Commodity Bulls' Seven Fat Cows Will Be Followed by Seven Skinny Ones

Remember the biblical story of Joseph and the seven fat cows?

For commodity bulls, this may be the era of the seven fat cows. In a recent article, Cynicus Economicus points out that the world has seen an imbalance between the supply of resources and labour:

[T]he availability of oil per worker has seen a significant decline. In such a situation, there must be a consequence. If a worker in country A increases their utilisation of oil, then a worker in country B will have less oil available…

In such circumstances, the resources will flow to the labour that utilises the resource in the most cost effective way, and where there is the commensurately high return on capital.

Notwithstanding all of the fiscal and monetary stimulus, he believes that resource prices are on an upward trajectory. This may mean, that at an extreme, we may see a seven in front of gold or oil prices (and I don’t mean $700 gold or $70 oil).

Followed by seven skinny ones…
Don’t think that scenario has a happy ending, however, as the seven fat cows are followed by seven skinny ones (see my previous comment here). Commodity inflation would inevitably be followed by a deflationary collapse caused by massive demand destruction.

James Hamilton, who blogs at Econobrower, wrote extensively on the connection between oil prices and economic growth [emphasis mine]:

When I first began working on my Ph.D. dissertation in 1980, I was intrigued by the fact that the oil embargo of 1973-74 and the collapse in Iranian oil production after the revolution in 1978 were both followed by global recessions. But when I called attention to the fact there had been a sharp increase in the price of oil prior to 6 of the 7 postwar U.S. recessions up to that point, the general response was one of skepticism.

By the time I was presenting evidence of this relation at various seminars in 1981-82, the Iran-Iraq War had produced yet another shock to world oil markets and the NBER declared that the U.S. experienced a new recession immediately on the heels of the previous downturn, meaning that the evidence had now become that 7 out of 8 recessions had followed oil price increases…

We received some more evidence on this relationship when Saddam Hussein invaded Kuwait in August 1990, causing oil prices once again to double and coinciding with the 9th postwar recession. The price of oil also shot up before the 2001 recession. Add in the conjunction of the oil shock of 2007-08 with our current economic pickle, and my count is now up to 10 out of 11.

Inflation and recession?
Gregor MacDonald at gregor.us believes that we are likely to experience higher volatility in commodity prices as the world economy oscillates between the forces of commodity shortages and deflationary growth:

We have very likely been in an inflationary recession for nearly two years now, with massive deflation in housing and yet stubbornly higher food, energy and health care costs–the latter well above the price levels of just a few years ago. The risk, in my view, is that both trends now accelerate. And, that we experience next something more akin to an inflationary depression.

For now, we are seeing the start of a commodity friendly environment that may culminate in a hyper-inflationary blowoff, especially if the world loses confidence in the USD.

By all means get on for the ride on the hard-asset train, but don’t forget to get off when you get to your station.

Comments

[Dave Wrixon:]

I think perhaps the US had its Seven Fat Years under Bush.

Jun 16 07:11 AM

[Dr. O:]

>>Commodity inflation would inevitably be followed by a deflationary collapse caused by massive demand destruction.>>>Commodity inflation would inevitably be followed by a deflationary collapse caused by massive demand destruction.>\<<lt;<

Already happened: oil from $15 to $150 in ten years, followed by the 2008-2009 economic and financial collapse.

>>We have very likely been in an inflationary recession for nearly two years now, with massive deflation in housing and yet stubbornly higher food, energy and health care costs–<<

The "deflation" in housing is the bursting of an asset bubble. Food prices (and I shop twice a week) are not stubbornly high. Five dollar pizzas and foot long subs are the rule. I shop twice a week and the only thing the ticks me off is the high price of Cinnamon Toast Crunch cereal.

Energy prices? Natural gas is 4 bucks. Oil and gasoline are high, and that is a big drag on the economy, point conceded.

Health care costs? Yes, in general if you have insurance your contribution vs. your employers has probably gone up, as have your co-pays as have your out-of-pocket expenses for not-covered or partially covered services.

If you don't have health insurance and a significant health issue arises its often a financial disaster.

Off point: I'm a practicing doc. You give me tort reform so I don't have to order 5 tests for every physical complaint to cover my ass against potential litigation and I'll support some form of national health care plan. Without tort reform and with a national health plan (which will continue the downward spiral of compensation for my work) I'll retire as soon as possible. Truth.

Jun 16 08:06 AM

[Larry House:]

Good piece, Cam. It is not too hard to catch the train, but it can be very hard to get off at the right time. We have some real challenges to face that are not yet fully on the radar screen. Be careful out there.

Jun 16 10:06 AM

[David Braun...:]

Dear Dr. O,

Tort reform is a mixed bag. I live in Texas where they passed tort reform a few years ago. My wife contracted meningicoccal septicimia and miraculously survived with only losing a few finger tips and the bottom of her feet. Unforturnately, because of misjudgement by one of the attending physiicians, she was taken off of anitbiotics and off of isolation too soon. She contracted psuedomonus septsis and again almost died. She lost both of her legs above the knee and had amputation of all of her fingers. I went to an attorney who told me that if I lived in any state except Texas that my wife's case would be a slam dunk multi-million dollar victory. Texas tort reform limits teaching hospitals to $100,000 in actual damages and no punitive damages. I think tort reform of that magnitude creates an enviroment where doctors, nurses and administrators can and do become careless.

I liked your comments to Cam Hui's excellent article.




On Jun 16 08:06 AM Dr. O wrote:

> >>Commodity inflation would inevitably be followed by a deflationary
> collapse caused by massive demand destruction.>>&g... inflation
> would inevitably be followed by a deflationary collapse caused by
> massive demand destruction.>>> massive demand destruction.>\<<lt;<lt;&...
>
> Already happened: oil from $15 to $150 in ten years, followed by
> the 2008-2009 economic and financial collapse.

Jun 16 11:13 AM

[mpherson:]

Good lead to comments on the rapid fluctations in oil price. Musical comedy and serious discussion !

Jun 16 01:19 PM

[HardwoodFlo...:]

Halleluiah !!! Finally a post that makes MACRO sense:

Fundemantals don't drive this market.

Raise the margin requirement on commodities- from 10% to 30% and watch the cockroaches head for the exits. as it stands right now the downside loss potential is only 10%- the fund just declares bankruptcy with a 10% loss if the "bet" goes the wronge way. I'm sorry I mean "investment" not "bet".

Also, there were two guys from Stanford who did an anlysis of the oil market last fall. They proved that with just $10B you could control the price of world wide oil.

So the $8 billion in Commodity ETFs that has come BACK to the market in the last little bit has had no barring? (you should see the graph of money going into Commodity ETFs and overlay that over oil- it's the exact mirror both up and down). No, it's probably as you assert the fact that the fundementals of oil are determining the price.

So, wow, I guess it must be the hurricane season or the "summer" driving season, or political instability or what ever chaos theory suits/rules the day. The price of rice should go up because of rain fall in south east asia- never mind the rice prodcution in the rest of the world.

For commodity's it's the same trade as last summer: bid the dollar down, bid commodities up (this in turn will raise input costs to companies and squeeze the consumer) then short stocks because the raising input costs will not be offset by increase consumer demand. It's a terrific world the hedge funds, totally unregulated, have created for themselves- being a pariah on the consumer. I'm so glad they are unregulated! I'm also glad they aren't speculators but, instead, greedy disgusting little pin heads who create and add no value at all. At least they will be able to afford their rentals in South Hampton, Nantucket and Newport this summer.

Unfortunatly for you, who believe in the "fundementals", this creates a negative feed back loop whereby the problems created by peak oil kill the economy and, then too, kill the price of commodities. so don't be the dumb money in this trade.

Lastly and finally in all these disjointed comments: peak Oil destroys globalization. Because frieght turns companies from global players to regional players...

Jun 16 06:16 PM

[Fighting Yoda:]

Commodity price rises can not lead to inflation as 70% of cost of production is labor. Wages are falling as everyone would notice, also prize of Pizza and subs and the rest. Oil/Gas price rises alone can not create inflation - core CPI actually ignores energy prices.

Jun 17 03:06 AM

[Dr. O:]

Some people might argue that rising commodity prices ARE inflation, lol.

Jun 17 09:09 AM