Frankel Revisited: The Problem of Supply

Frankel blames the rising cost of storable commodities on low interest rates, an explanation now gaining favor among a number of economists. This may not be the case. We may in fact be seeing something more ominous: real—or perceived—shortages, not contrived, not something that any monetary policy can mend easily, i.e., by increasing storage premiums.

The question is: How can we tell the difference between a real or perceived shortage and one that can easily be mended by simply changing an economic factor such as interest rates or storage premiums? If we fail to understand root causes and just tinker with monetary policy, we will be inviting dangerous repercussions.

While perceived shortages are as dangerous as real ones, I contend that the shortages are real, growing, and dangerous. In an earlier post, I argued that energy costs are rising in real terms. That argument I will extend to include the problem of supply, both in the near and long term.

Frankel’s Argument

Frankel explains his argument as follows:

High interest rates reduce the demand for storable commodities, or increase the supply, through a variety of channels:
– by increasing the incentive for extraction today rather than tomorrow (think of the rates at which oil is pumped, gold mined, forests logged, or livestock herds culled)
– by decreasing firms’ desire to carry inventories (think of oil inventories held in tanks)
– by encouraging speculators to shift out of spot commodity contracts, and into treasury bills.

Conversely, low interest rates do precisely the opposite: Increase the demand for storable commodities, or decrease the supply by

  • Decreasing the incentive to extract today what can be extracted tomorrow
  • Increasing firms’ desire to carry inventories (no longer as expensive to keep them)
  • Discouraging speculators

Frankel would certainly agree that other factors—such as the rice crop failure in Australia—can indeed affect prices, but he cautions that looking at one commodity is a mistake. Because we are seeing an across the board rise in all agricultural and all mineral commodities, we must look at a factor all share in common. That factor for him is lower interest rates. Jim Hamilton agrees.

How does Frankel arrive at his conclusion? He does so through two graphs. The first is a line graph charting the rise of all commodities between 2000 and 2008. It is the one I find of most interest.

Initial Problems with the Explanation

He does not chart interest rates here. For the U.S., interest rates dropped markedly between 2000 and 2003; then remained relatively stable between 2004-2007. A number of observations are of interest here:

  • Oil price is the one price that most closely tracks the “all commodity price index.”
  • Metals price seems somewhat out of whack with the other three, spiking sharply in 2006, only to drop and then rise again.
  • Around 2004 prices started to rise significantly; by 2005, they had begun to climb markedly; after a small, brief dip in 2006, they again escalated.

Energy Demands and Growth: The Real Problem

Oil is a central commodity; its price governs the price all of the others, especially agricultural commodities. While oil is important for the transportation of all goods, it plays an additional role in the production of many agricultural commodities, i.e., fertilizer and pesticides…. That oil tracks “all commodities” is, I think, no mistake. While interest rates do play a role in commodity prices, that is only the beginning of the story.

Most important is the following fact: In January 2008, the actual production of oil only slightly eclipsed the old May 2005 record, despite the fact many farmers, hoping to cash in on ethanol subsidies, used some of those crops—or land—to produce ethanol. Diversion of crop land is a form of extraction, to use Frankel’s terminology. Questionable ethanol subsidies aside, interest rates have not put a lid on this form of extraction.

In short, just at the time when energy demand is rising, we seem to be at a plateau in the production of oil.

Sadly, we are now in the position of having to use land itself to produce energy—and not food. That we now face food shortages should come as no surprise. We may well be bumping up against only one of the ugly realities that will face us this century: Not enough oil, something more dangerous, an energy shortage.

For those of you nautically minded, consider further some additional telltales:

  • Between 2004 and 2012, China plans to add 562 coal-fired plants – nearly half the world total of plants expected to come online. India could add 213 such plants; the US, 72.[9] Note the date: 2004, a year before the last peak in oil production.
  • Expensive and environmentally costly mining of oil is now an option (Tar Sands)
  • Increasing interest in and exploitation of alternate energy sources: wind, solar, nuclear.

Now consider the following:

  • In 2003, for every 1000 people, China consumed 4.96 barrels of oil each day. By 2005, it was consuming 5.009 barrels for every 1000 people. For a country of 1.3 billion, that is a significant rise in the demand for oil.
  • In 2003, India was consuming 2.18 barrels per 1000 people; by 2004, it was consuming 2.269.
  • In 2003, the U.S. consumed 68.87 barrels/1000 people.

Surely, the pace has quickened since 2005, certainly in both India and China, which, combined, account for almost a third of the world’s population.

It is no longer a question of whether there is sufficient oil lying undiscovered or untapped. Those arguments have little weight here. The speed at which both India and China approach the U.S. consumption levels has profound implications. Continued world growth is now in question.

Because of its importance, the price of oil is inelastic. Supply is running headlong into increasing demand, affecting not only energy and transportation but actual production of essential commodities. When we have to divert crop land to the production of oil, we know we are in trouble.