Emerging Markets, Oil and Commodity Prices and the Possibility of Stagflation

Stagflation

If emerging market stocks run another 20%-30% from here, I am pretty sure oil will follow. The same logic that investors are using to bid up asset prices, liquidity from the Fed, can and is being used to bid up oil prices.

The thing is, there is no theory to figure out what the price of a commodity should be. For stocks, one can use DCF or some other intellectual justification. What should one use to figure out the price of oil? Supply is more than demand today. So should oil fall to $50 or $40. Why not $10? An economist will say - well the price of oil should be such that demand is met over the next few years and oil exploration companies are able to earn their cost of capital. If oil companies make excess profits, then price of oil is high. Needless to say, this logic has zero practical applicability.

Markets are open right now for both equity and debt, and the Fed will be hoping that investors calm down a bit. Because if they don't, by their very actions, investors will cause inflation to happen. It might not happen in the US as much where commodity prices are not a big part of CPI, but it will definitely happen in emerging markets like India.

Return of the Friedmanites

Suppose commodity prices keep going up. The closed mines will open up as soon as selling price crosses their cost of production. However, because demand would not have come back to the same degree, their production will go into inventories - unless the cost of production also moves up so that the mines remain unprofitable. That would require some giant scheme so that the general price level in the world economy goes up. In particular, wages need to go up, which doesn't seem likely looking at the state of world affairs.

So, production goes into inventories. There are no end buyers. Do prices go down, or bulls keep arguing that China will take care of the inventories in a year? Does dollar weakness keep commodity prices high which leads to stockpiling of inventories?

The key to inflation is not output gap. It is commodity prices, at least in emerging markets like India. The last year was the year of Keynesians. I think Friedmanites are going to get an opportunity to strike back very soon. How exactly we get inflation, I am not very sure. Investors are taking Libor + 50bps funding provided by the brokers to take a flyer on everything risky.

Comments

[rick12345:]

Oil, being a scarce resource is supply driven and don't let anyone tell you otherwise. OPEC, like the greedy bankers on wall street, can manipulate the market any way they choose (ceteris paribus), sending the price up or down.

Jun 01 05:03 AM

[Mad Hedge F...:]

You got that right. If you have been aggressively long commodities of every size, shape, color, and flavor, as I have been all year (www.madhedgefundtrader...), then you just had one of the best trading months of your career. The CRB index rocketed by 17% in May, the best move since the early days of the first oil shock in 1974. That year I spent weekends driving my Volkswagen van from Los Angeles down to Mexico, where I filled it with jerry cans of gasoline because it was still selling for 25 cents a gallon there (an early attempt at arbitrage). I finally sold the vehicle and used the cash to buy a one way ticket to Japan (Remember that John E?). My favorites went up the most. Crude leapt 29%, Silver clocked in a 23% return, and gold was up 9%. The producing stocks also did spectacularly well. Coal producer Massey Energy (MEE) soared by 44%, dragged up by oil, while my beloved Freeport McMoran (FCX), with the world's largest gold and silver reserves, rose by 30%. While these things are all superheated on a short term basis, the ten year agreements are still good. You can find massive Chinese buying behind almost every one of these. Hmmmm, I wonder if those bell bottoms still fit.

Jun 01 10:33 AM

[cameroni:]

You are right, Supply is more than demand, but uncertainty about the dollar is greater than confidence in government actions to bring a solution to our problems. Oil is money by another name and is being bid up on that basis. It hedges inflation as surely as Gold (more surely actually but reward also brings risk and it could drop as precipitously as it rose.)

I have been anticipating 70 dollar oil and it now looks poised to break towards the 80's. Part of the commodity bubble trend I suppose.

Jun 01 09:46 PM

[Homer II:]

Right on!

long oil, gold, copper, & emerging markets.

Jun 02 03:11 AM