Blue moon economics

by Kurt Cobb

Published on 23 Mar 2008 by Resource Insights. Archived on 23 Mar
2008.

http://www.energybu lletin.net/ 41832.html

As the United States sinks into a financial vortex and begins to drag
the rest of the world with it, commentators are reaching for every
form of hyperbole available. Former chairman of the U. S. Federal
Reserve Board Alan Greenspan characterized the current trouble
as "the most wrenching since the end of the second world war."

So unexpected and extreme have recent financial trends been that even
the man who warned that derivatives are "financial weapons of mass
destruction, " legendary investor Warren Buffett, has encountered
difficulties when his companies waded into the derivatives market.

Concern about a cascade of failures among financial institutions led
the Federal Reserve to make loans to the beleaguered investment bank
Bear Stearns Cos. by invoking authority it last used in the 1960s.

All of the events of recent weeks including the wild swings in both
the stock and commodities markets are signaling the advent a rare
full-blown, long-term credit crisis not seen in, well, a blue moon.
Some are saying we haven't seen anything like it since the 1930s. As
frightening as such pronouncements are, they all imply a rare but
cyclical crisis that is understood to be severe, but ultimately of
limited duration. Yes, such a crisis only occurs once in a blue moon,
but when it does, despite all the damage that results, it eventually
comes to an end.

All of this may turn out to be true, but only if the cause of this
economic crisis is strictly as advertised, namely, too much credit
given to too many people at prices too cheap for too long until many
overreached and could not make good on their obligations. The
problems appear to extend all the way from the humblest subprime
mortgage holder to major financial institutions at the center of Wall
Street.

Certainly, the reckless expansion of credit is one important cause
for the crisis. But another cause seems to be hidden in plain sight.
There is another market on high boil that both Wall Street and the
public seem to be ignoring, the commodities market. Grains, energy
and gold have been making spectacular new all-time highs. And, even
as one trader managed to lose $140 million for his commodities broker
employer in the wheat market, eyes remain riveted on Wall Street and
the stock market.

There are all the usual explanations for the commodities bull market
including that 1) growth in China and India is providing enormous new
demand for basic commodities, 2) we are simply going through a normal
cyclical upswing in commodity prices, and 3) new investment vehicles
such as hedge funds and exchange traded commodity funds have made it
easier for more people to speculate in the commodity markets. All of
these things may be true.

But there are also other very disturbing causes. What is now being
called a once-in-a-thousand- years drought has gripped Australia, one
of the world's four remaining grain exporters. (The other major
exporters are the United States, Canada and Argentina.) The result
last year was an Australian wheat crop that was cut in half. That
helped to send grain prices soaring. Is the drought related to global
warming? If so, then there is reason to believe that the problem
isn't temporary and that it may spread to other grain growing regions
around the globe.

Another cause for rising grain prices may be that damage to the soil
caused by decades of industrial farming is catching up with us. The
rate of increase in global grain production has slowed dramatically.
And, even though absolute grain production has continued to rise,
yield per capita has been in a gradual decline for more than two
decades. Whatever the reason, increases in grain production are not
keeping up with population growth.

As for the high price of oil, it may indeed be due to high demand in
Asia. But another cause may be slowing rates of discovery that have
led many to conclude that a peak in the rate of world oil production
may be no more than a decade away. And, as oil prices have risen,
there has been a scramble to produce liquid fuel substitutes such as
ethanol from sugar and corn and biodiesel from soy. This has led to
higher demand and record prices for both corn and soy and to elevated
prices for sugar. If the tightness in the oil market is due to an
approaching oil peak, then the price trend in these energy crops is
unlikely to abate soon.

There is, of course, the central role of oil in the world economy and
the financial implications that an oil peak would have. First and
foremost, it would mean very high energy prices for as far as the eye
can see. It could also mean financial turmoil for importing nations
such as the United States, turmoil that may already be manifesting
itself in the form of a credit crisis.

Even the prices of crucial industrial metals such as copper, lead,
nickel and zinc have risen sharply. Copper, for example, has risen
from a low of 60 cents a pound at the beginning of the decade to a
recent price of around $3.50. More worrisome are rare metals used in
important consumer and business products and processes such as
platinum used in catalytic converters in cars, indium used in LCD
displays, and rhodium used for critical electrical contacts which
have been up as much as 500 percent, 1,000 percent and 2,000 percent,
respectively.

All of this is supposed to stimulate supply and bring down commodity
prices. But, this is simply not happening in the oil industry where
large international oil companies have been unable to replace their
oil reserves despite their high levels of exploration and development
spending. As this new picture of harder-to-find oil has emerged,
these companies have instead begun to focus on buying other oil
companies and on buying back stock which, of course, does nothing to
increase oil supplies. It is true that substantial oil resources
remain underground in OPEC countries. But these countries have little
incentive to produce much more oil than they do today. Why not leave
reserves in the ground and get higher prices later as the money is
needed?

Nowhere is the problem of finding additional supplies of energy
clearer than in the North American natural gas market. Natural gas
production has been stuck on a plateau of about 27 trillion cubic
feet of annual production since 1998. To quote from a previous piece
of mine:

But, it's not for lack of trying. From a low in early 1999 of 397
active gas drilling rigs in Canada and the United States combined,
the count has vaulted to 1,753 active gas rigs for the week just
ended [January 18, 2008]. And, the high rig count is not just a
recent phenomenon. Combined gas rig counts first reached 1,000 in the
year 2000 and fluctuated between about 700 and 1,300 from then until
mid-2005. At that point they broke through the 1,300 level and never
looked back. The simple fact is that natural gas in North America is
getting harder to find; and when we do find it, it is coming in
smaller quantities that flow at slower rates than in the past. That's
why we are having to drill so many wells just to run in place.

So much for the idea that high prices will automatically bring on
supply. High prices may be able to stimulate drilling, but they
cannot alas create natural gas.

For metals, prices have come down, but not to their previous levels.
And, as for food, farmers have been shifting what they grow depending
on which grain prices are going up. But, there is little room left to
add acres unless conservation programs are completely abandoned.

The question then is this: Are we merely experiencing a cyclical,
albeit once-in-a-blue- moon event that will resolve itself in lower
prices for all the commodities that make our modern society
possible...or are we facing a long-term struggle for the declining
resources of the globe, a struggle that will potentially endanger our
lives and completely transform our society? The answer may be no
clearer than the moon when it plays hide and seek on a cloudy night.
On other hand, the moon that I can make out on such an evening
doesn't seem to be the least bit blue.