Llewellyn

King

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July 7, 2008

The Revenge of the Commodities

Call this the Age of Commodities. Also think of this as the age in which commodities, long relegated to the cellar by economists and markets, have fought back. They have fought back with such vigor and catastrophic effect on global business that they may be the determining force in the November election. But Sens. John McCain and Barack Obama have been tiptoeing around the global crisis triggered by a run on commodities.

Wikipedia defines the category well: “A commodity is anything for which there is demand, but is supplied without qualitative differentiation across a market. In other words, copper is copper. Rice is rice. Stereos, on the other hand, come in varieties of quality. And the better a stereo is, the more it will cost. Whereas, the price of copper is universal, and fluctuates daily based on global supply and demand.”

The tricky thing about commodities is that they vary widely in cost, depending on marginal shortage or marginal overproduction. Think of a village that needs two bags of onions a month. If local farmers bring in two and a half bags, the local price will collapse. And if they produce one and a half bags, the price will soar. Worse, if there are too many onions, farmers will grow fewer the next year, and a shortage with high prices will result.

This is what has been happening with oil. In the 1970s, the real price of oil was nearly as high as it is today, and enormous effort went into finding more oil. In the 1980s, this began to pay off. And in the mid-1980s, when Saudi Arabia joined the rush to the bottom by increasing its production from 6 to 10 million barrels of oil per day, devastating things happened in America. Banks across the Southwest began to collapse, Houston real estate went begging, the search for new oil slowed, and the boom in SUVs got underway.

The commodity trap has been known for a long time, particularly in agriculture. Globally, governments have tried to control the volatility in agricultural commodities with price supports.

But when it comes to raw materials, fending off overproduction has been more difficult. The Organization of Petroleum Exporting Countries had the defense of price as its initial goal, not the gouging of the world. Likewise one of the goals of the Paris-based International Energy Agency, largely created by Henry Kissinger, was to establish price floors as well as price ceilings. It has failed to do either, and now it is more of a statistical shop than a market mover.

After World War II, the conventional thinking was that those countries that had raw materials and agricultural commodity exports would prosper. Well-intentioned academics went around the globe advising producers that they would have a bright future if they just sold their commodities on the world market. Australia was told that it would become rich without effort on coal, copper and wool. Jamaica was told to relax because it had bauxite. And Chile and Zambia, both rich in copper, were told that their future would be rosy.

But the future belonged not to the commodity producers, but rather to those who converted those commodities into value-added goods. Japan and Taiwan flourished, while their suppliers fell into commodity servitude. Of the four countries I have mentioned, Australia and Chile woke up late to their predicament, and they diversified. Jamaica and Zambia did not get the message, and they languished.

In 2008 the world is paying the price for underinvestment in commodities, and for a savage growth in demand from Asia. Not only are China and India sucking up oil at an ever-increasing rate, but they are also sucking up everything from coffee beans to Maine lobsters. India now boasts a middle class of 175 million people, and China probably has an equal number. That means a demand for the better things in life is surging ahead of supply, producing shortages and high prices for almost anything that is grown or mined.

Governments are jumping in to make things worse, destroying incentive by trying to protect local consumers. Farmers in Argentina are in revolt over government attempts to tax grain exports. And Vietnam is trying to restrict the export of rice. Farmers in both countries are being incentivized not to grow more, but to grow less in a time of shortage.

America is doing its part to worsen a bad situation where corn is concerned. We subsidize ethanol from corn, but have high tariffs on ethanol imported from Brazil, where it is made from sugarcane and is plentiful. There is no duty on imported oil, but there is on ethanol, which is treated as a food import.

Despite the best efforts of governments to frustrate markets, the world will probably produce itself out of its current shortages. Unfortunately, it may not be able to produce itself out of a shortage of its most important commodity – oil. Tight supply may be permanent.

© 2008 North Star Writers Group. May not be republished without permission.

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