It was a news blast worthy of the Great Depression — at the end of April, Costco and Sam's Club, among other retailers, suddenly slapped rations on U.S. customers, limiting the amounts of flour, rice and cooking oil they sold. The move came as hoarding, by consumers spooked by rapidly rising food prices, left the retailers with dwindling grain supplies.

And while that seemed like a drastic step in the U.S. — where consumers are used to getting what they want when they want it — it was nothing compared to the reactions the international food crisis has sparked elsewhere. From Haiti to Egypt to Mexico to Italy, protests and riots have rocked the globe in reaction to soaring food costs. Food inflation has gotten so out of control some economists believe it represents a greater threat to world economic growth than the ongoing credit crunch.

What's behind the sudden surge? Economists are hard-pressed to reach a consensus. Experts point to a myriad of factors that, combined, are making matters worse. In the U.S., the increased use of corn in ethanol production is playing a role. Meanwhile, the global spike in oil prices is adding to transportation costs, which get passed down from farmers through manufacturers and retailers to consumers. Further, growing middle classes in developing nations are altering consumption patterns, stretching supply capacity. Devaluation of the dollar — down 40 percent in the last six years — also hurts, since many commodities and futures markets are dollar denominated. Lastly, untimely droughts in Australia and Eastern Europe have cut grain production in both places, straining supply even more.

In the U.S., one of the most important factors, according to Jim Wisner, president of Wisner Marketing Group, a Libertyville, Ill.-based supermarket consulting group, is the use of corn for the creation of ethanol. Last year, two billion bushels of domestically produced corn went toward ethanol production, representing 19 percent of the harvest, according to the U.S. Department of Agriculture. The crop happens to be the primary feed grain in the U.S., and as demand for corn rises, so do prices for other feed grains, Wisner notes. Those increases are in turn passed on to animal products, while, attracted by higher profits, farmers devote more of their land to corn, limiting the supplies of other grains, says Herb Walter, a partner with PricewaterhouseCoopers.

Rising middle classes in fast-developing countries, most prominently China and India, are also playing a role, according to Jay McIntosh, director of consumer products for the Americas with Ernst & Young. Where previously, the typical Chinese diet was built on grains, Chinese consumption habits have changed to include more meat, fruit and vegetables, according to the Food and Agriculture Organization (FAO) of the United Nations. Since corn plays an important role in meat production — approximately 7 pounds of the grain are used to produce 1 pound of beef and another 6.5 pounds are needed for 1 pound of pork — those products have also gotten more expensive, and scarce. As a result of growing demand, global food stocks have been declining by about 3.4 percent a year since 1995, the FAO estimates. Currently, global cereal stocks equal 451 million tons — that's down more than 13 percent compared to the previous year.

Making matters worse, the weather lately has curtailed global grain production. Recent droughts in Australia and Eastern Europe and rough weather in Canada, the Midwestern U.S. and Western Europe have cut back on grain output. The droughts have taken a particularly high toll on rice crops, which need large quantities of water in order to thrive. Further, the typhoon in Myanmar drastically cut into that nation's rice production. It previously was projected to be a net rice exporter this year, with 600,000 tons of rice, but instead will be a net rice importer since the five states hit by the cyclone are responsible for 65 percent of the country's annual harvest.

Then there are the sharp spikes in the price of oil, which make it more expensive to produce and transport agricultural products. Since June 2007, oil prices have jumped 50 percent, to $138 a barrel. That means that the price of gas, necessary to operate farm machinery during planting and harvesting, now averages more than $4 a gallon. The figure is even higher for diesel. Petroleum-based fertilizers are also more expensive — their price has increased 160 percent in the first two months of this year, according to FAO figures.

As a result of all these factors, during the first quarter of 2008, international prices on all major food commodities reached a 30-year high and continue to climb higher. On June 12, the price of corn futures traded on the Chicago Board of Trade broke a record at $7.03 a bushel, while wheat traded at $8.69 a bushel and soybeans at $15.16 a bushel. In the first half of the year, the FAO price index for vegetable oil rose 97 percent, for grains 87 percent, 58 percent for dairy products and 46 percent for rice. (Some believe speculation by index funds on commodities and futures markets is also playing a role.)

In the U.S., in the three months leading up to May 31, consumer expenditures for food increased 6.3 percent, according to the Department of Labor, compared to an increase of 4.9 percent for all of 2007. In May, expenditures for cereal and bakery products rose 1.6 percent, after posting similar increases in February, March and April, expenditures for fresh vegetables increased 0.5 percent and the price of beef went up 1.5 percent.

What's more, we are hardly through with the process, according to Wisner.

“I don't think we've seen much more than the tip of the iceberg at this point,” he says. He estimates that only 60 percent of the ultimate price increases on food have been realized. In the FAO's estimation, over the next 10 years, prices for vegetable oil will rise another 80 percent in inflation-adjusted terms, prices for grains will jump between 40 percent and 60 percent and prices for meat will rise 20 percent.

Cashing in on inflation

What's the upshot of all this for U.S. retailers? The fact that this wave of food inflation is occurring at the same time as a broader consumer slowdown in the U.S. has created an compelling dynamic for discounters, wholesale clubs and supermarket chains. Discounters and wholesale clubs are thriving as cost-conscious consumers are doing more and more of their shopping in their sector, according to Ted Taft, managing director of Meridian Consulting Group, a Wilton, Conn.-based firm. This is evidenced by the strong same-store sales figures Wal-Mart, Stores, Inc., Costco, BJ's Wholesale Club and Sam's Club have racked up in recent months.

Wal-Mart, for example, has made headway in the grocery sector by carefully managing its inventory, according to Morningstar analyst Joseph Beaulieu. After posting same-store sales growth of 1.5 percent in 2007, the chain registered an increase of 2.7 percent for the first quarter of 2008. In May, Wal-Mart's same-store sales rose to 4.4 percent.

The discounter's net income also rose in the first quarter, by 6.9 percent, to $3 billion, while its earnings per share were up 11.8 percent, to $0.76. “The consumers are buying only what they have to buy at the lowest price and that's good for Wal-Mart,” says Howard Davidowitz, chairman of Davidowitz & Associates, Inc., a New York City-based retail consulting and investment banking firm. “We've gone through a decade where Target fried Wal-Mart on everything, and now you are seeing that Wal-Mart's performance is up because it has a bigger percentage of consumables and food than Target.”

Indeed, during the first quarter of the year, Target Corp. reported a 0.7 percent decline in same-store sales, a 7.5 percent decline in net income, to $602 million, and a 1.3 percent decline in earnings per share, to $0.74.

Some of Wal-Mart's success has come at the expense of traditional grocers as they struggle to match the Bentonville behemoth on prices. Yet at the same time, grocers themselves are capturing dollars from the restaurant segment, Taft says. Americans are eating out less and instead opting to spend money on prepared foods sold in stores. The net result is that supermarkets aren't yet losing as much ground to discounters and warehouse clubs as you might think. In fact, many are posting same-store sales gains.

The bottom line, according to Davidowitz, is that discounters, warehouse clubs and supermarkets all sell what the consumers need to buy — and will continue to need to buy regardless of how high prices go.

Year-to-date same-store sales gains for most chain stores averaged 2.0 percent a month. Grocers are exceeding that performance. Safeway Inc., for example, registered same-store sales growth of 4.5 percent for its first quarter of 2008, ended March 22. It expects growth up to 3.2 percent for the year, excluding fuel sales. The chain's net income for the quarter was up 10.9 percent, to $193 million, and its earnings per share rose 12.8 percent, to $0.44. The Pleasanton, Calif.-based company operates 1,740 supermarkets throughout the U.S. and Western Canada.

Cincinnati-based Kroger Co., which operates 2,486 stores, saw a 15 percent jump in profits for its first quarter, ended May 2. Profits came in at $386 million, up from $336.6 million a year ago. Revenue, meanwhile, jumped 12 percent. Kroger also raised the lower end of its earnings guidance for the year as a result of the robust gains. It now expects earnings of $1.85 per share to $1.90 per share, up from its previous guidance of $1.83 per share to $1.90 per share.

Other grocers have yet to report first quarter results. Supervalu Inc., a Minneapolis-based operator of 2,475 supermarkets, registered flat same-store sales in the fourth quarter of 2007, but expects growth of 1 percent to 2 percent during its fiscal year 2008. The chain's net income rose 24.8 percent during that same period, to $141 million, and its earnings per share surged 22.2 percent, to $0.66. And Montvale, N.J.-based Great Atlantic & Pacific Tea Company, operator of 456 A&P and 141 Pathmark stores, reported same-store sales growth of 3 percent for it's A&P division and 1.5 percent for the Pathmark division in the fourth quarter of last year. The company's net income was up 40.8 percent, to $57 million, and its earnings per share were up 39.2 percent, to $1.35. A&P did not provide guidance for 2008.

Playing defense

Grocers aren't just sitting back and watching the returns roll in. In fact, many are employing aggressive tactics to keep shoppers from switching to discounters or warehouse clubs.

Many are stocking greater volumes of private label products, which cost less than brand name offerings. And when there are cheap, moderately priced and expensive versions of every product available in the same supermarket, people have an easier time cost-cutting, Walter points out.

“They can say, ‘On this product, I really want a premium brand, and on this one, I don't,’” he notes.

Some supermarket operators have also been using creative tactics to take advantage of high gas prices — for example, many of the stores operated by Kroger Co. recently began a promotion campaign that offers customers 10 cents off per gallon of gas for every $100 spent on in-store purchases.

Supermarket chains will also continue to reap benefits this year from the slowdown in the restaurant sector, which in 2007 accounted for 47.5 percent of all U.S. food sales, according to the National Restaurant Association, an industry trade group. In March, the association's Restaurant Performance Index, which tracks the health of the industry on a monthly basis, registered a 0.9 percent decrease from February, to 97.9, the lowest level on record. March also marked the seventh consecutive month when the index fell below its base of 100, which signifies contraction in same-store sales, customer traffic and capital expenditures. More than half of the surveyed restaurant operators reported a same-store sales decline for the month and another 38 percent expect lower sales volume over the next six months.

In 2008, customer traffic at U.S. restaurants will likely experience slower growth than in 2007, which at 0.7 percent was unremarkable, forecasts NPD Group, a Port Washington, N.Y.-based market research consulting firm.

As customers cut down on the number of times they eat out, they will compensate by picking up more food at the supermarket, particularly if the chain they frequent sells fresh, ready-made meals, according to Milton Cooper, chairman and CEO of Kimco Realty Corp., a New Hyde Park, N.Y.-based REIT with a 120-million-square-foot shopping center portfolio.

“As people stop going to the restaurants, supermarkets get value in one of the most profitable markets — prepared foods,” Cooper said during Kimco's presentation at the 2008 REIT Week conference in New York City on June 5.

Party at the warehouse

At the same time supermarkets have survived, warehouse clubs have thrived. In January 2008, 90.1 percent of consumers surveyed by America's Research Group, a Charleston, S.C.-based consumer behavior research firm, indicated they shopped at warehouse clubs, the highest percentage of any store category by far. In March, the number went up to 93.7 percent.

In May, when same-store sales for all U.S. chain stores amounted to 3 percent, wholesale clubs registered a same-store sales increase of 8.4 percent, according to data from ICSC. BJ's Wholesale Club led the way, with growth of 13.4 percent, followed by Costco, at 9 percent, and Sam's Club, at 6.5 percent.

“All of the warehouse stores will pick up some of the supermarket money because they genuinely offer value,” says Wisner. “If people went once every two months before, they will go once every six weeks now.”

The Issaquah, Wash.-based Costco, for example, posted a same-store sales increase of 6 percent for its U.S. stores in the third quarter of fiscal year 2008, ended May 11. The chain's net income increased 31.7 percent during the period, to $295 million, while earnings per share went up 36.7 percent, to $0.67.

Those results were in large part due to the strength of Costco's food section, since consumers have been cutting back on non-perishable items like furniture and electronics, Costco vice president Bob Nelson told analysts during a June 5 conference call.

Natick, Mass.-based BJ's Wholesale Club reported a sales increase of 9.6 percent for the first quarter of the year. The retailer's net income rose 25.9 percent, to $17 billion, while its earnings per share went up 38.1 percent, to $0.29.

“The reason Costco and BJ's are thriving is that number one, they sell food, and number two, they sell it at the lowest possible margin,” notes Davidowitz.

However, just because shoppers can get better value at a warehouse club or at a discount outfit like Wal-Mart doesn't mean they will abandon their favorite supermarket, says Taft. People develop loyalty to grocery stores based on a number of factors, he notes, including the level of customer service and the quality of the food. When faced with steep price increases, their immediate instinct will be to limit their number of shopping trips and switch to less expensive items within each product category, rather than go to a less expensive store.

That will prove particularly true for upscale chains like Whole Foods Market, Inc., that sell higher-priced foods catering to more affluent consumers who typically shop at lifestyle centers, says David J. Livingston, a Pewaukee, Wis.-based supermarket consultant. Whole Foods shoppers already expect to pay a premium when shopping at the grocer, he notes, so a few extra dollars either way isn't going to make much of a difference.

Austin, Texas-based Whole Foods Market, reported comparable store sales increase of 6.7 percent for the second quarter, ended Apr. 13, compared to a 6 percent increase during the same period in 2007. The chain operates 270 stores in the U.S., Canada and United Kingdom.

In the end, though prices for staple foods will likely rise further, according to Wisner, the impact on the supermarket industry will be limited. Some consumers will increase their reliance on discount operators and warehouse clubs, but most will continue to shop at their favorite grocery store.

What's more, the pressure from the competition might force supermarkets to put extra effort to control inflation, says Livingston, by buying more inventory in advance, for example, or improving their economies of scale.