Thursday, 18 April 2013

The Hows and Whys of the End of the Commodity Super-Cycle

Some of you may have heard me witter on about oil on Radio 3counties, 4 or most recently 5-live. On Tuesday morning, I managed imperfectly to explain how prices prevent shortages. Oil is actually a pretty good example.

I remember Oil at $14 a barrel back in the early noughties. The conversations I was having then were about the roof in the price due to Canadian tar sands, the world's largest hydrocarbon repository, which became economic to exploit at $40. The Oil Price, in response to shortages, and anticipated shortages caused by rapid Chinese growth, rose rapidly from 2002 or so. In the short run, the supply of oil is fixed. So, for a decade or so ever cheaper money was chasing a short-run fixed supply of oil. One of the effects of the "Greenspan put" was to raise oil prices. The Oil Price spiked in response to the financial crisis in 2008 to its high and has remained persistently over $100 since. Just as it seemed logical back in the 90's, following two decades of sub-$40 oil that this was indeed a ceiling through which Oil prices would not go; people though $100 looked like a floor below which the price wouldn't fall. In markets, the consensus is usually wrong.

This high price led to talk of the "end of the Oil economy". High prices became built in to people's thinking, just as low prices had for the decades before that. Soon, Oil executives started to give the go-ahead to projects in deep water or held in deep rocks which are costly and difficult to reach based on higher returns. The result of this is an increase in supply. North Dakota for example is benefiting from an Oil Boom due to rock-fracturing technology, better known for disrupting the Gas market. New technology was developed to extract oil cheaper and more efficiently from where it had been un-economic to extract previously.

This extra capacity in the Oil industry was matched by a focus by the consumer on demand. People started insulating their homes to use less heating fuel. Cars and Air-conditioners became more efficient. People are driving slower, as cars now show the point fuel consumption and people see how much more fuel they use at 85mph compared to 70mph. Remember how cars on motorways used to drive at 80-90mph in the fast lane, and now there are few people breaking the 70mph limit? Accidents have fallen. In the UK, petrol sales have fallen by over 20% from their peak in 2008 thanks to these effects.

So supply has risen in response to high prices, and use has fallen. What's going to happen to the price? You've got bankrupt oil states who are no longer beholden to OPEC, like Venezuela who will need to sell every drop they can produce if their economy isn't to collapse. So the fall in price may, in the short run lead to MORE production, as desperate producers try to meet forecasts based on higher prices creating a rapid fall in the price, even from here.

Industrial metals are showing the same story. There are no primary smelters of Iron in Europe because we've got all the Iron we need, and simply recycle existing metal. China will develop its car economy based on Aluminium chassis, not steel and will demand less steel than did Europe at the equivalent stage of development. Yet there are vast open-pit Iron-ore mines in Australia with robotic 400-ton trucks pulling ore that few will need. The price of Iron and steel are falling.

The writing was on the wall. The top of the market indicator for Metals is AIM-listed start-ups going after "rare-earth" elements in slag heaps. We had plenty of those. Obvious, really, in hindsight.

The point is that a price mechanism in a free market has worked to ensure that there was never a shortage of  Oil or industrial metals. The price rose, capacity rose to take advantage of the high price, supply rose, consumption fell and eventually the price collapses. This is also why free-market systems don't have famines, as the same thing happens with food. And do you know who prevents famine? The speculator, and most especially the hoarder. As it's his store that keeps everyone alive. And also why anything a government provides, (Schools, Hospital beds, building permission for houses etc..) we will always be short of, because there is no demand/supply mechanism to allocate resources. There's no signal saying "invest here, not there" in a planned system.

So. Are the prices of Oil and Metals going to continue to fall? Yes. Probably. But the confidence interval on that statement is no more than 51%. Are we ever going to run out? No. Of that I am certain. Don't get me started on Gold-Bugs except to say

"Bwahahahahaha. Told you so" 
having been wrong for, um, about a decade.



4 comments:

Simon Jester said...

"Remember how cars on motorways used to drive at 80-90mph in the fast lane, and now there are few people breaking the 70mph limit?"

(My emphasis)

Bloody hell, it really has been a long time since I last drove a car!

Robert Edwards said...

It wasn't $14, it was $9; at least in 'the backs', where I was studying it. Not a big difference, given where we are now, but at the time, it seemed vital. Events, dear boy...(Supermac)

As for gold, that is something and nothing. a fear market; the price of industrial metals (which I realize gold is, in a relatively small way), then look at the forward curve, which reflects much...

Simon said...

"now there are few people breaking the 70mph limit?"

At rush hour, that's probably true. Any other time, not so much.

Andy said...

I don't want to appear picky but there are are at least two 'iron smelters' in Europe...

One in Scunthorpe that uses millions of tonnes of iron ore to make millions of tonnes of steel at the integrated steelworks there and the other is in the Netherlands at IJmuiden.

Plus of course there are others in Germany and France.

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