. Margins here are typically very tight though, as all market players have the same information and are bidding for the same crops, and with so many active in these huge markets the ability to manipulate prices is very limited⁵.

Traders make money by storing, transporting and releasing crops to respond to changes in supply and demand, moving commodities from places or time periods where they are in surplus to those in deficit. Meanwhile, farmers profit from growing what is in shortest supply and processors choose the cheapest feedstock and the best time to buy them. All of this means that the movements and shape of futures prices can reveal all kinds of fundamental information about the state of expected supply and demand across the economy, and chart the dynamics of shocks as they develop.

So with this in mind, let's look again at what food prices did in the period around Russia’s invasion, and talk about what happened over those opening days. First, let's revisit that diagram of hard winter wheat prices below (the variety most commonly grown in Ukraine), but this time with the start of the invasion marked. 

July 2022 Chicago Hard Winter Wheat contract - prices over Q1 2022

Source: Bloomberg

Prices certainly rose on the day of the invasion, to around US$350/tonne, but then hovered around that level or even came down in the immediate days after. Like much of the world it seems that the traders were listening to the American predictions of conflict more than the Russian denials, and while the invasion was not certain to occur it was almost entirely priced in.

However, what happened in the days right after was interesting. It was not until early March that prices surged, rising to over US$400-450/tonne. This was the jump that needs to be explained, and given that the market moves on information with delays measured in minutes or seconds, this cannot have been from traders updating on the start of the invasion itself.

I don’t know how closely you were following the news in the first week of the invasion, but I certainly had never seen anything like it. The war has been unprecedented in the volume of footage emerging, which has been quickly spread by traditional as well as social media.  The day of the invasion was live streamed from traffic cameras across Kyiv, and incredible footage emerged of fighting in the streets and airport north of the capital, leading to things like Russia’s 40 mile convoy of jammed military traffic becoming infamous. For Europe, open warfare was now right on the doorstep, and given Russia’s naked brutality significant support formed for Ukraine. I think the performance of the Ukrainian military was also key here, in particular their effective resistance keeping the prospect of victory going. This performance was backed up in part by the last minute support given by NATO, and people could see their countries making a difference in preventing the capital’s fall⁶.

Russia’s government seemed to expect that Europe would be divided, maybe with good reason. Prior to the war attitudes to NATO were mixed and key countries such as Germany had become seemingly dependent on Russian gas. Maybe with a quick victory combined with an information blackout this could have worked, but what actually happened was very different. Early divisions across Europe and NATO evaporated in days, with Germany reversing its early position and supporting a ban on SWIFT for the Russian financial system and canceling the Nordsteam 2 gas pipeline project. In the end even Switzerland’s government bowed to public pressure in early March and joined the EU in sanctions, abandoning its long held neutrality in past measures. The collective force and range of these sanctions seemed to take the Russian government by surprise, it seems unlikely that they would have kept so many of their central bank reserves and personal assets abroad if they could have predicted their seizure for example, and it is likely that others were similarly surprised.

Energy and natural gas prices rose sharply as a result of these sanctions and disruptions, as well as prices of fertilizers. Russia and Belarus are key suppliers of potassium, and natural gas is the key feedstock for the nitrogen fertilizers that underpin our food system. There is no rule that farmers always have to make a profit, which they know all too well. However, if agricultural markets are tight and need to incentivise farmers to keep fertilizer applications high, food prices must reflect rising input costs. While detailed 2022 numbers are not yet out, the United States Department of Agriculture estimated that it cost US farmers around US$870 to plant and harvest a hectare of wheat in 2021, around US$165 of which was spent on fertilizers and US$35 on fuel. Based on the ~80% rise in wholesale fertilizers and ~45% rise in fuel costs the USDA reported in early 2022, this suggests input costs rose by around US$140 per hectare, or just under US$50/tonne of wheat, which seems reasonable enough as an estimate.

This explains why longer term prices jumped, but not the US$100/tonne increase for deliveries in mid 2022. Instead, this seems to be driven by the unexpected intensity and duration of the conflict versus initial predictions. With no early end in sight, the Black Sea blockaded, civilian vessels under attack and Russia under sanctions, the disruption to grain exports was more severe than first projected. This served to remove Ukrainian bulk food exports from international markets for much of 2022⁷, and meant alternative sources of wheat and maize would need to be found, which raises prices. While the degree of impact depends on number of factors, a rough estimate is a 1% contraction in the availability of the big four crops (soybeans, rice, wheat and maize) results in around a 7% rise in prices⁸. Given the average price of the basket of these four rose by around ~12% in March, this implies a reduction in availability of around 1.5-2% for the worldwide, a volume equal to just over half of Ukraine’s exports of wheat and maize in a typical year.

So, what are the lessons to be learned from all of this for potential forecasters? It certainly seems to be another win for the foxes, who know many things, over the hedgehogs who know one thing very well. It was not enough to know about agriculture or even predict that war would occur, the really important stuff happened after and depended on the effectiveness of things like Ukraine’s military reforms post 2014 and how Germany’s energy policy will evolve. However, this is a tall order for an aspiring fox, as an accurate forecast of crop prices here required you to make a better conflict prediction than many respected security commentators and make a better estimate of European politics than many politicians. 

Conflict in particular is a sphere that is inherently difficult to forecast, where almost by definition both sides must have radically different assumptions of the likely outcome or they would not be fighting. Given that some very serious catastrophes could either be caused or exacerbated by conflict, reducing uncertainty in this domain or preventing nuclear powers from blundering across red lines due to poor understanding would be of great value to humanity.

In addition, it highlights once again just how little slack exists in modern supply chains for things like energy and food. We have not had a disruption of global food supplies exceeding a few percent since detailed global estimates started to be collected by the FAO in 1962. However, just after WW2 global caloric availability declined by an estimated 12% compared to pre war totals⁹, and we cannot assume shocks of a similar magnitude will never happen again. This is especially the case with climate and conflict still looming on the world stage. There are actions we could take here to build resilience, but this may well require planning and preparation in advance across many countries and domains. It will be a lot of work, but given what a 2% output shock can do to prices, we need to be prepared.

1. Mykhaylo Zabrodskyi, Jack Watling, Oleksandr V Danylyuk and Nick Reynolds, 'Preliminary Lessons in Conventional Warfighting from Russia’s Invasion of Ukraine: February–July 2022', Special Resources, 30 November 2022, RUSI gives a really good overview of what is publicly known so far of Russian military decision making in the initial section of the invasion.

2. For example: “The West’s Weapons Won’t Make Any Difference to Ukraine” - written by two senior members from the RAND corporation. https://foreignpolicy.com/2022/01/21/weapons-ukraine-russia-invasion-military/. They perhaps regret that title.

3. Oryx’s open source list of photographed losses has now exceeded 10,000 vehicles for the Russian military.

4. Some of the larger trading houses deliberately maintain loss making operations in order to keep up to date with market data for this reason, and raw data is guarded carefully.

5. There was once an incident involving a futures contract for onions in the United States that was sufficiently thinly traded for someone to form a cartel, but luckily for present day Americans trading onion futures is now prohibited by an act of congress.

6. Interestingly it seems that the United Kingdom’s early efforts here proved a big factor behind our best performance in 24 years in Eurovision a few months later.

7. This has now thankfully partly changed, following the agreement to open the channels for civilian shipping, however conflict has made it impossible to plant across swathes of Ukraine’s farmland, and the task of clearing unexploded ordinance will be a long one.

8. Roberts, Michael J., and Wolfram Schlenker. 2013. "Identifying Supply and Demand Elasticities of Agricultural Commodities: Implications for the US Ethanol Mandate." American Economic Review, 103 (6):  2265-95

9. The best summary I’ve read here is “The Taste of War: World War Two and the Battle for Food by Lizzie Collingham”, which is very readable.