If you want to see two examples of demand creation and destruction that helped first raise up then hammer down crop and commodity prices, just look at the BDI and two big ethanol plants in North Dakota.
The BDI is the Baltic Dry Index, which is a measure of what it costs to rent a cargo ship. From over $100,000 per day at the commodity price peak – far more expensive than allowed within its historic range – it collapsed to, in some accounts, zero.
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Prices had been softening for most of the previous month, but heading into the Labour Day long weekend, the price drops were startling.
That’s right – zero. Some shipowners were actually taking on cargoes for free just to keep the vessels operating, according to reports. The BDI didn’t show that final plunge in values, although it did reach down to about $5,000/day. It’s recovered somewhat from there, but is still many times below where it was less than a year ago.
That swing way high and now down low is due to the massive inflation in commodity demand that occurred until mid-summer 2008, then suddenly evaporated.
The world’s economies were so greedily sucking up coal, steel, grain, potash that ship operators could crank up their prices to almost unbelievable levels and still get people lined up to pay them.
When the worm turned, and the economy went bad and the world’s financial system crashed, all that demand evaporated and the shipowners could find no-one to rent their formerly sought-after vessels.
It’s a great example of how demand is a far less firm feature than many economists and analysts like (and need) to accept. It’s one of those “does not compute” events that throw out all the programming of reasonable expectations. It’s that “19 times out of 20” disclaimer that is added to most surveys to explain why sometimes they are completely wrong. If demand can collapse this greatly and this fast, are any demand assumptions in a year like this anything more than a crapshoot? That real demand for shipping was produced, in part, by Chinese investors’ perception that the ever-growing U.S. economy would consume whatever the factories they built with the shipped-in steel produced. That perception has gone and so has the demand for the ships.
Another great example of demand creation and sudden destruction is the two non-functioning ethanol plants in North Dakota. At a presentation to the Keystone Agricultural Producers in Winnipeg, North Dakota Farmers Union president Robert Carlson noted that two brand-new, 100 million gallon per year plants are sitting idle in his state, never having been put into production because in between construction being started and completed, oil prices collapsed and made it impossible to operate the corn-based facilities at a profit.
The building of dozens of plants like this across the United States was part of what drove crop prices through the roof – the expectation of big new demand drove fearful and speculative buyers into a frenzy of buy-now-before-it’s-too-late with corn and other crops. It wasn’t the actual, real world demand of plants actually buying corn that always drove the prices, but the expectation that new demand would appear and create a shortage.
It was perception-based, and in this year of suddenly reversing perceptions, assuming anything is questionable looking forward.
That’s a situation financier George Soros discussed in his book, The Credit Crisis of 2008 and What it Means. Soros has made billions of dollars from observing how far out of whack perceptions can become about supply and demand, and by how poorly economic forecasters have tended to understand the perceptual basis of supply and demand.
I’ll let him talk for himself:
“The shape of the supply and demand curves cannot be taken as independently given because both of them incorporate the participants’ expectations about events that are shaped by their own expectations. Nowhere is the role of expectations more clearly visible than in financial markets. Buy and sell decisions are based on expectations about future prices, and future prices, in turn, are contingent on present buy and sell decisions.
“To speak of supply and demand as if they were determined by forces that are independent of the market participants’ expectations is quite misleading. Demand and supply curves are presented in textbooks as though they were grounded in empirical evidence. But there is scant evidence for independently given demand and supply curves. Anyone who trades in markets where prices are continuously changing knows that participants are very much influenced by market developments. Rising prices often attract buyers and vice versa. How could self-reinforcing trends persist if supply and demand curves were independent of market prices? Yet even a cursory look at commodity, stock and currency markets confirms that such trends are the rule rather than the exception.”
“The very idea that events in the marketplace may affect the shape of the demand and supply curves seems incongruous to those who have been reared on classical economics. The demand and supply curves are supposed to determine the market price. If they were themselves subject to market influences, prices would cease to be uniquely determined. Instead of equilibrium, we would be left with fluctuating prices. This would be a devastating affairs. All the conclusions of economic theory would lose their relevance to the real world. It is to prevent this outcome that the methodological device that treats the supply and demand curves as independently given was introduced. Yet there is something insidious about using a methodological device to obscure an assumption that would be untenable if it were spelled out.”
Soros then goes on to explain how the theory of rational expectations was erected to deal with this problem and how, in his mind, its answer – that individual participants might be confused by their own perceptions but that the market as a whole would perfectly reflect the true underlying supply and demand situation – is completely wrong. Here’s what he says:
“Rational expectations theory seeks to overcome this difficulty by claiming that the market as a whole always knows more than any individual participant – sufficiently so that markets manage to be always right . . . I have considered this interpretation so far removed from reality that I did not even bother to study it. I have worked with a different model, and the fact that I have been successful using it makes nonsense out of rational expectations, because my performance far exceeds what would be a permissible deviation under the ‘random walk’ theory.”
Soros might be a little harsh with the academy of economists, and he may oversimplify the nuances of modern economic theory, but his view is worth considering in this year in which none of the best forecasts of mainstream economists has been anywhere near correct. For farmers right now, assessing how much demand will likely be out there after the new crop is harvested is essential. But getting some sense of how much of last year’s apparent demand was use-based and how much was perception-based, and how much of the use-based demand was a product of perceptions of an ever-growing demand in the future isn’t going to be easy for anyone right now.
How much demand has been destroyed by last year’s peak and plunge? No one knows yet, but the BDI and those ethanol plants in North Dakota give a pretty powerful hint of the situation right now. If the BDI stays down and ethanol plants continue to sit idle and others continue to be closed, it’s going to be a signal that a lot of demand isn’t coming back soon. If the BDI keeps rising, and oil prices go up and some of those shuttered and never-opened ethanol plants go into production, it’ll be a sign that some of last year’s demand is seeping back into the market.
