Commodities in Context

In the 1970s, a four-fold rise in the price of oil brought the world economy to its knees. The Arab oil embargo left a deep scar in the psyche of many countries and drove a broad-based response: significant investment in oil production capacity outside of the Middle East, fuel-efficiency standards, and nuclear power, to name a few. These responses, combined with inconsistent growth in the developing world, drove down the price of oil. In response to that, oil companies then found it un-economic to make further significant investments in productive capacity, particularly in a political context that was more sensitive to environmental concerns.

Oil prices have quadrupled again, to a peak of over $142 a barrel as of this week. This time, stagnant oil output and growing demand from developing economies have caused a slow motion crisis, offset for much of the past few years by the deflationary impact of improved global production and logistics costs and a swelling of global labor supply. The global economies are again responding by searching for new sources of oil (or reexamining known, more expensive sources), promoting fuel efficiency, and looking for alternate sources of energy. We disagree with the most extreme analysts of the current situation – that the price of oil will soon hit $200 a barrel or, once speculators have been driven away, that the price will fall to $50 – but continue to manage our clients’ portfolios with the understanding that improbable does not mean impossible

High oil prices are hurting economies around the globe but the American stagflation of the 1970s, which was due in part to the policy response at the time, has so far been avoided. But when combined with a credit crunch, falling home prices and costly food, high oil and gas prices are stretching middle- and low-income households in developed countries.

Who’s to Blame?

As politicians and consumers look for scapegoats, a new villain has been presented: the speculators supposedly profiting from other people’s hardship. An estimated $260 billion is invested in commodity funds, including the $100 million or so from Aspiriant’s clients and staff. Surely all that capital, blindly buying oil regardless of price, is to blame, right? Of course not. As described in our prior Commentary, we choose to invest in an index of commodity futures, not the commodities themselves. Every barrel we buy in the futures market, we must sell back again before the contract matures. Our investment could theoretically drive up the price of oil for delivery in the future, but not of oil for delivery today.

It may be that rising futures prices creates an environment of greed and fear, where suppliers are emboldened to demand (and purchasers are driven to pay) higher prices than justified by current supply and demand. But that accusation doesn’t stand up to much scrutiny either. The oil price is set in one of the most liquid, transparent and global markets. Which is not to say that it is a perfect market – it is rife with political intervention, taxes, tariffs, and environmental regulations. But it’s hard to imagine a synchronized campaign to drive oil prices materially higher than they “should” be – even OPEC has been unable to accomplish that.

In our view, the reasons for rising oil prices are more straightforward. Finding and developing new oil fields is expensive and time-consuming. It takes great courage to make huge investments when oil prices are low; and yet that is precisely when they are needed. Meanwhile the talent that might otherwise have studied petroleum engineering has been siphoned off toward more lucrative careers in investment banking, hedge fund management, or consulting.

When prices are low, oil-rich developing countries welcome the capital and technology of the large oil firms; when prices are high, neo-socialist governments kick them out again. Environmental regulations which limit drilling and investments in alternative energy (who wants a wind farm ruining their view?) may be designed to protect our quality of life, but it’s no surprise that they come with a financial cost. Even the long standing practice of pricing oil in dollars, a source of stability in the past, has contributed to high prices as the value of the dollar has declined.

Nothing to fear but…

The prices of oil and gas have soared, but this is how a market economy is supposed to work. As (fallible) business managers throughout the economy go about their business, there will inevitably be an overproduction of some goods and an underproduction of others. How are these imbalances corrected? As anyone shopping for Christmas cards on December 26th can attest, short-run imbalances are corrected through prices. When production is very concentrated and the good in question very critical, there is the complication of market and political manipulation. Governments have a role rooting out fraud and collusion. But that’s about all they can reliably do.

This oil shock will take time to resolve; but it, too, will pass. The 1970s showed how supply and demand, painfully inelastic in the short run, eventually give rise to conservation, new production, and substitution. When the new oil fields are on-line, when the SUVs are all hybrid and new technologies breathe life into abandoned oil projects, the other half of the cycle will begin. Similar responses will ease the current pain in agricultural markets.

In the meantime, we’ll maintain (or introduce) a broadly diversified commodities exposure in client portfolios because the small commodities position hedges the much larger positions in global equities. Though the Goldman Sachs Commodities Index, up almost 80% in the last 12 months alone, may ultimately suffer a significant decline, that event would be wonderful news for most other capital markets because it would signal an easing of inflationary and geopolitical pressures.

We’ll have more to say on those related topics – inflation and geopolitical pressures – in another edition of Insight.

Jason Thomas, Ph.D.,
Chief Investment Officer

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