Monday, February 04, 2008

Do high commodity prices speak for themselves?

Stunning new highs in some world commodity prices have catastrophists of all types tapping out SOS in their sleep. There was, of course, the rise of oil which started 2007 at $50 a barrel and rose above $100 on the first trading day of this year, an all-time high. Wheat which began 2007 at around $5 a bushel reached $10, another all-time high, before retreating slightly. Soybeans which started last year around $6.50 a bushel ended the year above $12 and went on to set an all-time high last month just above $13. And, gold, that quintessential barometer of fear, rose from about $640 an ounce to above $900 recently, shattering its old highs.

Not every commodity rose or rose by as much. But the general trend has many of those concerned about peak oil, biofuels, and the effects of climate change saying, "I told you so." There is certainly a lot to be worried about. And, there is a good case to be made that long-term policy choices concerning energy, biofuels and climate change are now colliding with the physical facts on Earth and leading to a vicious cycle of interlocking problems that can't be solve by doing more of the same.

Still, it is the peculiar mission of markets to make fools ultimately of all who predict them and all who interpret them. The soothsayers on Wall Street and the vast majority of commodity forecasters were caught by surprise by the moves mentioned above. Markets are social phenomena and as such, they represent the constantly changing opinions and activities of thousands and sometimes millions of participants--activities and opinions which can never be fully observed or assessed. That is why it is in the nature of markets to surprise. If everyone could have known early last year that the oil market would reach $100 by the first trading day of this year, they would immediately have bid it up to that price. But, price movements in markets are about things which are not known or which lie in the future and therefore cannot be known.

This is why it is dangerous to affix any particular meaning to any particular price, whether high or low. The reasons for the price of any commodity are as multifarious as the people whose activities influence them. Too often we think that news makes markets. But, in reality, most of the time it is markets that make news. Those who get paid to write about markets are expected to come up with some reason each day for the latest price movements of Citigroup, Hewlett Packard, junk bonds, gold or wheat. But how can these writers possibly know the reasons?

In addition, there is the cardinal rule of neoclassical economics: High prices bring on more supply or substitutes or both. The watchword among right-minded economists (that is, cornucopian ones) is that this too shall pass. And, that's where the argument starts. Those who've been preaching that there would come a day when high prices wouldn't pass--a day when resources really would be running out because adequate new supply can't be found or grown at any price and because ready substitutes are not available--those people are now saying that that day is here.

The problem is that these two sides are talking about different things. The economists are talking about markets and the professional worriers are talking about resources. It is possible for something to be relatively cheap, but still not be accessible to everyone who wants it. Ask those who lived through the Great Depression. But the coming difficulties, "the long emergency," as James Howard Kunstler styles it, will be one of shortage not glut. For the market fundamentalist, however, there is no such thing as a shortage; there is only price. Price is what balances supply and demand even if some poor souls will simply have to go without. (There is a shortage of yachts for all who would like them, the market fundamentalist might say, but not for all who can afford them.)

It is all too likely then that the skyrocketing prices predicted for oil, for example, of $300, $500 or even $1,000 a barrel will never materialize. Yes, many people will do without oil, or a least without as much oil as they would like. And, that means that the price of oil will not go up forever. That's because many oil consumers will simply drop out of the bidding with each successive price hike. And, ultimately the dropouts will halt the upward pressure on oil prices perhaps at levels far lower than $300. The economists have a polite term for this. They call it "demand destruction." What they don't want you to think about is that sometimes, perhaps this time, a lot of people will be demolished in the process.

The same process, unfortunately, may be unfolding for cereal grains and perhaps other critical commodities about which we currently do not worry. But no commodity will be a one-way street. There will be swings enough for the market players to stay engaged. And, when prices do come down, these players and their affiliated economists will point to the drop as proof positive that the market is working just fine--which if one is concerned only with markets and not with people will turn out to be true.

There is another consideration for both sides of the debate. In truth, most commodity prices appear to be below their inflation-adjusted highs even if you use the U. S. government's admittedly stingy methods for calculating inflation. The government's current method calculates wheat's all-time inflation-adjusted high as $28.25 a bushel in February 1974 ($6.35 in 1974 dollars). And, if you use the price of $3 a bushel in 1974 dollars--a level which wheat maintained almost all the time from the beginning of 1973 through 1975--the inflation-adjusted price today would still be $13.52. But the government intentionally underestimates the inflation rate to keep pension and social security cost-of-living adjustments down. To get around this John Williams of Shadow Government Statistics (subscription required) designed a calculator based on the old, pre-adjustment government methods for calculating inflation. That calculator puts the wheat price spike at $75.94 in today's dollars and the $3 a bushel floor at $36.34.

Calculations for all four commodities mentioned above are summarized in the table below:

Are Commodity Prices Really That High?

(in U. S. Dollars)

CommodityDate or RangePrice TypePriceBLS1 Inflation AdjSGS2 Inflation AdjCurrent Price (2/1/08)
Gold (oz.)Jan. 1980Spike$850$2,295$6,165$908.70
Gold (oz.)1979-1981Average$450$1,380$3,720$908.70
Oil (bbl.)Dec. 1979Spike$38$104$280$88.96
Oil (bbl.)1979-1981Arbitrary Floor$24$66$177$88.96
Soybeans (bu.)Jun. 1973Spike $12.90$61.29$164.75$12.87
Soybeans (bu.)1973-1975Approx. Floor$5.00$24.65$66.26$12.87
Wheat (bu.)Feb. 1974Spike $6.35$28.25$75.94$9.43
Wheat (bu.)1973-1975Approx. Floor $3.00$13.52$36.34$9.43

                               1U. S. Bureau of Labor Statistics
                                                    2Shadow Government Statistics

What all of this suggests is that the catastrophists may, in fact, be a little bit early and that the cornucopian economists may be too optimistic, at least about the near term. While history doesn't ever exactly repeat itself--Mark Twain liked to say that it rhymes--commodity prices look like they have considerable room to run. And, that's even if they never make it to the practically airless heights suggested by figures emitted from the inflation calculator at Shadow Government Statistics.

But perhaps the most important indicator is not how high these commodities will get, but how low they will go once they fall back from whatever new highs they achieve. The real price of commodities has been going down for more than a century. This is because the race between technology and resource exhaustion has been been won decisively by technology. Whether that will continue is now in question.

One indicator will be to see not what new highs are achieved in various commodities in the coming years, but whether a new floor is established that is significantly above previous historical real prices. In other words, higher lows will be more indicative of our situation than higher highs which are usually a very temporary phenomenon.

Exceedingly high prices for commodities, especially for oil, could conceivably tip our fragile economy into a recession or even a depression. That would temporarily lower demand for commodities and thus lower prices. Many commodities would then appear to be in surplus as fewer and fewer companies or people would have the means to buy them. We could again experience what some of our parents and grandparents experienced in the last depression: great want amid seeming plenty.

But if the high prices that cause this (as yet hypothetical) depression are due to the fact that resource depletion is stealing the march on technology, we may not know this for some time. Higher real lows in commodity prices, however, may give us one clue.

The impetus under such extreme circumstances will be to try to boost consumption. And, with so much slack in the economy, it may work. But if we have come to the crossover point where depletion is outrunning technology, we may find any recovery short-lived.

All of this amounts to speculation, a sort of thought experiment in an attempt to answer the question which is the title of this piece. My answer to that question is as follows: Commodity prices do not speak for themselves. Their meaning is not self-evident, and therefore many voices take on the task of speaking for them. Of course, I may suffer the fate of so many others who have tried to forecast or explain the markets. But, if my thought experiment proves broadly correct in its outlines, we may be on the front edge of an economic and social storm that will destroy the conceits of market economics and cast us into a dark and difficult struggle to find a new way of thinking about our economic and social lives.


Anonymous said...

The tricky part is factoring in the "bubble factor."

A debt-loving society (especially one enjoying newer, lower, interest rates) risks moving from one bubble to the next.

Everybody thinks they are "fleeing to quality..."

(I expect the bubble factor is much stronger in metals than in foodstuffs, but given the ability of food futures to act as speculative vehicles, they are not entirely immune.)

Edward Ulysses Cate said...

Another tricky part is "are prices really that high," or is the value of our money really that low. It looks more like the market is trying to discover the value of a US dollar, rather than trying to find the price of commodities. It's more than semantics, because it's dollars we are paid for our labor. I strongly feel it is being pilfered at an ever increasing rate. Thanks for sharing your thoughts with your commentary.

Anonymous said...

Kurt, excellent analysis, one of your best.


It's not just the dollar - it's fiat currencies. Over the last year, gold is up 35% against the dollar and almost as much against the pound and Mexican peso. Even against stronger currencies - the yen, euro, frank and Canadian and Australian dollar - gold is up almost 20%. This suggests resource depletion may be in the early stages of winning the battle against technology.


Anonymous said...

the biggest factor of rising commodity prices is speculation. The commodity traders are using the infos like diversion of food for bio fuel, political tension in middle east, higher standard of living of people in China as tools to create panic in markets and lift the prices of all commodities like crude, wheat, rice, steel, iron ore etc.