Supply and Demand Have Little Relevance in Commodities Prices

Commodities price is driven by supply and demand. This is as true as the law of risk and reward.

Except, the law of risk and reward hardly applies for the last few years. As such, so does the law of supply and demand since the commodities bubble started last year (arguably earlier) and ended a few months ago. If you need any proof, here are two pieces of news, randomly selected sources from a blind Google search (not intending to target the sources in any way), to illustrate my point:

1. On 04/29/2008, disruption in Nigeria causes oil price to surge $1.50 to a then-record of $119.93. Hmmm...how interesting.
2. On 07/18/2008, disruption in Nigeria causes oil price to drop $5.31 to $129.29. Hmmm...how interesting...wait, WHAT?

The oil run-up of last year bothered me a great deal. So I decided to make an effort to make sense of it. Back then everybody was talking about supply and demand, peak-oil production, Saudi Arabia's exaggerated oil reserve, etc. etc. But I couldn't understand how these slow-moving variables could possibly cause the insanely fast-moving price. Then I read about how a new breed of speculators have joined the market and driven up price. That makes perfect sense, but just as explaining why water boils by saying the temperature is 100C -- it provides absolutely no information. Why did those speculators all of a sudden swamp into commodities?

Then it hit me. The real negative interest rate. When the real interest rate is negative, it doesn't make economic sense to hold cash. Real assets that people need have a much better chance of holding value through inflation. (I know, I can't be even the millionth one realizing this.) With real estate out of the question last year, commodities was a logical place to park your money. And it's a self-fulfilling proposition and yet another positive feedback -- the higher the commodities price, the higher the inflation pressure, and therefore the higher the commodities price...ad nauseam.

Did supply and demand have anything to do with the equally dramatic burst of the commodities bubble since July? No more than the run-up. I have a theory on why but it's off-topic so I'll leave it out. And the last leg of the plunge was no doubt a part of the Great Unwind by hedge funds and banks, primarily triggered by the Lehman CDS settlement.

It's primarily inflation, both real and expected (but probably not the nominal, systematically understated CPI), in relation to interest rate. Similar commodities bubbles driven by negative real interest rate have happened before. But this time it's amplified by the massive amount of concentrated capital, from individuals, corporations, and governments, created through years of internationalization, as well as the dramatic increase in capital flow and leverage through fantastic progress in capital markets and regulations such as securitization and Basel II.

Over the longer term, years and decades, there's no reason to believe the law of supply and demand will break down. But in the shorter term, in a market swamped by speculators who never intend to take delivery, supply and demand have little relevance.

In the very short term, minute-to-minute and day-to-day, supply and demand will have relevance, but only in a nominal and deceiving way. Imagine a fallen autumn leaf in water, a very smart one with a PhD in fluid dynamics, with access to a massive cloud of blades running Linux and models coded in A+. She can explain every minute movement from the molecular level up. Supply and demand. But there's a problem. When demand goes up 1%, sometimes the price goes up 0.1%, sometimes 10%, and sometimes even -1%. She doesn't understand. But Reuters reporters call her anyway and dutifully report on how supply and demand drove the price in their obligotary end-of-day headline.

Enough with the cynicism. What will happen to commodities?

On 10/3, right after the passage of the Bailout Pork package, I said commodities would have another long-term run-up. On 10/13, I said the market would have an intermediate-term bottom "before or around 10/21". In retrospect, I was a bit early on both accounts, as I am usually. I didn't see the delay effect of the Great Unwind of forced hedge fund liquidation and bank deleveraging. But I wasn't too far off.

I still stand by them today, only with more conviction. Bernanke's Fed has totally lost its mandated independence from politics. He'll be bullied by Washington and Wall Street into keeping the interest rate below real inflation. The next President, no matter who, will probably not have the political will to call Uncle Ben to tackle inflation until it's too late (this is a change from what I said in my 10/3 article), unless the economic appearance improves drastically in the next few months (unlikely). So we'll have yet another asset bubble, in commodities, and commodities-driven inflation, starting from somewhere between yesterday and mid-2009.

The inflation driven by the housing bubble in the last few years was stealth. Those who hitched a ride, the homeowners, didn't complain. Those who missed out, the homeless and the renters, complained but were completely drawn out by the party noise. But commodities-driven inflation will be direct and apparent. So my hope is it wouldn't last too long. And that would be a good thing for society.

Until the good thing happens, enjoy your ride on commodities.

Stock position: None.

Comments

[john s. gordon:]

we already know that speculation using 40/1 leverage (i.e., excess money supply with noplace to park) trumps supply/demand. so what else is new?
> jack

2008 Oct 30 09:13 AM

[flow5:]

the evidence of inflation is represented by "actual" prices in the marketplace. The "administered" prices of the world's commodities would not be the "asked" prices were they not “validated” by (MVt), i.e., validated by the world's Central Banks ( i.e., as Friedman maintained "inflation is always and everywhere a monetary phenomenon")

2008 Oct 30 12:16 PM

[Dave P:]

Of course, the price of a commodity is governed by the laws of supply and demand. And yes, it also has to do with speculation. The two ideas are not mutually exclusive.

Speculative demand is part of the demand for a commodity. Similarly, when a speculator decides to hold onto his inventory of a commodity because he thinks the price might go higher, that has an impact on supply. I will grant you that speculative demand is very volatile compared to other parts of the demand, but it is still part of the demand.

I thought your argument was going to be somewhat different when I saw the title. What a lot of folks find perplexing is that the price of a commodity might go up even though INVENTORIES are higher. I've heard a lot of pundits claim that proves that supply and demand do not work in the oil industry, for example. Bill O'Reilly is one.

What they are ignoring is that inventories are not the same thing as supply. If you have an econ degree, then you know that mathematically, supply is a CURVE, while inventories are not. Inventories is simply a number.

Supply is a relationship between the price of a product and the quantity that suppliers are willing to supply. The higher the price, the more they are willing to supply. The folks who erroneously equate inventory to supply, however, are effectively assuming that all of the inventories are available for sale at any given time at the market price, whatever it might be. And that is simply not the case. People who hold inventories look for the best price they can get, and they are willing to continue holding them if they are not satisfied with the price that is available. In order to determine what the supply is, you can't just look at the inventories. You've got to get inside the inventory holder's head to find out what his price is. The market system is what does that.

2008 Oct 30 12:41 PM

[homan:]

All markets anticipate future action, that being said markets overshoot up and down and speculators definetly pile on when there is a live market. The narrative is really just a story told to suck investors into the market. The dot com buble, housing buble, and comodity buble each had a story after all every good product finacial or physical has to be sold with a convincing story buyer be ware.

2008 Oct 30 03:08 PM

[RWC:]

CHECK OUT THIS ARTICLE FROM A FORMER OIL MARKET REGULATOR www.dailymarkets.com/c.../

2008 Oct 30 04:17 PM

[dsrtwriter:]

We are again seeing a cycle. With prices down in metals, existing efficient mines may be put on "care and maintenance" or reduce output in response.
Marginal mines recently opened to meet high prices will close, but again be maintained should there be a rebound in a few years.

New exploration budgets will shrink,but exploration will continue.

Oil and mining companies may be witnessing a more dramatic drop this time than previously, but they have lived with these swings for years.
Inventories will drop and not be renewed until the prices recover, and then likely the price rise will again be dramatic due to the lack of inventories and decreased output of producers, which cannot be immediately switched back on (inputs such as equipment, employees, etc. must be reintroduced).

Commodities may or may not have bottomed at this point, but one can be sure that in the future, producers are not going to extract metals and oil without asking for a lot more U.S. dollars.

2008 Oct 30 07:12 PM

[Bo Peng:]

Dave P, of course you're right in saying "demand" in the futures market is, well, demand in the futures market. What I'm trying to say here is something different, beyond semantics. Demand in the futures market is "real demand" plus demand created by real interest rate.

2008 Oct 30 09:20 PM