Considerable media attention has been given to the behaviour of commodity markets, notably the fall in crude oil prices, which according to some pundits “will continue for the foreseeable future and speculators are buying puts at USD 20 per barrel.” Other pundits, also keen to have their time on television, see “a return to prices of USD 70 per barrel” or some other figure above the spot market of the moment.
Oil prices are not alone in the spotlight. Gold is always centre stage. Now and again, coal and iron ore gain some attention, owing largely to their importance to Australian export earnings and the unclear state of the Chinese economy.
Depending on your choice of pundits, these price declines are either very good news (“petrol prices are lower so let’s go for a drive, and air fares will drop so we can fly abroad on holidays this year”) or alternatively they are very bad news (“job losses loom for North Sea oil workers.”) And North Dakota.
These recent declines do not surprise me, nor do they trouble me unduly. Why is that?
First, commodities, whatever they are - metals, fuels, agricultural products - are not an asset class. They are cost inputs. Land is an asset class, but not the products derived from the land, whether it be potash or pork bellies. You may know the joke about the lorry load of rancid sardines, changing hands at higher and higher prices until a would-be buyer opens a tin and complains. It ends with the punch line “Guv, these sardines are for trading, not for eating.”
Next, the market price for these cost inputs ultimately reflects their costs of production, plus a margin for entrepreneurial risk-taking. If you can do this at a low cost (think Saudi oil fields), you get a larger economic rent than the higher-cost competitor (think shale oil and deep fracking projects).
Successful mining and energy companies often say they only invest in projects whose costs rank in the lowest quartile of established sources. This excellent approach requires information about the cost curve for the commodity in question, data that are readily available.
When governments design national budgets based on export prices that are not achieved, or companies cannot repay their loans to banks who shared their expectations of high prices, the market is not to blame. The market is what it is, not what you might imagine it should be.
William G Prast
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