Monthly Archives: October 2008

Oil Cartels Just Aren’t Sexy Villains Anymore

Now that commodity prices are going down as quickly as they went up, it seems to be accepted wisdom that “speculation”, specifically investment speculation on the part of investors such as hedge funds, had a substantial part in where the prices peaked.  At first blush, this seems a reasonable assessment.  However, the more I’ve thought about markets and commodity markets in particular, the less I’m inclined to agree so whole-heartedly.

Basic market economic theory is based upon the principles of supply and demand. Supply and demand curves work very well for markets where buyers and sellers are flexible to change their consumption and production. They work less well to accurately represent how basic commodity markets work. When I say basic commodities, I mean natural resources or basic goods produced directly from natural resources. Things like fuel and food. The idea that these markets are particularly inflexible is probably not a new thought, but it certainly isn’t a popular thought since everything I read on the matter treats the basic commodity market as just another market when it clearly isn’t.

There is a single underlying principle that undermines using economic principles such as supply and demand when basic commodities are concerned. Flexibility. Consumers are very flexible with regard to how much they will pay for basic commodities if they have to and will strongly resist adjusting their consumption. Likewise, production of basic commodities takes considerable time, planning and infrastructure. Producers are not very flexible when it comes to altering their production.

This difference in flexibility, specifically the issue of planning which strongly affects the basic commodity market, results in a new dimension being added to the problem. Basically, there is a high cost associated with change because of the planning, time and infrastructure involved. As a result, consumers and suppliers look to recent history when making decisions, not just the current price. Consumers will likely do little in the very short term when prices increase to reduce their consumption of food and fuel because it won’t be worth the effort to change if the price increase is short lived and prices return to normal. Suppliers are even less sensitive to change because they have long production cycles and need to develop significant infrastructure for production. A new reality must establish itself before behavior changes. In short, people make these kinds of plans based upon trends, which take time to develop.

In the most recent rise in basic commodity prices, demand was augmented by new wealth in Asia. The inflexibility of demand quantity in the rest of the world and in supply quantity drove up prices. Eventually, demand gave in a little. People began to change their lives to conform to basic commodity shortages that would clearly be in short supply indefinitely. The problem was that suppliers were not capable of reacting quickly enough to keep up with demand. Undoubtedly, they also could remember the 90s and weren’t so sure they wanted to react quickly. Then there is the problem of those that try to corner the market.

In normal times, cornering the market on a basic commodity like grain, metals or energy is rather difficult. Eventually, you will have to sell to realize a profit and selling ends up increasing supply in an environment where suppliers are more likely to be maximizing their capacity through efficiency or shortcuts and consumers are more likely to be conserving. This will likely lead to a loss on the part of the one cornering the market and consumers, and a gain for suppliers. It only makes sense to try and corner the market if you’re a supplier like OPEC for instance. If you are a speculator, market timing (short or long) is your only real ally. Buy low and sell high.

All of this relates to the recent behavior of basic commodities markets in that it characterizes the situation and motivation of the players. Inflexibility on the part of suppliers and consumers means that basic commodities markets inclined to go up very fast when supply gets tight and go back down fast when it becomes plentiful.

Compounding the price fluctuations due to inflexibility are those who might want to profit from the situation. Wall street most certainly is going to be attracted to the projected trends for commodity prices and make investments to make profit. However, they represented a total investment in the low billions for this one commodity in a market of between 80-90 million barrels per day. At $100 oil, this is $8-9Billion/day. I would think that an organization that controls roughly 35% of oil production would have much more control over the market. There are also oil companies with incentives to wait to deliver their products until prices went up. Suppliers will be inclined to make shortages worse when they occur because unlike a speculator they don’t have to play games to profit, they can collect those paper gains from prices rising through their regular sales. They have more incentive and more power to manipulate the markets, so why is all of the attention on Wall Street?