Distortions in Commodities Markets: 2008 Oil Bubble

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"Commodities rise with inflation. . .if the markets for commodities are free from distortion"

Recently, I received a letter from an asset management firm. The letter was to inform clients about the firm's investment strategies for the future.

They repeated the widely held belief in the inevitability of inflation. The strategy they suggested was investing in commodities. Their reasoning makes sound economic sense.

"During periods of inflation, prices of commodities - and companies that mine, refine, or produce them - tend to rise." Logical but wrong.

The premise that commodities rise with inflation is correct if the markets for commodities are free from distortions. They are not.

In the past few years we have seen and continue to see bubbles in commodities markets that have nothing to do with inflation. They have to do with distortions and inefficiencies that are now all too common in global markets.

Let us start with the oil bubble. From 2002 to 2007 the price almost doubled from $30/barrel to over $60.

In late 2007 the Chinese began to have a problem. China's state-owned oil companies had to buy petroleum products at market prices and sell them at fixed prices. As the gap began to rise, so did the pressure on supplies.

Both stockpiling and price increases were illegal, but occurred anyway.

As the market price of oil began to sky rocket, so did the costs of the price controls. The gap between international and domestic prices—about 20% for petrol and 40% for diesel—cost the Chinese government estimated $27 billion or about 4% of the budget according to an HSBC estimate. Many other countries had similar policies and problems.

With all commodities, supply is less elastic than demand. The synchronized buying by the Chinese based on political orders spilled over into the international market.

In May (2008), China became a net importer. The result became a speculative frenzy—exacerbated by lack of transparency.

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