Farmer’s new profession

I’ve been told that my post are depressing by a friend and thus I’ll share something humorous (you’ll soon want me going back to to depressing).  I noticed the stats on the Farm systems balance sheet and the thought crossed my mind that the American farmer could set up shop as a consultant on Wall-Street in order to educate the suited men on what a un-leveraged balance sheet look like. 

The interesting thing here is given that agro-commodities (the output of farm) are so much more volatile than banks products it illustrates the reality of the Minsky cycle; in that if volatility goes down firms leverage up so that the risk is the same (or is perceived to be the same) and if volatility goes up firms leverage down.  Thus level of volatility tells us very little about the riskiness of a sector or country without knowing the embedded leverage.

Oil, How low can you go?

It is my personal view that black gold (oil) five or ten years out will have appreciated in real terms, in large part due to dollar depreciation, continued world growth, and the mix of oil coming from higher cost sources. In the short run, however, I think there is a decent chance that oil prices will fall further.

Off and on in the news you hear that OPEC is meeting to cut production. On the surface, this makes sense.  It is a cartel; member countries coordinate production in order to hold the price of oil above what it otherwise would be in order to make more money.  Why aren’t there more cartels out there?  Yes they are (in some cases) illegal, but that is not the primary reason.  The primary challenge of a cartel is that the incentive to cheat is too great, and unless there is a barrier to entry in the market, the cartel has no chance of holding together.  Oil producers have a good barrier to entry (you can’t produce oil), but they still have incentives to produce a little extra in order to make more money.

Nowadays, the incentive to cheat is big across the board.  The breakeven fiscal oil price in 2009 ranges from the mid 50’s to the mid 60’s, below that the government has to borrow money to pay for its cash outflow.  The breakeven oil price for the current account ranges from the mid 20’s to the low 70’s, although most countries are in the high 60/low 70 range.  Given that oil is below these levels, countries and governments will either have to borrow to pay their expenses, or increase oil production to bring in more revenue.  Of course if they all increase production the price will go down, making everyone worse off.

The cartel has worked in the past when there was a strong marginal producer who was willing to take the cash flow hit (by producing less) in order to maintain the price level.  Saudi Arabia did this for a while in the early 80s but in August 1985 they linked their output to the spot market.  Their production increased from 2 million barrels per day in August 1985 to 5 million barrels per day in early 1986.  What happened to the price of oil? (See chart-remember this was in the middle of the Iran-Iraq war and during a period of mild economic growth.)

Capping Volatility: Why price caps may have lead to oil volatility.

It is not surprising that congressional hearings on oil prices are asymmetric.  When the price goes up, legislators are up in arms demanding to know who is responsible, but when it goes down, the explanation is irrelevant.  It was less than a year ago that the heads of regulatory agencies, hoping to prevent a populist and foolish response to the new economic reality, were appearing before congress to argue that the price move was not driven by speculators.   (CFTC testimony)

Admittedly, new demand for something, regardless of its source, will push the price up. But portfolio demand, unlike product demand, seems unlikely to be able to cause increases in prices without causing inventories to increase which at some point would push down the price and are thus less consequential over the long term. And as demand wanes prices will fall but why have the price movements been so large?  Higher volatility makes it harder for firms to plan (and increases the cost of hedging). 

The underlying reason for the large drop in oil prices is a drop in global demand related to the economic slowdown.  But let me try to explain why I think the price movements have been so dramatic.  One portion of the conversation during the price run-up in oil was that emerging market price caps were causing excess demand.  This may be true, but it misses that price caps can also cause excess volatility.  .  Yes, Venezuela gas prices being 12 cents a gallon induces more consumption than the market price would  As long as the governments of these developing economies can pay for the price caps, demand for oil in the marketplace is much more inelastic than it otherwise would be.  The onus of adjusting to movements in the price of oil is therefore on developed countries. Since fuel is a smaller portion of income for consumers in these countries, they respond less quickly to price movements. This requires the price movements to be larger than they otherwise would be in order to affect demand.  Consider the pre- and post-demand contraction chart below.  The movement of the ‘Market Price given price cap’ is larger than that of the ‘Market Price without price cap’.

Pre-Demand Contraction

Post Demand Contraction

It is true that a major factor of the current price drop is a drop in product demand.  But it is interesting to note that a large part of the drop is a function of investor deleveraging (which in many ways has prevented the market from fulfilling its long term planning role), and it is not unreasonable to believe that, if the price continues to fall, it will be a function of oil producers trying to cover their import and fiscal bills by expanding production. But when thinking about the volatility of oil markets over the past year, one important factor is the effect of market caps in developing economies on movements in demand.