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Why Commodity Bubbles ALWAYS Burst

By Charles Sizemore⋅ February 2, 2010 ⋅ ⋅ Post a comment

Harry Dent and many, many other analysts over the years have written volumes about the nature of cycles in commodity prices. To summarize those volumes in one paragraph, commodity bubbles are always self defeating. Once a valuable commodity becomes prohibitively expensive, market mechanisms correct the imbalance in a couple of different, complimentary ways:

High prices lead to reduced usage (setting the air conditioning at 80 degrees instead of 75, for example)
High prices lead to efficiency drives (think insulation in homes and increased fuel efficiency in cars)
High prices lead to substitution effects (switching from gasoline to diesel in your choice of car or from steak to chicken at your dinner table, for example)
High prices lead to new sources of supply being searched for and found (consider Brazil’s enormous recent oil discoveries in the Atlantic)

These adjustments do not always happen overnight, of course. Depending on the rate of technological change and other factors, some supply/demand imbalances can persist for years or decades, and sometimes the points above can conflict with each other. One example is rubber. Rubber is an expensive commodity to harvest, and substitution effects only go so far — artificial rubber is not as durable as the natural variety and requires crude oil as a primary ingredient. Crude oil, as we all know, is subject to its own wild price fluctuations.

This is what the Economist had to say on the matter:

Despite the invention of synthetic rubbers, there is often no good substitute for the real thing, for nothing artificial yet matches natural rubber’s resilience and strength. This is because natural-rubber molecules, the product of a stepwise synthesis by enzymes, have a more regular structure than the artificial ones made by chemical engineering. Around a fifth of an average car tyre is therefore made of natural rubber. In an aeroplane tyre that figure can be more than four-fifths. Moreover, the price of synthetic rubber is tied to that of the oil from which it is made, rendering it vulnerable to changes in the oil price. Because oil is likely to become more costly in the future, natural rubber looks an attractive alternative from an economic point of view as well as an engineering one. — from “Blow Out,” January 2, 2010

One of the benefits of living in this modern era is that technological innovations happen at a faster clip than in centuries past. The same Economist article reported on a new form of natural rubber extracted from dandelions, of all things. If successful, the world will have access to virtually limitless amounts of high-quality natural rubber.

Will it work? We have no idea, of course. We’re not industrial scientists. But the efforts of these scientists gives us hope that the boom and bust cycle of commodity prices will always persist. Capitalism and the innovation that it fosters will always find a way to eliminate supply bottlenecks and lower commodity prices in real terms.

So are we already experiencing “peak oil,” as some analysts worry? Frankly, who cares. When the price of oil rises to the point that it starts to significantly cripple economic growth, we’ll start fueling our cars with natural gas.

Charles Sizemore, CFA

Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy

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Discussion

5 comments for “Why Commodity Bubbles ALWAYS Burst”

Very nice points.

“So are we already experiencing “peak oil,” as some analysts worry? Frankly, who cares. When the price of oil rises to the point that it starts to significantly cripple economic growth, we’ll start fueling our cars with natural gas.”

See, This is the problem! Market forces will work out any imbalance, real, percieved or created. Even the NBA and NFL and MLB suffer through this effect.

Too many of my liberal friends and my children simply ‘feel’ that health insurance is too expensive or that corporate greed causes flat wages. They don’t see the big picture at all. My kids attended Amherst, Columbia, NYU, UMASS which could explain alot.

Can we bust and boom on our educational system?

They never seem to run out of need of my support. Perhaps because I don’t give them enough. I expect them to walk on their own now that I have provided through a greedy corporate structure the means for them to earn a decent living and contribute to my social security check - which I will take as soon as I can

High wages, even at the minimun level, lead to greater productivity through advanced technology and outsourcing. Hmmm. Wall Street bonuses? Or maybe they are not high enough yet!

Posted by rankin.douglas | February 3, 2010, 2:26 am
Thanks, Rankin. I agree completely. Regarding health insurance, this issue is a major frustration to me. One of the reasons that insurance is so expensive is that the tax code that incentivizes private employers to provide it creates distortions that raise the price for everyone else too. This is not a “market problem” as many liberals believe, but a problem caused by well-intentioned but flawed regulation. If you eliminated the corporate subsidy for insurance and made it taxable like all other wages, the market would have a chance to work its magic and lower prices. Unfortunately, I think this will have to remain hypothetical, because no one in congress would vote for such a thing. VERY frustrating..

CLS

Posted by Charles Sizemore | February 3, 2010, 8:51 am
“So are we already experiencing “peak oil,” as some analysts worry? Frankly, who cares. When the price of oil rises to the point that it starts to significantly cripple economic growth, we’ll start fueling our cars with natural gas.” - CS

I think we should care. The cost of energy encompasses many more things than the what is paid out to fuel cars. For example, the manufacture of goods and the extraction of raw materials to make those goods. … Also as the oil supply lowers and it’s price rises, the price for natural gas will also naturally rise, all the more so to the extent that the technological infrastructure is in place to use it to fuel vehicles.

Posted by Neophyte999 | February 3, 2010, 1:44 pm
[…] These adjustments do not always happen overnight, of course. Depending on the rate of technological change and other factors, some supply/demand imbalances can persist for years or decades, and sometimes the points above can conflict with each other. One example is rubber. Click here to continue… […]

Posted by Why Commodity Bubbles ALWAYS Burst « Financial Commodity Investments (FCI) Alternative Investments/Managed Futures Blog | February 3, 2010, 4:47 pm
Something else occurred to me after rereading the original CS post. I understand and agree with the author’s four corrective market mechanisms as far as they go ingenuity, but later on he goes on to say: “Capitalism and the innovation that it fosters will ALWAYS find a way to eliminate supply bottlenecks and lower commodity prices in real terms.” I capitalize “always” as I think there is a combination of three factors which neither man’s ingenuity or other natural market corrective mechanisms can perpetually continue to overcome: 1.) an ever increasing world population. 2.) an ever increasing desire around the globe for higher standards of living through material goods 3.) an ever decreasing supply of raw materials GENERALLY. On the last one, it’s not just that energy sources are depleting dramatically, as I understand it so are the various other non-renewable materials. Plus as I previously stated in my first comment the extraction of these materials requires energy in the first place. The market is ingenious and so is man but I submit that the limited supply of resources puts a ceiling on all corrective mechanisms.

Posted by Neophyte999 | February 4, 2010, 4:13 pm