Arnold Kling  

Mark Thoma's Question

Long Tail of Politics Watch... A Question for Paul Krugman...

He asks,

how do you explain the large run up in, say, agricultural commodities which cannot be left "in the ground" until later?

Interesting question. Some off-the-cuff observations.

1. The point about the run-up in other commodities raises questions about any oil-specific story. I suppose one can tell a story that runs from oil to ethanol to agricultural commodities, but that is a bit weak to begin with, and weaker still when one gets to metals, which I believe show similar increases.

2. I disagree with Mark on the storability of agricultural commodities. Wheat can be stored as crackers. Corn can be stored as corn flakes. If speculators drive up the price of corn nine months from now, but there is abundant corn today, my reaction as Kellogg's is to ramp up corn flake production today, so that I don't have to rely as much on the expensive corn that is coming in nine months. But that means I buy lots of corn today, which raises the price, just as if I were buying it to store in a silo.

Let me emphasize that I am not saying that high commodity prices are a speculative bubble. Tyler and I tend to think the opposite. I like his term anti-bubble. That is, speculators guessed wrong a year ago, and prices now are catching up to reality.

What I am saying is that speculators do drive the prices of oil and other commodities. Moreover, they do so in the futures markets. Furthermore, there are alternative ways of storing commodities other than grain silos or oil storage tanks, so you can't rely on those inventory figures as indicators of the presence or absence of speculation.

I should mention that I am not opposed to having speculative markets in commodities. On the contrary, I think that speculators are important in sending signals to commodity producers and consumers.

I have been arguing that the news in oil markets has not been particularly dramatic in the past year. Paul Krugman takes a different view:

Declining Russian production, growing doubts about whether the alleged Saudi excess capacity really exists, etc.. Basically, CERA-type optimism about big new oil supplies coming on line any day now has been fading.

Whether this is "big news" or not is a matter of opinion. I am not going to go to the mat to defend my view.

I would just point out that Thoma's question raises the bar a bit for the "big news" view. What "big news" has at the same time hit agricultural markets and other commodity markets? It seems to me this nudges things in the direction of monetary surprises or autonomous changes in speculative sentiment.

Comments and Sharing

COMMENTS (6 to date)
BottyGuy writes:

"2. ...Wheat can be stored as crackers. Corn can be stored as corn flakes. ... my reaction as Kellogg's is to ramp up corn flake production today..."

I don't think so, Kellogg's is a manufacturing and distribution operation. The goal of any such business it to minimize storage of parts (ingredients), and finished product (cereal). You need to deliver the product to the store when the store needs it. Kroger is not going to store it for you or hold the cost on their books for 1 month let alone 9 months. Kellogg's wants to minimize warehousing, product is manufactured and put into trucks for distribution to the market.

Gary Rogers writes:

I think it is a mistake to try to prove that the increases in oil prices or other commodity prices come from any single cause. Fed policies have certainly contributed to the problem as interest rates are dropped to avert a recession. Low interest rates make it difficult to hold cash so investors look for a place to park their money. This leads to more speculation than normal. The weak dollar makes the price of everything go up. Environmental policies have prevented us from building refineries or drilling off shore oil wells for the last 30 years causing limited oil supplies. Ethanol legislation has also had a big effect on grain prices. Since there is less excess capacity, events like floods, political instability in oil producing countries or other threats to supplies also cause jumps in price. The fact that we have two presidential candidates that promise to be worse than the current administration also has to shake confidence in future supplies.

The things I mentioned, though, are relatively static inputs to the price. Changing prices can be an input to itself, causing price increases or decreases based only on the current trend. This is one of the primary causes of price bubbles and as much as politicians would like to legislate this away, it is one of the characteristics of prices. No one thing creates the final price of oil or other commodities and no one solution will allow anyone to control the price. The amazing thing is how well the market can take all the factors and balance them into a single price that reflects the sum of current and expected conditions.

fundamentalist writes:

Along with Gary Roger, I'm surprised that Arnold hasn't at least mentioned monetary policy. Doe he think the money supply is endogenous?

Still, I think his model is the best around if you use prices adjusted for inflation. I think one explanation for the interest of speculators in commodities recently is that they were focused on real estate until they sensed the top of the market at which point the got out and switched to commodities. Kyosaki (Rich Dad Poor Dad) has writtent hat large investors had abandoned the stock market long before its peak in 2000 for real estate. After real estate they went to commodities. My bet is that they will focus on the stock market once they think commodities have peaked.

As for oil supply, there is a lot of friction in changing supplies as another poster has written. Increasing supply from older fields often requires drilling new wells and laying the necessary pipe to connect the new wells to the main pipe. In addition, a lot of investment in technology to keep the oil flowing is required during the life of a well. Unfortunately for us, countries that own oil have not spent the necessary maintenance funds on their oil fields. Even returning to old levels of production will require huge amounts of investment. Even today there is a shortage of drilling rigs and skilled oil field workers.

aaron writes:

Uncertainty should drive futures prices down, not up.

It should drive down futures prices, but drive up spot prices provided that stocks and/or consumption can be increased.

aaron writes:

Sorry, I'm an idiot. My thinking was something like "If I might not get what I'm paying for, I won't pay much".

James A. Donald writes:
market fundamentals justified a much higher price in 2007?

... meaning that we had what Tyler Cowen calls an "anti-bubble" in oil.

Rather, market fundamentals have changed, and changed radically. The market was right in 2007 and right in 2008. The political arrangements that made it relatively safe to pump oil are failing. The situation in Nigeria is rapidly deteriorating, and similar problems occur everywhere to a lesser extent. We were in denial about Nigeria, perhaps still are, and wonder if we are in denial everywhere.

China's growth was anticipated, or should have been. That Nigeria has fallen apart and Mexico may well do the same was not anticipated. In retrospect, the Nigerian situation should have been foreseen, but people could not believe what they were seeing, and indeed, many people still cannot.

Comments for this entry have been closed
Return to top