The commodity “bubble” gets bigger

Much talk has been made in recent months about the commodity bubble, and when we will see the prices of oil and corn fall back from their current all-time highs. Not only has the recent rise been attributed to speculation, but market forces were also expected to ease the upward trend. Among these expectations was an increase in oil output in response to record prices and an increased corn yield in response to demand for ethanol and rising meat consumption in the developing world. Unfortunately, supply is tight enough in both markets to make i difficult for this simple solution to come to fruition.

Before the flooding this week, weather in Iowa had already seriously lowered expected yields. Earlier this week, the USDA dropped their estimates for this year 3% from 12.1 billion bushels to 11.7 billion bushels or about 390 million bushels. In response to this news and the continued flooding of the region, corn futures rose to record prices for seven straight days, closing at 7.3175 on Friday. The USDA is releasing a new crop acreage report on June 30. We will see how high prices rise with some predicting $8/bushel. Soybeans and wheat futures also rose in Friday trading, with soybeans near all-time highs. Is this caused by a bubble, or real issues of supply and demand reflected in the market? I think the answer is clear.

Rising corn prices will not only have an impact on food prices, but also the viability of ethanol. It is estimated that at current prices, corn is roughly 76% of the cost of producing ethanol. This environment could cause many ethanol producers to shut down, putting even more pressure on gasoline and crude oil.

Oil also maintained its place in the $135 area this week, closing at $134.86. There are significant concerns of supply and demand as major oil fields deplete and the world demand continues to rise. Regardless of levels of production, net exports to the US have fallen in the past year. April imports were down 2.5% from a year ago. Increases from Iraq and Nigeria were able to offset a large portion of the decline seen from other exports such as Algeria, Mexico and Venezuela. In a previous post we briefly discussed the possibility of Nigeria helping to offset the declines seen in Mexico and other exporters. Iraq will also be an important swing producer which will be necessary to keep imports near current levels. Conditions on the ground will the the determining factor as to whether Iraq can significantly increase production.

The third largest exporter, Saudi Arabia, is also capable of temporarily increasing production by as much as 3 million barrels/day by 2009, for a total capacity of up to 12.5 million barrels/day. The Saudis project to maintain 1.5 to 2 million barrels of spare capacity to meet any supply shortages. Late yesterday, it was announced that that the Saudis are planning to increase production by a further 500,000 barrels/day after increasing about 300,000 barrels/day from last month. How much of that oil will go to the United States? According to the EIA, 19% of Saudi crude exports went to the US in 2005, with roughly 50% going to the far east. Using the same proportion, roughly 100,000 additional barrels/day would be available.

We will see next week what impact this has on oil futures, and whether supply concerns will persist. Saudi Arabia will likely have to prove its ability to increase production before the market eases. The net impact may also be negligible if other nations such as Mexico continue to slip in production, and the share of imports coming from volatile regions such as Iraq and Nigeria increases. With these facts coupled with the concerns over ethanol, it does not appear likely that oil futures will be making any sort of return to previous levels. After all, this is clearly a supply and demand issue, no matter what the nightly news may tell you.


3 Responses

  1. Supply and Demand Sets Oil Prices – If You Believe That, I have a Bridge in Brooklyn I Want to Sell You!

    Next time you have to buy diesel fuel, home heating oil or $4 plus gasoline. Ask yourself this question: Are crude oil, heating oil and gasoline necessities, or just ordinary speculative commodities? If they’re the former, how can they be the latter? How can anyone buy into supply and demand setting oil prices when the markets are overwhelmed by everyone from small speculators, to institutional investors, to commodity index funds and large hedge funds and to Wall Street banks buying massive amounts of oil contracts? We also have the b.s. of “geo-political” concerns and government disseminated bogus “inventory” numbers. More on these factors at

  2. The speculators act the keep the market efficient, they don’t set the prices. I think the geopolitical and inventory numbers have an amplified effect due to it being such a tight market. Are any institutional investors longing oil and storing it away somewhere, taking a large amount off the market? No. Are we seeing more bearish bets than bullish bets on oil futures? Yes. Speculators by their sheer size are not going to have no impact on a market, but they are not going to set prices for the medium-term.

  3. […] That is wrong in many, many ways. There is no such thing as ‘normal’ supply and demand when we have been continuously using more oil, and intertemporal supply is limited to how much there is in the ground. Inflation has been growing in a number of developed nations, and far more steeply in the developing world, but the rise in nominal oil prices is shockingly higher than the rise in everything else, even though energy is often used as an input. Certainly, money supply is not the main problem, and to the extent it is a problem, it is a simply a contributing factor to the larger problem of too much demand. Saying that oil prices are an issue of weak money and not demand is a nonsensical, semantic-heavy argument. The speculation part of the argument has already been addressed on this blog, and needs no further debunking (see here and here). […]

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