The Bennett Newsletter
Ben Bernanke will take smug satisfaction from the drubbing the markets have delivered recently to silver, gold, and oil. He contends “self-correcting” markets operate and the recent price surge is “transitory”. Therefore he resists interest rates raises to curb inflation.
My position conflicts; the falls are only a correction and that prices for commodities will appreciate on both fundamentals and speculation (more later). The fundamentals differ. Gold appreciates on scarcity and scares of inflation.
Oil appreciates on scarcity too; supply cannot keep up with demand. Did you know that oil supply peaked in 2006? Reserves are low, and the International Energy Agency (IEA) states that 4 new Saudi Arabia’s need to be discovered to keep supply going as previous bonanzas like the North Sea and the Gulf of Mexico are running down.
The picture is made more complex, and certainly less transparent, by futures market speculation. Silver had increased by 400% since 2008, but when brokers increased margin payments on orders, silver took a bath.
Nevertheless, food prices have surged to record levels and have not suffered a decline. The Food and Agriculture Organization’s food Index is 36% higher than last year and in April corn advanced 11% and wheat 4%. Corn and wheat have surged 71% in the last year on weather-induced shortages. The shortage may continue as dryness has delayed some planting. Part of corn and wheat’s price rise will be driven by speculators on the futures market, although many of the spot-market orders are by millers/food processors without sufficient contracted supply.
Agricultural commodities rarely have a sustained price rise. Usually crops are grown by many farmers and prices are controlled by competition. But there are good years and bad years, so prices fluctuate. Prices rise in bad years.
Two things then happen. First, the high market price encourages imports (when available/practicable). If we refer to the graph of US onion prices we can assume a poor harvest in 2009, and a shortage in 2010. Let’s assume onions were diverted from around the world, and this brought the US price of onions down within weeks.
In this case the American consumer benefitted from globalisation while consumers elsewhere lost out. The price of onions shot up in India and the Middle East. This inflicted great hardship as the onion is a necessary part of daily diets. Many people in that region could not afford a food staple. The Indian Government belatedly banned exports (a similar scenario had occurred in many countries recently over the rice shortage).
Meanwhile, the second thing that took place was that American farmers reacted to the stimulus of price rises by planting more onions that previously. They over-shot. The result was over-supply in the American market and desperately low prices. Presumably, US wholesalers will be avidly attempting to sell onions abroad.
Onions are an annual crop, and the dynamics I have outlined have relevance to wheat, corn, rice etc and even pork bellies and eggs. Some crops have a longer lead time (like oranges or wine) but eventually the price signals of demand will stimulate supply and lower prices.
Now let’s venture into the counter factual. Let us suppose that there is an onion futures market. Onion futures would have gone ballistic in 2010 and farmers all over the world would have planted them at the expense of other crops. Eventually there would be an onion glut, and crops would have been ploughed in. The onion futures would correct and would afterwards behave soberly, meeting producers and consumers needs. The corn, wheat and other markets have done this for years and prices were quite stable until recently.
So what has changed? Many commodities are close to peak production, and their supply cannot be easily increased as the land area is not increasing and most areas are well farmed and fertilized. In some cases further increases in production are difficult as water resources are inadequate and facing competing pressures from commercial, industrial and domestic users. Water is a severe limit on production increases.
In the case of grains there have been other competing users. Obviously animal feed has always competed for grain, but this is increasing as incomes rise and consumers demand more protein. Ethanol is another competing user. With rapid population growth, rising incomes and switches to refrigeration and protein consumption, grain supply for food is increasing only modestly and cannot be readily increased sufficiently to meet burgeoning demand.
Enter climate change. There is evidence that climate change is already operating to diminish cereal yields. For example, an article in Nature reports a major study that concludes that global corn production is about 3.8% lower than it would have been in a non-warmed world* http://www.nature.com/news/2011/110505/full/news.2011.268.htm
My basic argument is that commodities are rising:
a. because of supply constraints and surging demand, especially from emerging markets.
b. because the futures market has been invaded by speculators.
Futures markets have been very serviceable for producers and consumers since they were established in Amsterdam and Osaka in the 1600’s, but recently they have been dominated by speculative money.
At present the distortion of markets is due to QE2 which is aimed at lifting asset values (forget the cant about jobs). QE2 has been called by President Putin as “economic hooliganism” but its effect can be seen in the close correlation of Federal Reserve Reserves and commodities in Graph B.
Bernanke is printing $600 billion a month and lending it to crony banks at 0.25% and they have piled it into futures markets. The Fed has imposed an adverse supply-side shock.
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