Something I read recently regarding why the oil prices are climbing, that has nopthing to do with supply and demand. Intresting, but I don't know much about the global market place. Any Truth? (couldn't post the links so I pasted the text.)
If you think prices have become insane, you're right. But insanity rules markets for everything from oil to rice right now. In fact, insanity is the new "normal."
For example, why should oil sell for $119 a barrel, a whopping $55 a barrel, or 86%, higher than it did last April?
It's like the United States is suddenly out of oil, right? March crude oil reserves in the U.S. were actually 2.4 million barrels higher than reserves in February and only a trifling 3.4% lower than reserves in March 2007, according to the Energy Information Administration. An 86% jump in oil prices because reserves fell by 3.4%? I don't think so.
The global picture is similar. Global oil stocks held by developed economies came to 2.58 billion barrels at the end of March -- pretty much the same as at the end of 2007.
Global supply and demand is tight, with the latest projections from the International Energy Agency showing supply at 87.3 million barrels a day and demand at 87.2 million barrels. Tight, but supply is still ahead of demand.
Don't stop with oil prices, though. Look at rice, which recently cracked $1,000 per metric ton. The price of export-quality rice is up 173% in a year, even though global rice stocks will finish 2008 about 1 million metric tons higher than at the end of 2007, according to the U.S. Department of Agriculture.
Or copper, which is setting record highs just about every day and has climbed in price by 30% so far this year. Or aluminum -- up 28% this year. Or wheat. Or corn. Or, well, you name it.
Why normal rules don't apply
We've all heard the explanations. Demand for this or that has soared due to growth in developing nations, increasing production of biofuels or whatever, and supply has stumbled due to miners' strikes or an electricity shortage or a drought in Australia.
But lots of folks -- I get e-mail about this every day -- don't buy these stories. They see small production shortfalls, but still substantial stockpiles, and ask how this adds up to a 100% increase in the price of oil or rice or wheat in a year.
More on rising prices:
Gas to hit $1.40 a litre this summer: report
High food prices coming: report
Why oil could hit $180 a barrel
Could we really run out of food?
Don't count on a 'normal' recession
How to profit from rising food prices
Well, it doesn't -- in a normal economy. But the global economy is now playing by different rules, the rules of economic scarcity, and the rules of scarcity say the normal relationship between supply and demand and prices doesn't hold. Yes, prices are insane. But this kind of price insanity is exactly how a scarcity economy works.
The concept of scarcity is central to the economics of normal markets. Most goods, whether bluejeans or peanut butter, don't exist in unlimited supply. The market rations those goods with prices that match supply to demand.
For example, at $3 a pair, consumers might demand 2 million pairs of sneakers, while factories can produce just 1.5 million pairs. At $8 a pair, demand might fall to 1.5 million. Consumers who wanted sneakers at $3, but don't at $8, delay or forgo buying sneakers, or wear sandals instead.
It starts in our heads
And in a normal market, if there isn't enough demand at $3 a pair, the price falls -- either in the short term through discounting or in the long term by companies going out of business -- until demand meets supply, and the market clears.
Scarcity markets play by different rules. In fact, scarcity markets exist because buyers believe the normal rules of supply and demand have broken down. Buyers in a scarcity market don't believe higher prices will depress demand or increase supply enough to allow supply to meet demand. In such a market, prices are driven by fear that there will not be enough supply at any price.
If, for example, companies that need copper to make electrical machinery, wire or pipes bid prices higher because they worry that current prices won't bring supply and demand into alignment anytime soon. They fear they won't be able to buy copper at any price when they need it.
Scarcity markets aren't created overnight. Potential buyers need to be bloodied by repeated experience on both the supply and demand side. Consumers of copper know that for each of the past six years, the copper industry has failed to deliver projected increases in supply.
In 2008 and 2009, according to UBS AG (UBS.N), the industry will fall short again. The bank projects production a shortfall of 800,000 metric tons over those two years.
In the oil industry, major suppliers that were being counted on to increase production have announced production declines. Production fell 1% in Russia for the first quarter, for example. And suppliers who were being counted on to stabilize production have announced even bigger shortfalls. First-quarter production in Mexico dropped almost 8%.
And it helps establish scarcity economics as the rule of the markets if potential buyers become convinced that higher prices won't dampen demand. That happens fastest in markets for goods that buyers especially need. Most Asian consumers of rice, for example, can't choose to eat less without running a real risk of hunger or starvation. And there isn't a ready substitute for high-priced rice. What are they supposed to do, eat even-more-expensive wheat or corn?
A sense of inevitability
But the most profound effect of scarcity economics on prices comes in markets where buyers who were convinced that higher prices would cut demand come to believe that higher prices have little effect on demand. That has happened in the oil market in the past year. Oil at $80 a barrel and gasoline at $3 a gallon (79 cents US a litre) were supposed to cut demand and bring prices back down. But they didn't.
Judging from the futures market, where oil trades above $100 a barrel as far into the future as the eye can see, potential buyers believe today's high prices won't reduce demand anytime soon.
And because demand for oil hasn't declined, oil analysts now worry it will take a run above $175 a barrel from the current $119 before price reduces demand. (See my April 22 column, "Why oil could hit $180 a barrel.")
Once a scarcity market is established, it produces behaviour by buyers that can lead to the very scarcity they fear. Hoarding, for example, can empty shelves. Of course, the emptying shelves themselves create panic buying that just empties the shelves faster.
Security at any price
And by taking supply off the market, hoarding produces shortages. During the gasoline crises of the 1970s, drivers who topped off their tanks daily out of fear there wouldn't be enough gas the next day helped cause those long lines at gas stations and, by moving a substantial part of the gasoline supply from the public market into their private tanks, reduced the available supply.
Scarcity economics also turns the relationship between low- and high-cost producers upside down. In a normal market, a low-cost producer sets prices low enough to sell out all of production and high enough to maximize profit without decreasing demand and endangering sales. In a scarcity market, the high-cost producer sets prices because buyers who fear they won't be able to get the goods they need will pay almost any price to ensure themselves of a supply.
You can see scarcity economics at work in today's fertilizer market, for example. Potash of Saskatchewan (POT.TO) produces potash and nitrogen fertilizers. But with the world short 1.2 million metric tons of potash in 2008 and desperate for nitrogen fertilizer, Potash is seeing its already high margins soar to astounding heights. In announcing its first-quarter earnings, the company projected that margins in 2008 will be roughly 3.5 times as high as in 2007.
Price insanity becoming the norm
Think that's insane? As long as scarcity economics rules the fertilizer market, there's a good chance Potash will get its price, and other fertilizer makers will go along for the ride. The global scarcity has made high-cost, government-subsidized producers in India the price setters in the market: If you've got to have supply, you'll pay any price, right? That price and not Potash's production costs are now setting the market price.
Supply contracts for potash for the second half of 2008 are up for negotiation in Japan and India. Japan paid just $120 a ton for potash in its contract for the first half of 2008. China recently signed a long-term contract for $576 a ton. That was a $456-per-ton price jump. And even with that increase, the Chinese didn't get all the potash they wanted. The country is now looking at a shortfall that some experts peg as high as 40%, just when China is trying to increase food production to cut inflation in domestic food prices.
From 1989 through 2006, potash delivered in Asia sold for $200 a metric ton. According to the company, potash prices could reach $1,000 a ton by the end of this year. That has left Wall Street analysts who recently increased their projections to a range of $700 a metric ton struggling to catch up.
And yes, that all sounds insane. But insanity is "normal" when scarcity economics rules. Remember that when you try to figure out what price to pay for shares of any producer of fertilizer, copper, tin and oil these days.
