June 16, 2008

Fire Burn and Cauldron Bubble

LOOKING AT THE MARKET today, I am reminded of the very old and very true short-seller's saying that the market can stay irrational longer than one can stay solvent. We have more than 1.2 trillion barrels of oil in the ground, and supply still outstrips even heightened demand, yet oil nearly hit $140 per barrel this morning. Double double toil and trouble, fire burn and cauldron bubble, said the witches in Macbeth, and look at all the trouble they caused with their advice.

It is a bubble, and it will burst -- the only question is when. Already, we are seeing what the experts pleasantly call "demand destruction" as the result of higher prices -- no surprise there. That will only continue as Governments around the world, who subsidize gasoline for their people, reduce or eliminate those subsidies because they have become unaffordable. If you ask me, only China, which has a trillion of our dollars in its coffers, will be able to keep those subsidies going over the long term -- and even then, if they are smart, they will reduce those subsidies over time.

Unfortunately, I haven't a crystal ball that can tell me the exact moment oil will start to correct, and sadly, the oil market is not like the Dutch tulip market, which famously crashed in 1638 when traders held an auction, got no bids for their bulbs, and then collectively said, "Oh, shit." It may be a while before the oil market has a similar realization, and I make no predictions as to when that might happen. I do, however, think investors might want to consider investing in sectors that are currently out of favor, as that's generally how profits are made: buy when no one else is interested and sell when everyone is interested. That's what David Herro, the chief investment officer of Harris International, has recommended. It might not be a bad strategy.

Although I'm pretty damned certain oil is in a bubble, I am less certain when it comes to the run-up we've seen for agricultural commodities. Right now, I think there's definitely a lot of froth in the marketplace, and it's likely we are seeing some form of bubble at present. However, the economics behind the run-up in agricultural commodities are somewhat different than with oil. About the agricultural markets, we know the following:

1. Everybody needs to eat.
2. People continue to be fruitful and multiply, particularly in developing nations.
3. The developing nations are getting richer.
4. The first thing people, particularly in poorer nations, do when they get more money is improve their diets.
5. More people + more money = higher prices for food, particularly quality food.
6. Food security is crucial to the stability of developing nations.
7. Prices for food are inherently based on agricultural yields. As yields improve with time, prices fall.

History shows us our present situation is nothing new, which may or may not be comforting, depending on one's viewpoint. When the Black Death swept through Europe in the late 1340s and early 1350s, and killed off a third of its population (in some places, half), it created a fundamental change in the continent's economy. It was one of the few times in history that labor got the upper hand over capital. With so few workers, their wages improved markedly in real terms, even as demand for goods and services (mostly goods) fell due to what one might call demand destruction.

(As an aside, this created a huge mess for Europe's feudal-based "Governments" at the time. Remember, no one knew anything about economics back then. Plus, it threw a wrench into the whole social order, as merchants and other upstarts started wearing fine clothing and eating well and worst of all, started putting on airs. For more on this, Google "sumptuary laws.")

Anyway, the plague survivors discovered that because their competition had conveniently died, they were able to reap great economic benefits from their lords and masters. But as in all things, this did not last, as the economic historian Fernand Braudel pointed out (see Civilization and Capitalism, Vol. I). In Swabia in 1550, as Braudel notes, a man named Heinrich Muller wrote that things had changed:

In the past they ate differently at the peasant's house. Then there was meat and food in profusion every day; tables at village fairs and feasts sank under their load. Today, everything has truly changed. Indeed, for some years now, what a calamitous time, what high prices! And the food of the most comfortably-off peasants is almost worse than that of day-labourers and valets in the old days."

In 1550, the start of the Iron Century (so named because life pretty much sucked), there was an extra factor that entered into the equation: the galleons carrying immense quantities of gold and silver from New Spain. Sadly, the Spanish crown was feckless and had a thing for starting wars, and spent the gold extravagantly. Since the currency of the age was based on precious metals, and people didn't understand how inflation worked -- that wouldn't come until a few decades later -- it ruined Spain's economy and made life difficult for everyone else.

The long and short, however, was that food prices skyrocketed -- and stayed high up until the 18th century, when developments in agriculture kicked off improvements in yields that have continued up to this day.

But getting back to the modern age, let's look at the situation. The world population continues to rise, and more people than ever have money to spend. Even the poorest trader will splurge on chicken or beef -- especially beef -- once he gets a bit of extra pocket money. India and China's middle classes are expanding rapidly, and with that comes a demand for better food. We know demand has been so high in certain places that nations are cutting exports for staples such as rice, thus creating higher prices on the world markets for remaining stocks. This does not mean there are shortages -- but it is certainly indicative of greater demand.

The question, thus, is this -- will yields improve going forward, and by how much?

I do not pretend to know the answer to this question. Nor do I know whether the present run-up is a "bubble" or simply a matter of fundamentals. But it is something to keep in mind going forward if one is considering the agricultural markets and the companies operating in them. For if yields improve markedly, long-term prices will fall. If they do not, prices will almost certainly rise.

IMPORTANT NOTICE: I am not an investment advisor and do not work professionally as a money manager. As a result, you should consult with someone who does that for a living before making investment decisions. You should always read a prospectus or similar document detailing the potential risks and rewards of an investment before sending money. You could lose a lot of money investing. You'll almost certainly lose it if you invest in commodities, which is a fool's game. Also, there's a hell of a lot of risk investing when prices are high with the hope they're going to go higher. You don't want to buy high and sell low, so keep that in mind. All rights reserved, yada yada yada.

Posted by Benjamin Kepple at June 16, 2008 12:52 PM | TrackBack
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