Yves here. Yours truly is not alone in comparing the strange time we are in to the phase of a tsunami when the ocean recedes far from the shore before a monster wave sweeps in, overwhelming everything in its path. Unless you’re familiar with the pattern, the water receding just looks odd, against a dire warning of the need to get high ground as soon as possible. This article explains why the deceptively calm economic phase, here as indicated by the relative volatility of commodity prices relative to widely expected deficits, is set to end, and it’s not going well.
Written by CityAM.com the online presence of City AM, London’s first free daily business newspaper. Cross posted from OilPrice
Commodity markets have spent the past three months doing unusual balancing act. Despite some notable disruptions to global energy flows in decades, the global economy has continued to operate remarkably smoothly. After the initial rate hike, prices of several key commodities have stabilized or declined. Yet this apparent calm is deceptive. The reason the system is holding together is because governments, producers and consumers are pulling down the barriers that normally protect the global economy from disruption. Those buffers are now approaching dangerous limits.
Inventory is being reduced at an amazing rate. Oil reserves around the world have fallen to levels that industry executives describe as unprecedented. Aluminum markets are facing similar pressures. Bloomberg recently calculated that the combined stocks tracked by the London Metal Exchange, CME Group and Shanghai Futures Exchange would include less than five days of global supply.
The dramatic recovery in commodity prices reflects the fact that the global economy has proven to be more volatile than many expected. Strategic reserves have been used on a large scale. The United States and Japan have both pulled oil from emergency stocks to prevent supply losses. US jet fuel emissions have reached record levels. Even China has managed to reduce crude imports without any apparent decline in its fossil fuel reserves, a recent report from the Oxford Institute for Energy Studies suggests is due to changes in refinery yields and industrial flexibility. In fact, China has been introducing greater flexibility into its industrial system rather than relying solely on outsourcing.
All of these developments show the market reacting in the same way that economic theory would predict. When key inputs become scarce, producers seek alternatives, inventories are reduced and available capacity is pushed hard. These changes can be very effective. They buy time. But time is ultimately what assets represent. Every barrel taken out of storage, every ton taken out of storage, and every industrial process in use today simply postpones the time when supply and demand must be realigned.
The US Strategic Petroleum Reserve is an example. The United States entered the crisis from a much weaker position than previous energy shocks. Having reached a peak of more than 700 million barrels in 2010, the SPR had already been reduced by almost a third before the unrest in the Middle East began. Recent releases have helped stabilize markets, but they have done so by using the very buffer that exists to absorb future shocks. The important question is not whether the SPR can technically be eliminated. It won’t. The more important question is whether markets are beginning to doubt that policymakers have enough money to continue to stave off disruption indefinitely. Once that confidence is gone, the existence of underground barrels is less likely than the idea that the greenhouses are running out.
At some point, arithmetic becomes inevitable. The world cannot forever consume more material than it produces. Tactical caches can only be issued once. An inventory can only be drawn once. Filters can only be reconfigured so far. Eventually, the general framework of supply and demand begins to reassert itself, and a new equilibrium must emerge between available supply and desired consumption.
Seek Destruction
Economists have a neat name for this process: destruction of demand. The truth is very painful. Destruction of demand occurs when prices rise to a level that forces consumers and businesses to reduce their consumption. Households spend more on fuel and less on everything else. Airlines cut routes. Manufacturers are holding back on investment. Energy-intensive industries reduce production. Consumption does not fall because people choose to eat less but because high prices leave them with no other choice.
This is why inventory levels are so important. As long as the stock is still there, markets can reverse the correction. Once they are depleted, prices become the primary means by which balance is restored. Neil Chapman, senior vice president at ExxonMobil, recently described the situation with unusual candor. He pointed out that oil prices are still unclear because inventories have been reduced. Yet those ranges are now approaching levels rarely seen in today’s markets. Once those barriers disappear, economies change rapidly. As Chapman puts it, “the model will say Brent will rise” to $150 or $160 per barrel.
Most governments will certainly try to protect consumers from the consequences. Tariffs, subsidies and emergency funds are politically attractive when energy costs rise. However, such measures do not eliminate hidden economic losses. They simply redistribute. If consumers are protected from higher costs, then taxpayers, bondholders or investors must absorb the costs instead.
Japan provides the first illustration of this dynamic. The government has proposed more financial support while at the same time insisting that it will not require higher borrowing in a calendar year. The markets seem skeptical. Yields across the Japanese government bond curve have risen as investors try to pinpoint where the cost of this intervention will eventually fall. The pressure did not disappear; it is simply transferred to another location within the program.
This is the uncomfortable reality facing policymakers around the world. No financial engineering solution can replace the missing oil barrels. No accounting adjustment can create a non-existent aluminum inventory. No subsidy can turn a scarce commodity into an abundant one. The shocks from the Middle East are real, and while the global economy has responded admirably with swaps, efficiency gains and devaluations, these measures are temporary rather than permanent solutions.
When inventories become too low, markets force a new equilibrium. And the new equilibrium in the poor world means what it sounds like: higher prices, lower consumption and lower living standards. Stock markets do not predict a poor country. They enforce one.
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