Saturday, May 27, 2006

Commodity Markets and Government Disruptions

In recent months, we have seen volatility in energy prices. Crude oil reached a peak of $75/barrel, but has now retreated below $70. Natural gas shows an even greater range, as it has now fallen to around $6/mcf, less than half the peak prices experienced this past winter.

Markets work. Higher prices drive changes in consumer demand, including conservation or product changes. For example, rental car companies now offer reduced rates on low-mileage alternatives, reflecting weaker consumer demand for gas-guzzling vehicles. Automakers are bringing to market more smaller, fuel efficient vehicles. On the supply side, higher prices create incentives for production, including the production of substitute goods. This all works wonderfully well if the process is not disrupted.

Unfortunately, politicians feel the need to disrupt these processes. The predominance of their own interests in preserving their power base, sometimes at the expense of the longer-term wellbeing of the republic, leads them to pander to what they perceive to be the popular demands in the marketplace. Targeting big business is good politics, even when the price increases are beyond their control. (An excellent piece in National Review Online by Thomas Nugent, reminds us that no one gave credit to the gas company executives when natural gas prices dropped dramatically. It can be found here:

Recently the FTC produced a report that showed that oil companies were not manipulating the marketplace or behaving inappropriately in connection with recent increases in gasoline prices. (Drs. Goss and Thompson and I showed the same thing in Nebraska in a report published by the Nebraska Attorney General’s office this past January.) However politicians of both parties, including longstanding supporters of the industry, could not resist the opportunity to wave cautionary flags (at the least) or continue bashing oil company executives.

Sometimes the disruptions come indirectly, though, through choosing the next alternative source of technological innovation or substitute product. We have been critical on these pages over tax incentives and credits for hybrid vehicles, which do not make economic sense even at these gasoline prices. However, tax credits for purchase make it easier for people to make the statement that they are “green” and supporters of a cleaner environment and for makers of these vehicles laugh all the way to the bank -- all at taxpayers' expense.

Ethanol production has gained significant political clout as oil prices have increased and politicians want to claim credit for providing the solution. (As previously discussed, attempts to claim credit for job production are laughable. Yet this persists, as shown on the front page of today’s Omaha World-Herald. The Iowa edition highlights the clash over job-creation claims by democratic gubernatorial candidate.) Senator Grassley, ever sensitive to the corn-growing significance of Iowa (which used to be known as the “Tall Corn State”), is now being joined by his colleague across the aisle, Senator Clinton. (Hmm, could this have anything to do with the Iowa caucuses? Or are they planting corn in New York?) (The Des Moines Register story on Sen. Clinton's change of heart can be found here:

Ethanol is a nice idea, as it does create a fuel from a renewable resource that is readily available. Moreover, the production process creates byproducts, including animal feed, that are useful (and in fact, feeding animals is a big part of the reason we grow so much corn.) The run-up in petroleum prices may even make this economical – but for the most part government incentives are propping up this production over the longer term. While this production provides a boost to rural communities and increases corn prices, one wonders about the long-term effects of this distortion of market forces. In the long-run, ethanol is probably not a viable substitute good for petroleum, particularly if oil prices moderate as many expect will happen.

In the meantime, corn producers will likely reap some benefits from the establishment support of the ethanol bandwagon. Corn markets are affected by many factors, including weather and export demands, and longer term futures prices for corn have increased significantly over the past several months. (A chart available at the Chicago Board of Trade site ( will show this graphically - but I cannot figure out how to paste it in blogger. ) Decembe 2007 corn - a crop that will not even be planted for another 11 months, has risen from the $2.50 level in Marcy 2005 to $3.11 today. The strong upward trend suggests what the market believes about this commodity. If oil prices continue their slide, it is not at all clear that the emphasis on expanding ethanol will persist. This current situation may present some hedging opportunities for corn producers, who can lock in significant profits at these price levels.


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