Wednesday, April 16, 2008


Sentiment is so one sided that all news is now bad news for food and energy prices. For example, the fact that the US is now using less than 82% of its refining capacity to produce all the fuel we need is now the bad news! Oh My! Tigers and Lions and Bears! Two years ago, the price of gas had to go up because there was not enough refining capacity. Now the price must go up because we are not using our refining capacity? I have not seen a bread line or a gasoline line in the past two years while the evil corporations were unable to make enough or since these evil corporations have purposely stopped making enough.

While I believe inflation is a monetary phenomenon, there is truth in Keynesian Economics, an excess of capacity is normally present during a decline in prices. The Saudis say they have excess production capacity and the refiners obviously have excess refining capacity, at least in the near term. The annual switch from winter blends to summer blends does not fully account for the current rate of utilization.


Food and energy prices are and always have been volatile. An event recorded in Israel some 3,000 years ago tells how the price of wheat imploded overnight. The farmer who grows too many tomatoes should not waste the energy to pick the last of them. The farmer with the last bushel at the market might easily quadruple his profit. Because of this volatility, inflation indexes have historically been calculated two ways, including food and energy and excluding food and energy. Also, it is the volatility that has lead governments to pay farmers not go grow, pay farmers to grow extra and to place exorbitant taxes on foreign production, driving up the cost of food to the public. Politicians need to stay out of the middle of healthy markets!

The problem, in the first place, is that even the cumulative total wisdom of the entire market cannot guess the future price of commodities with great precision, the guess of a bureaucrat or politician is likely to be much worse. It is hard to estimate what someone will pay for a bag of rice next year. There are too many unknowns. The game being played by the market participants is a game of "adaptive expectations". Farmer Jones grows 1,000 acres of corn and 500 acres of beans. Farmer Smith grows 800 corn and 700 beans. When the price of corn soars to record highs, Jones and Smith make a lot of money. When they plant their crops the next year, they are likely to check with the one another before planting. If a lot of farmers switch from beans to corn, the price of beans might soar and the price of corn might fall. The economic term that helps describe the relationship between the price of beans and corn is "cross elasticity of demand". Both corn and beans can be used to make fuel and both can be used as food.

Supply and demand of food and fuel jump around. Eventually, the supply demand curves look like a spiderweb. I foresee a big spiderweb in the making. The excess capacity building up in refinery capacity is a very bearish, even though the next two new refineries are months away from production. The current excess is present even though recent economic indicators show there is still underlying economic strength. GNP can rise at the same time fuel usage falls as a result of increased efficiency and substitution.

The news ain't all bad but the perception of it is terrible.