On August 5, Russia banned grain exports for the rest of the year. Drought has destroyed about 20% of the wheat crop of one of the world’s top wheat exporters. The ban will run from August 15 until December 31. At a minimum.

Wheat prices, already up 70% this summer, climbed again. Wheat was “up” another 8.3% on the Chicago Broad of trade that day.

The ban on Russian exports (Russia exported 21.4 million metric tons of wheat in 2009.) comes on top of prior forecasts for a smaller than expected U.S. corn harvest, and smaller than expected plantings of wheat in Canada due to a wet spring.

Wheat farmers in the United States, Argentina, and Australia will pick up part of the slack—as well as the benefit of higher prices. The wheat harvests in Canada and the European Union are not forecast to be particularly abundant this year.

But the ban on Russian exports isn’t the end of the story. On August 6 Russian Prime Minister Vladimir Putin fueled the speculation that other countries would also end exports when he said that Kazakhstan and Belarus should join Russia’s ban. Kazakhstan exported 7.5 million tons in the 12 months that ended on June 30 and Belarus shipped 400,000 tons, according to the U.S. Department of Agriculture. Another wheat exporter in the area, Ukraine, could well refuse to follow Russia’s lead because of political tensions between the two countries. But formal ban or not, the drought and wildfires that have devastated Russia’s grain crop are likely to reduce supplies from the Ukraine too. That country exported 9.2 million tons of wheat in the 12 months that ended in June.

Global wheat stockpiles aren’t anywhere near danger levels. The forecast now is for the bad weather and the export bans to cut world wheat stockpiles by 2.5% to 192 million tons, according to the International Grains Council.

 But the bans on exports by individual countries have more to do with internal domestic politics than any fear that the world is running out of wheat. Individual countries are trying to head off a surge in food prices that would create a wave of domestic political protest. Peak wheat prices of 13.50 a bushel in February 2008 set off food riots in Egypt, for example. Domestic wheat prices in Russia climbed 19% in the week before the country imposed its export ban.

And the bans have set off a scramble for supply and that has led to the wild surge in wheat and other grain prices on commodity exchanges. For example, Indonesia and Japan, Asia’s two biggest wheat buyers, have started to scour the markets for alternative supplies from the United States, Australia, and Argentina

That has created a psychology of shortage among global commodity traders who are now seeing commodity disasters everywhere. For example on Wednesday August 4 agricultural stocks led the Shanghai Composite Index to a 0.4% gain on speculation that recent floods will lead to a decline in the rice harvest—and higher rice prices. Chinese vice premier Hui Liangyu called on local authorities to increase rice planting after foods damaged more than 7 million hectares of farmland, according to the Xinhua News Agency on August 4.

It’s important to recognize two things about a commodity price surge like this.

First, the commodity markets quickly absorb bad (or good news). Most of the current bad news is now in the price of a commodity like wheat. So pending more new bad news prices are probably getting close to a top.

Second, while the commodity markets and commodity prices react pretty quickly to news it takes a while for those price increases to work their way down through other financial markets and through the general economy. Commodity related stocks—such as the shares of producers of fertilizer and of farm equipment—have moved up on news of the shortages and higher farm prices, but they by no means yet discount all the bad news in higher share prices. Other less obvious beneficiaries of the shortage and commodity price increases, such as alternative producers outside the usual economies and producers of alternatives to the commodities in short supply (soy beans as a replacement for corn in some animal feeds, for example) have, so far, moved up even less strongly.

And the negative effects of the surge in commodity prices on the profits of commodity buyers are even slower to work themselves into share prices.

There is one wild card I’d suggest that you watch out for: India.

India banned wheat exports in 2007 in an effort to rebuild reserves after a series of dismal harvests that resulted from a failure in the monsoon rains. That effort largely succeeded and India is now sitting on 33.6 million metric tons of reserves in government warehouses after a record 2010 harvest of 80.7 million tons. At the end of July wheat reserves were nearly double the target for 17 million tons in reserves.

And yet the Indian government hasn’t lifted the ban on exports. The commodity markets would love to know what that means.

Speculation falls into two camps.

First, there’s a belief that the government burned badly by past protests over rising food inflation is just being super conservative. (Wholesale price inflation climbed 10.6% in June. That was the fifth straight month in double digits.)The government will delay a decision to resume exports until it is absolutely 100% sure of this year’s harvest. Since the June to September monsoon rains determine the size of India’s grain harvest that would put any decision off until October when the next wheat crop, the one that will be harvested in the second of 2011, is planted.

Second, there’s the belief that India’s notoriously inefficient food storage system has struck again and a significant share of the country’s grain reserves is rotting in inadequate storage facilities. This theory is supported by anecdotal evidence of grain stacked under tarps in open fields. Government warehouses have the capacity to store only 42 million metric tons of grains, but current wheat and rice stocks total 60 million tons. If spoilage is the problem, India is probably out of the export market until 2011.

Which leaves the commodity markets hanging on India’s decision in October 2010 or later. Plenty of time for shortage psychology to power big moves in commodity prices.

Full disclosure: I don’t own shares of any company mentioned in this post in my personal portfolio.