Why oil traders got caught out by the commodity cycle - again
The inherently cyclical nature of some commodity prices has fascinated economists since the late 19th century, but still continues to catch both investors and producers unprepared.
Regular and apparently self-sustaining price cycles were first observed in the price of hogs in the United States and Germany in the final quarter of the 19th and first quarter of the 20th centuries.
Economists in Italy, the Netherlands and the United States separately published theories in 1930 to explain why prices cycled up and down regularly rather than settling at an equilibrium level.
Cambridge economist Nicholas Kaldor likened the pattern to a spider’s web, giving rise to the popular name for cobweb models.
Mordecai Ezekiel, an agricultural economist working for the US government, published a paper in 1938 entitled "The Cobweb Theorem" , which remains the clearest and most persuasive explanation of commodity market cycles.
Economists from the ultra-rationalist University of Chicago subsequently developed a model of commodity cycles consistent with rational forward-looking behaviour.
But it is backward-looking expectations about prices coupled with the delays in adjusting supply that provide a good explanation for the deep and recurrent cycles in the oil industry.
Deep price cycles are inherent in capital intensive industries like oil and mining
In the first few years of the 21st century, painful memories of the long period of low prices in the 1990s held back plans to expand production even as prices surged.
More recently, the production and investment plans of the major oil companies and US shale drillers appear to have been based on the assumption the period of ultra-high prices experienced since 2011 would be sustained indefinitely.
The availability of oil supplies in the early 2020s depends on investment and hiring decisions being made now, just as the availability of oil supplies in the mid-2000s was heavily influenced by reduced investment and layoffs of skilled personnel a decade earlier in the 1990s.
Deep price cycles are inherent in capital intensive industries like oil and mining, and exacerbated by the tendency to project fairly recent conditions into the far future.
Yet the desire for some sort of stability remains deeply ingrained among commodity producers and even some consumers.
As a case in point, Opec’s founding statute, from 1960, commits the organisation to "devise ways and means of ensuring the stabilization of prices in international oil markets with a view to eliminating harmful and unnecessary fluctuations".
In fact, Opec has never managed to stabilise prices, and there are good reasons to believe it never will given the characteristics of the oil industry (long investment lead times coupled with extreme uncertainty about future prices).
Opec’s fondness for stable (high) prices is shared by Glencore’s chief Ivan Glasenberg. Glasenberg has blamed rival coal and iron ore producers for over-investing during the boom years and creating the conditions for a supply-driven slump.
Glasenberg has repeatedly called for a more "disciplined" approach to investment in future, as if the commodity price cycle was somehow voluntary and driven by ill-considered management decisions.
Glasenberg might as well wish for the moon. Deep price cycles are normal in capital-intensive resource industries, and there is nothing he or anyone else can do to eliminate them.
US shale producers, Opec and the rest of the petroleum industry are currently getting a brutal reminder. Until recently, many seemed convinced oil prices would find a floor close to US$100 per barrel.
Now most oil industry leaders have been forced to adjust their expectations and investment plans to assume prices will remain lower for longer.
This is almost certainly an over-reaction to recent price moves and will set the stage for the next stage in the cycle when investment and production prove inadequate.
In the meantime, however, new production is still coming onstream as drilling and investment programmes agreed in 2013 or even before are only now coming to completion.
Prices will remain under pressure, even as many analysts, investors and business leaders wonder if they have not already fallen too far.
But commodity markets have always operated that way. Instability and disequilibrium, rather than the opposite, are the norm.
Reuters
