INVESTING: Law of supply and demand wreaks havoc on oil prices

June 2, 2008

One of the first things a student in Economics 101 learns is the fundamental concept of supply and demand.

Who can forget those familiar graphs that show the two crossing curves and the critical point where they intersect-the price of the particular good. Next, we learned the effect of shifts in supply and demand, which lead to either an increase or decrease in price. Visually, those graphs allowed us to see how an increase in demand, without a commensurate increase in supply, would cause the price of a good to rise.

This phenomenon is on full display in the commodity markets these days, namely with the ceaseless rise in the price of oil. Oil prices have more than doubled over the past year, causing the price of gasoline and diesel to skyrocket. One index comprising 19 commodities-including metals, coffee and corn-has risen 31 percent over the past 12 months. Corn prices have nearly doubled in the past year and are at their highest level since the Civil War.

These rising costs are squeezing companies and consumers alike. Think of your household budget like a corporation, You Inc. You's cost of goods sold (expenses like fuel and food) is rising faster than You's income. The result is that profit margins are shrinking (leftover cash available for savings is going down). These rising costs are clearly starting to affect the behavior of consumers and corporations and causing a slowdown in the U.S. economy.

Some observers maintain that commodity prices have been artificially boosted by speculators, such as hedge funds, and claim there is a bubble in commodity prices. For example, some analysts have suggested that the true value of a barrel of oil is around $70, instead of the current market price of $130.

There certainly could be some fluff in the price of commodities. However, because we have witnessed a couple of other bubbles in recent times, both in Internet stocks and housing, we should be keenly aware that overpriced markets can rise much higher and continue much longer before cracking and reverting to mean price levels. How much speculation is in commodity prices? Low margin requirements in commodity futures do allow speculators to leverage their holdings in a commodity with a relatively small financial commitment.

The ripple effect of higher commodity costs eventually works its way through a company's operations and typically leads to higher prices for their products. We all have heard about fuel surcharges, but how about Dow Chemical's recently raising the prices on its products an average of 20 percent?

The odd effects of changes in supply and demand can be seen in the rice market. A global staple in less developed economies, rice has seen a tripling in price over the past two years. The rising cost of fertilizer, seeds and pesticides has doubled the cost of cultivating rice for a farmer in India. So farmers are switching crops to grow rubber plants, which are now twice as profitable as rice. Exacerbating the price rise, the Indian government is banning rice exports to conserve the grain for its own population.

Others blame government policy for the stinging effects of shifts in supply and demand. Critics of the Federal Reserve contend its weak dollar policies are contributing to high commodity prices. And government subsidies for ethanol have been blamed for the high corn prices.

High commodity prices appear here to stay in the near term. And the shifts in their supply and demand will exert their pull on our economy.

Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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