Monday, January 31, 2011

The Commodities Bubble, Speculation, and Demand Destruction

Today's 'Worth Reading'

This post is for all of you commodity bulls out there. If you read the source article, a case is made for commodity speculation bringing down the financial services industry a few years from now. (As if they've nothing else to worry about...)

source: FT Alphaville

Scenario #1:
Based on the currently inflated commodity prices, commodity producers in countries such as Brazil and Russia have clear business cases for investing in projects to dig more commodities out of the ground. As competition to launch such projects increases, the costs of completing them also starts to rise, with the owners of mining equipment and laborers capitalizing on the increased demand by charging higher rates. Because a portion of the demand for the projects is not coming from the real economy, an excess supply of mining capacity and commodities will be created.

...So as soon as investors start to doubt what constitutes ‘real’ demand for commodities and what’s pure speculation, they’ll head for the exits en masse, which will lead to a collapse in commodity prices, abandoned development projects and bank losses.

Besides the obvious food security stories in today's global news, inflated commodities are making a great target for those in need of cash, too. We are seeing sheep and turkey thefts in Europe, cattle rustling here in the U.S., and significant copper thefts around the world.

As for future scenarios, I particularly liked this next one from yesterday's DesMoines Register since input costs are always looming dangerously for those other than the mega-industrial farm producer of efficient scale. This coming year, the cost to plant one acre of corn is estimated to be $500 here in the U.S.

Scenario #2:
Corn prices rise to $8-$11 as bad weather (maybe in the United States this year?) worsens shortages. Cattle and hog herds shrink more as producers can't pay for feed, causing meat prices to skyrocket. Farmers profits are squeezed by higher costs for diesel fuel and fertilizer. Demand is destroyed. Corn and soybean processing plants, meatpacking plants and ethanol plants are forced to curtail or close. ----Sue Martin of Ag Investments

The number of cattle in the U.S. has been trimmed to a 53 year low. When producers lose money they quit producing. At some point volatile weather, volatile commodity prices, and volatile energy prices will result in difficult choices about whether to plant a crop, or not. Food production costs are closely tied to energy costs. Energy production is tied to the political stability of the oil producing nations which is tied to their food security.

These are reasons why, a few weeks ago, I included this next item from Kenya in my news, as I knew it could happen anywhere:

In Kenya, high agricultural inputs and fuel costs are driving the farmers in the grain producing region to diversify into dairy, fish farming and other ventures.
"“The current fuel prices are too high and we have no option but to reduce acreage under crop production to minimise losses,” said Mr Jackson Too, a farmer from Nandi County."

Commodity bubble warnings are not new and no one can time the popping of a bubble. Of course, the two above commodity popping scenarios don't even mention what would or could result in the way of the world's food-poor victims, food-inflation affected nations, and all of the resulting world political instability. Those things are too ugly to mention.


  1. Paul Krugman here takes a swipe at those who see speculation as the main driver of commodity price bubbles:

    And if you have the time, drill down into the Sanders and Irwin paper he references. In my experience, the financial overlays may add to overshoots and volatility but they are not the tail that wags the physical dog.

  2. jjb

    In answering your question, I will quote two others.....

    Here's what Yves Smith has to say about the Krugman article you linked: *Groan*. Long established readers will remember I had a long running argument with Krugman (not that he deigned to pay attention to me although he had previously taken note when I said things more to his liking) during the 2008 oil bubble (which I also shorted when oil was over $140, one of the few times I caught a peak pretty well). Krugman simply refused to consider that oil pricing does not hew to the classic “futures are just hedging/speculation” story, a great deal of oil is sold on contract with prices set by the BWAVE, which is an average of futures prices. And why did a lot of oil move to this pricing scheme? Due to manipulation of the cash market! There are more legs to the argument re oil, but here we see Krugman again insisting all commodities are the same and the prices all reflect fundamental forces. Help me.

    And from the FAO report, "The food price crisis of 2007/2008:
    Evidence and implications1": Several reports claim that grain prices have been drastically inflated by manipulative financial speculation. The fear is that such trading has undermined the price-smoothing capacity of agricultural futures markets, and increased the price risks encountered by consumers, producers and governments. Consumers in many developing countries, alarmed by increases in the cost of their staple foods, demanded policy responses from their political leaders.