The Lithium version of OPEC

A lithium cartel is being considered by Argentina, Chile, Bolivia and Brazil as electric vehicle (EV) market grows and with it the demand for mined lithium to turn into batteries. Bolivia, Chile and Argentina share part of the region which is rich in lithium reserves – known as the lithium triangle. Although Brazil is still establishing its extraction process, they do have experience in car manufacturing with low carbon emissions with the use of ethanol, biofuels and natural gas. With the opening of its Grota do Cirilo lithium mine in April, Brazil will have one of the few companies globally that has proven its ability to produce lithium in an environmentally sustainable manner.

Argentina is expected to produce 16% by 2030 that is up from 6% in 2021. They would overtake Chile as the No. 2 lithium producer in the world by 2027, behind only Australia.

A cartel could mean a higher cost for lithium which would then be passed onto EV buyers which could reduce the demand for EV cars. But a higher price could encourage a cheaper substitute material sodium-ion batteries for the EV market. However the cartel would most likely increase supply with a commitment from member governments. Below is a short video from the FT on the future of the lithium supply chain and how China controls about 60 per cent of global lithium processing. There is also mention of Latin American countries and their contribution to the global supply.

A2 Level Economics – Cartel notes.

A cartel operates in the Oligopoly market. It is a mistake to believe that ALL oligopolists face a KINKED DEMAND CURVE. Oligopolists may either:

• a) COMPETE VIGOROUSLY or
• b) COLLUDE (e.g. in cartels) or
• c) PLAY SAFE (as in Kinked Demand Curve Theory)

Collusion in oligopoly

Where oligopolists agree formally or informally to limit competition between themselves they may set output quotas, fix prices, or limit product promotion or development. A formal collusive agreement is called a cartel. A cartel can achieve the same profits as if the industry were a monopoly. Covert (formal) collusion occurs where firms meet secretly and make decisions about prices or output. Tacit (informal) collusion is much more difficult to control. This is when firms act as if they have agreements in place without actually having communicated with each other.
Collusion between firms whether formal or informal is more likely when:

• there are only a few firms in the industry, so reaching an agreement is easier and any cheating can be spotted quickly.
• they have similar costs of production and methods of production making any agreement on price easier to reach.
• the firms produce similar products. Cartels have been common in industries such as cement production in recent years.
• the products have price inelastic demand meaning that a rise in price by the cartel will lead to a rise in sales revenue for the firms.
• the laws against collusion in a country are weak or ineffective.

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Green economy – who are the winners and losers?

The Economist had a piece in their Finance and Economics section on the new energy superpowers. As the world attempts to switch to cleaner energy sources – the International Energy Agency (IEA) forecasts that wind and solar could account for 70% of power generation by 2050. This means a huge increase in demand for copper, lithium, nickel, cobalt etc. Who are the winners and losers from the move to green energy?

Invariably with any economy being able to exploit a natural resource there is the danger that investment is channelled into a commodity to the detriment of diversifying their economy. Economists refer to this as the Dutch Disease which makes reference to Holland and the discovery of vast quantities of natural gas during the 1960s in that country’s portion of the North Sea. The subsequent years saw the Dutch manufacturing sector decline as the gas industry developed. The major problem with the reliance on oil is that if the natural resource begins to run out or if there is a downturn in prices, once competitive manufacturing industries find it extremely difficult to return to an environment of profitability. See flow chart below.

According to the UN a country is dependent on commodities if they are more than 60% of its physical exports – in Africa that makes up 83% of countries. One of the major concerns for resource rich countries is the wild fluctuations in commodity prices which can lead to over investment – Sierra Leone created two new iron-ore mines in 2012 only for them to close in 2015 as prices collapsed. However the amount of jobs created in the mineral extraction industry is limited – across Sierra-Leone of 8m people, about 8,000 work in commercial mines. A major problem in these countries is that when there is money made from resources it tends to go on government salaries rather than investing in education. infrastructure and healthcare etc. The flow chart below outlines the problems of resource dependence.

Source: The Economist – The New Superpowers – March 26th 2022

Fossil fuels – not going away soon.

Following on from my previous post on COP26 you have to ask if there has been any move away from fossil fuels and what is the likelihood that there will be some reduction in their use.

Thompson Clark of Mauldin Economics made some good points on his Smart Money Monday article. Even with the investment being put into green energy stocks the performance of them compared to traditional energy stocks has been interesting to say the least – see graph below.

TAN = solar and green energy stocks – dropped 20%
XLE = traditional energy companies (Exxon, Chevron) – increased by 44%

Oil prices have risen to over $80 a barrel (see graph) which in turn has led to the US releasing 50m barrels of oil — about 2.5 days worth of US oil consumption. This comes as Saudi Arabia, Russia and other members of OPEC have rejected pleas to pump more supply into the market. Furthermore with the drilling bans in the US this summer this will only further limit the supply and therefore push up the price. For the move to a more green energy environment there needs to be more available supply of solar etc to quell the demand for fossil fuels.

Today 83% of the world’s energy supply comes from oil, gas and coal and there is no real change in consumption patterns. With supply pressures (no drilling) and demand (people coming out of lockdown) stocks in oil companies should continue to perform well.

Carbon Footprint – NZ v UK primary industry

Useful video on Food’s true carbon cost from the FT last year – mentions New Zealand apples being sold in the UK not necessarily having a greater global footprint. Apples kept in cold storage would cause a greater carbon footprint than apples being shipped from New Zealand.

Previously food miles (the total distance traveled as food is transported from its place of origin to the consumer’s plate) was one measure of the global footprint and New Zealand is particularly vulnerable due its large quantities of agricultural exports and its geographical isolation. However, transport had been taken out as it was difficult to single out one part of the food system and conclude that because it has come from thousands of miles away it is automatically less sustainable. Therefore, the food miles argument for favouring domestic produce was only valid if food is produced using identical processes around the globe.

In order to reduce CO2 emissions, merely taxing imported food can’t be seen as the answer. As CO2 is emitted at roughly all stages of the process of transporting food to the dining room table, an appraisal of the environmental cost of devouring food from different countries should assess CO2 emissions throughout the product’s complete lifecycle. Stages in a food’s lifecycle include sowing, growing, harvesting, packaging, storage, transportation and consumption. Every phase uses energy and consequently create CO2. These include; Direct Inputs, Indirect Inputs, and Capital Inputs. A simplified flow chart representation of these inputs and the farm outputs, including environmental impacts, but excluding the transport occurring outside the farm gate is shown in Figure 1. Although it was done in 2006 a study by Saunders et al assessed the total CO2 emissions released in the supply of four New Zealand and UK food products to British markets. The report showed (see Table 1 for report data) that in the case of dairy and sheepmeat production NZ is by far more energy efficient even including the transport cost than the UK, twice as efficient in the case of dairy, and four times as efficient in case of sheepmeat.

In the case of apples NZ is more energy efficient even though the energy embodied in capital items and other inputs data was not available for the UK. Onions – where transport emissions account for around two-thirds of all CO2 resulting form the supply of New Zealand crops – are the only product for which UK consumers can reduce CO2 emissions by favouring domestic produce.

A major contributor to New Zealand’s relative CO2 efficiency in dairy production is that New Zealand agriculture tends to apply less fertilisers (which require large amounts of energy to produce and cause significant CO2 emissions) and animals are able to graze year round outside eating grass instead large quantities of brought-in feed such as concentrates. European dairy farms involve housing animals for extended periods of time. The fact that New Zealand farmers do not require subsidies to be internationally competitive, unlike their British counterparts, indicates these efficiencies of production.

Fishing – Tragedy of the Commons

The Tragedy of the Commons was a title of an article by Garrett Hardin in 1968 although the phrase is more commonly used to name the effect which it describes. It explains what can happen when a number of individuals share a common resource and each individual is presumed to act rationally and in his own interest.

For instance if there 10 different farmers grazing a piece of land then there is an incentive to add one more cow to your herd as you gain all of the benefit of this extra cow and you only have to suffer 1/10 of the cost resulting from the increased degradation of the land. Thus although it is in each individual’s self interest to increase the size of your herd, in the long run the land use will be depleted. This concept can also be transferred to CO2 emissions where countries emit emissions in order to grow their economy but don’t consider the long-term impact of global warming on drought and disease.

Recently a lot of attention has focussed on the fishing industry which is worth $16 billion annually. International law states that 64% of the surface of the oceans are defined as ‘the common heritage of mankind’ although with the advent of technology and bigger and faster fishing trawlers the last 50 years has seen a significant depletion of stock. Approximately 90% of fishing areas are fished to sustainable limits or beyond.

Stopping overfishing

The Economist – 22nd October 2020

Property rights has been the traditional policy to try and overcome the tragedy of the commons. This gives exclusive rights to coastal states to police and maintain territorial waters but the looting still continues – since 2010 the proportion of tuna and tuna-like species being overexploited has increased from 28% to 36%.

Reducing subsidies is seen as the most pressing policy as they come to $35 billion a year of 70% are given to more developed countries. It is estimated that $22bn of the subsidy helps destroy fish stocks. In giving subsidies you reduce the running costs of operators but it also brings certain fishing fields within reach for trawlers from developed economies. Only 10 countries received the money from high-seas catches between 2000 and 2010 and that is with Africa having more fishermen than Europe and America combined.

Closing off more areas fishing is another alternative and it has been suggested that 30% of oceans should be designated as ‘marine protected areas’. Countries could also take responsibility by creating marine reserves within their territorial waters. However technology has provided an opportunity to limit the over fishing. Compulsory cameras on board fishing vessels which can identify suspicious behaviour and illicit species should be compulsory especially in exclusive economic zones that define a country’s control over resources such as fish. Australia, America and New Zealand have invested heavily in this this area of surveillance. For example, reports of interactions with seabirds and mammals increased 7 times when electronic monitoring was introduced to Australia’s longline fisheries in 2015. Overall reported catch remained the same. In New Zealand regulations for on-board cameras on commercial fishing vessels came into effect in 2018 – they applied to vessels from 1 November 2019 in a defined fishing area on the west coast of the North Island. To mitigate the overfishing governments could agree on some policies:

• National regulators to set basic standards for crew – no forced labour
• Countries failing to follow rules – banned from fishing
• Countries should only import fish from law abiding nations
• WTO to scrap subsidies that encourage over fishing – see above
• Outlaw bottom-trawling
• Subsidies to fish farming – it now accounts for approximately 50 percent of the fish consumed globally

Source: The Economist July 16th 2016 & October 22nd 2020

China and global energy – it has the wind at its back.

Since 2010 there has been a significant increase in US oil production which has made them much less reliant on other oil producers – oil and gas production has increased over 50% and the US is the biggest producer of both. Being less reliant on oil imports means that the US can now have greater power of nations that they used to import oil from – Iran, Venezuela and Russia. According to The Economist being the biggest producer of gas and oil doesn’t mean as much today for three reasons:

The Economist: – The changing geopolitics of energy. 17th September 2020.

• There is no longer fossil fuel scarcity as the demand for oil might have already peaked and with an abundance of supply prices have dropped significantly.
• Countries that are reliant on fossil fuels now realise that for the sake of climate change they need to change their energy source to a more natural option of power.
• Solar panels and wind turbines generate electricity instantly whilst fossil fuels provide energy to a medium which then generates the electricity.

In considering the above this paradigm shift does more for China than the USA. Even though China is the biggest importer of fossil fuels it is a leading exponent of renewable energy at gigawatt scales. However China is in a very good position to secure oil imports as:

• The increase in supply from new sources – Brazil, Guyana, Australia (LPG), and shale from the US – has meant a buyers market and this has suited the Chinese.
• China is also in a very strong position with those struggling oil producing countries in that it has given them oil-backed loans.
• China Development Bank lent two state-controlled Russian companies, Rosneft, an oil producer, and Transneft, a pipeline builder and operator, $25bn in exchange for developing new fields and building a pipeline which would supply China with 300,000 barrels of oil a day.

China energy sources:

• Coal-fired – more than 1,000 gigawatts (GW) of generating capacity which makes it the world’s biggest carbon-dioxide emitter. Coal use is set to expand in the years to come.
• Wind and solar capacity – 445GW, vast though it is by most standards, But China also has Hydropower capacity – 356GW of more than the next four countries combined.
• Nuclear power – building plants faster than any other country; nuclear, which now produces less than 5% of the country’s electricity, is set to produce more than 15% by 2050.

Wind and Solar

Both wind and solar power require raw materials to be functional – non-ferrous metals like copper. Batteries require zinc, manganese and potassium. Although there is a lot of supply of these commodities it is the difficulty of getting them to the market that is the problem. China has helped here through domestic investment – it now produces 60% of world’s ‘rare earths’. It now looks overseas to Chile to secure lithium on which batteries now depend on.

China – produces more than 70% of the world’s solar modules and can produce over 50% of its production of wind turbines. It dominates the supply chain for lithium-ion batteries – 77% of cell capacity and 60% of component manufacturing. In 2019 China eased restrictions on foreign battery-makers – costs of solar panels and batteries have dropped by more than 85% in the past decade.

To maximise its electrostate power China needs to combine its renewable, and possibly nuclear, manufacturing muscle with deals that let its companies supply electricity in a large number of countries.

Source: The Economist – The changing geopolitics of energy. 17th September 2020

Covid-19 hits oil prices hard

With the demand for oil dropping over covid-19 and the over supply in the market, oil prices have collapsed. Brent crude fell by more than half in March to below $23 per barrel. For many years OPEC – Organisation of the Petroleum Exporting Countries – has manipulated supply to maintain higher prices. Since 2017 both Saudi Arabia and Russia have been working together to prop up oil prices but have had a falling out over Saudi Arabia’s insistence on cutting oil supplies by 1.5 million barrels per day.

The Economist – 26th March 2020

Cost of extraction v Price of a barrel

Like any business you need to consider costs relative to the price of your good or service. Some shale oil wells in the US may have a break-even point of $40 a barrel despite the high fracking costs. However some sources say that it is above $60 a barrel with the higher-cost wells coming in at over $90 a barrel. These industries cannot survive in this environment of such low oil prices. Also the Canadian tar sands are another costly method of extracting oil and this could lead to a shut down of production.

By contrast in Saudi Arabia the extraction cost is around $9/barrel with Russia coming slightly higher at $15/barrel. The Middle East and North Africa are also very efficient, producing oil as cheaply as $20 per barrel. Worldwide, conventional oil production typically costs between $30 to $40 a barrel.

Nevertheless countries like Venezuela and Nigeria depend hugely on oil revenue for their spending. Although Russia and Saudi Arabia have significant foreign reserves the more the virus persists and demand keeps falling the greater the damage. Useful video from Al Jazeera below.

Saudi Arabia and Russia – oil price war

Below is a very good video from the FT outlining the latest disagreement between the USA and Saudi Arabia. Since 2017 both Saudi Arabia and Russia have been working together to prop up oil prices but have had a falling out over Saudi Arabia’s insistence on cutting oil supplies by 1.5 million barrels per day.

China the biggest importer of oil has cut back on oil consumption because of the coronavirus outbreak was bringing the economy to a standstill. Oil prices had their biggest one-day fall since the 1991 Gulf Crisis – some are expecting prices to go to $20 a barrel. What is at the heart of the fallout? Russia’s anger over sanctions targeted at its oil giant, Rosneft Trading. Washington imposed the sanctions last month over its continued support in selling Venezuela’s oil. Moscow was hoping to get Riyadh on its side to inflict economic pain on US shale producers, who Moscow feels have been getting a free ride on the back of OPEC+ production cuts. Shale production has pushed the United States into the number one spot as the world’s biggest producer of oil. Moscow hopes it could lead to the collapse of some of those businesses, if oil prices remain below $40 a barrel.

Source: Al Jazerra- Counting the Cost.

Why dearer oil impacts developing economies more.

It wasn’t long ago that $100 for a barrel of oil was the norm but with the advent of the shale market the production increased which depressed prices. It was felt that the flexibility of large scale shale production from the USA could act as a stabiliser to global oil prices.

Oil shocks – supply or demand?

Oil shocks are not all the same. They tend to be associated with supply issues caused by conflict or OPEC reducing daily production targets. In the case of an increase in global growth there is the demand side for oil which increases the price. However this doesn’t have a great effect as in such cases the rising cost of imported oil is offset by the increasing export revenue. However today’s increase has a bit of both:

Demand – global consumption has increased as the advanced economies recover after the GFC especially China
Supply – supply constraints in Venezuela from the economic crisis. Also tighter American sanctions on Iran and OPEC producers are not increasing supply with the higher price.

Higher oil prices do squeeze household budgets and therefore reduce demand. Lower prices are expected to act as a stimulus to consumer spending but it can also have negative effects on the petroleum industries.

Emerging economies the impact of higher oil prices

Oil importing emerging economies are badly impacted by higher oil prices:

• Terms of trade deteriorate as the price of their imports rise relative to their exports
• Exports pay for fewer imports = importers’ current-account deficits widen.
• Normally this leads to a depreciation a a country’s currency which makes exports cheaper and imports more expensive.

However this is not the case today. World trade is slowing and with it manufacturing orders therefore higher oil prices make the current account worse which in turn depreciates the exchange rate. For emerging economies who have borrowed from other countries or organisations a weaker exchange rate intensifies the burden of dollar-denominated debt. Companies in emerging economies have borrowed large amounts of money being spurred on by very low interest rates but they earn income in the domestic currency but owe in dollars – a weaker exchange rate means they have to spend more of their local currency to pay off their debt. Therefore indebted borrowers feel the financial squeeze and may reduce investment and layoff workers.

Another problem for emerging economies, as well as higher oil prices, is that central banks are looking to tighten monetary policy (interest rates) with the chance of higher inflation.

Source: The Economist – Crude Awaking – September 29th 2018

Clean energy – winners and losers

The impact of energy flows on the power and influence of nations has mostly been about the need for oil. Securing oil supply by ensuring its shipment, protecting the countries that produce it to the extent of going to war in an oil producing country has been prevalent in the 20th century. Oil being inelastic in demand has meant that as it becomes more scarce the price increases will result in higher revenue for the oil producing oligopoly. Countries dependent on the importing of oil have been at the wrath of higher oil prices caused by embargoes, wars, a financial crisis to name but a few – see graph below.

In fact the USA has been the most aggressive in protecting its oil supply to the extent that it saw it as their right to use military force in the Middle East – 2003 – second Iraq War. The reason given was to remove Saddam Hussein but this just disguised their real motive was to protect the oil fields. If they were so concerned about Saddam Hussein’s regime why didn’t they do anything about Robert Mugabe in Zimbabwe? The answer is Zimbabwe doesn’t have oil. Remember the Gulf War in 1990 was a UN sanctioned operation involving many countries not just the USA and UK.

However the idea of scarcity is coming to an end thanks to 3 big developments.

1. The shale revolution in the US has lead to them being the biggest combined producer of oil and gas – the US now pumps 10m barrels a day and it is making the country less reliant on imported oil. Also increases in US supply has added to the global market reducing the price.
2. China is now moving to a more service based economy and in the process is moderating its demand for coal and oil, slowing the consumption of electricity. More importantly though it is deploying gas and renewable energies and stopping the growth of carbon-dioxide emissions. It’s dependence on imported fossils fuels has been the catalyst to develop more of its own wind and sunlight for energy sources as well as it planner more electric vehicles.
3. Climate change requires low-carbon energy and the Paris accord of 2015 is a start to fight climate change. To achieve this goal trillions of dollars will have to be invested in wind and solar energy, batteries, electricity grids and a range of more experimental clean-energy sources. Ultimately this creates significant competition between countries in developing these technologies but also but at risk the access to rare earths and minerals to make the hardware. It seems that energy is now driven by the technology not the natural resource we are so used to.

Energy transitions since the Industrial Revolution has seen the following:

Coal ——> oil ——> technology and clean energy.

The obvious losers from this change will be those who have an endowment of fossil-fuel reserves and have relied for too long on oil without reforming their economies.

Traditional energy system (oil etc) is constrained by scarcity
The abundant renewable energy system is contained by variability

Ultimately the challenge for countries in future will be who can produce the most energy and who has the best technology. Those that don’t embrace clean-energy transition will be losers in the future.

Source: The Economist – Special Report ‘The Geopolitics of Energy’ 17th March 2018

Oil price rises a sign of a healthy global economy.

Oil prices have been irregular over the last four years with the price of a barrel of oil being over $100 in 2014. This price had been suggested as the new $20 due to scarcity of oil reserves. However by 2016 the price had dropped to $28 a barrel the talk was that there was a global glut. Today the price is around $70 and analysts have been perplexed as to what is behind this increase. According to The Economist three significant questions arise:

1. Why has the oil price more than doubled in the space of two years against all expectations?

The 2016 slump in prices ($28) was in part due to the weak demand and an abundance of supply – simple economics. But demand recovered quickly and in particular the Chinese economy quickly pepped up its economy with fastest growth rates. On the supply side OPEC were able to restrict output and stocks of oil in the US started to fall. This saw D > S = P↑. Usually when there is an increase in price it attracts other sources of oil which are more expensive to extract – eg shale oil in the US and the tar sands in Canada. This is in turn will increase the supply and lower the price. But small suppliers are finding it harder to increase output as the financiers want more focus on profit rather than output. It can take months before oil actually comes on-stream.

Source: The Economist 20th January 2018

2. Why have stockmarkets been pleased with higher oil prices when it is usually associated with economic crisis?

The overall impact of higher oil prices has been to reduce aggregate demand in the global economy. With higher prices one might expect that the profits would be pumped back into the circular flow and therefore stimulating AD. However the Middle East producers tend to be big savers of oil profits at the expense of oil consumers in the West. Also countries have become less reliant on oil – demand peaked in 2005. Oil exporters depended on high oil prices to fund their government spending as well as importing consumers goods – Venezuela is a classic example of an economy that has relied on oil revenue for over 80% of government spending. Most big oil producers in the Middle East need the price of oil to be above $40 a barrel in order to cover their import bill. But a rising price of oil is usually a healthy sign that China is growing as it is the world’s biggest importer of oil.

3. What will be the ‘normal’ price of oil?

The critical change in the oil market from 30 years ago is that there is now an abundance of oil. Back then it was seen as an asset rather than a consumer good – oil in the ground was like money in the bank. But new sources of oil such as shale and tar sands have amounted to the existence of plentiful reserves. It must be added on the demand side the gaining momentum of mass-market for electric cars have reduced the demand for oil. It is being suggested that not all oil will extracted as there will not be enough demand. It makes sense that the five big producers in the Middle East – Saudi Arabia, UAE, Iran, Iraq and Kuwait – which can extract oil for under $10 a barrel, to undercut high-cost producers and capture the market share. So it is better to have money in the bank rather than in the ground. Will oil prices plunge? Unlikely especially when oil exporters are cannot sustain low prices for very long – in order to fund their expenditure they need oil prices of $60 barrel.

Source: The Economist 20th January 2018 – ‘Crude Thinking’

 

Norway sovereign wealth fund takes an ethical stance

Norway’s soveriegn-weatlh fund surpassed US$11trn in assets on September 19th this year. With its significant revenue from North Sea oil and gas getting invested overseas it is likely to get even bigger to the extent that Norway can start to shape ideas abroad. It is increasingly speaking out on ethical behaviour of companies and is an increasingly activist shareholder. The ethics watchdog for the fund recommends that it excludes several firms in oil, cement and steel industries for emitting too much greenhouse gas. This may seem hypocritical in that Norway produces significant amounts of oil but it operates under its own ethical guideline set by parliament.

Source: The Economist – 23-9-17

Missing out on billions of dollars

Norway’s sovereign wealth fund has share in 9,000 companies, 1.3% of the entire world’s listed equity. It has lost out on billions of dollars of revenue by its government prohibiting any investment in tobacco companies and manufactures of certain weapons. The fund is forbidden by law from investing in firms that produce nuclear weapons or landmines, or are involved in serious and systematic human rights violations, among other criteria. These include Boeing, Airbus, Imperial Tobacco, Philip Morris. Last year the council looked into the construction industry in Qatar – host of the 2022 soccer World Cup – and neighboring countries, after reports of abuse by human rights groups. Since then new regulations have been implemented which protect the rights and living and working conditions of labour in the construction industry. This includes the right of immigrant workers to hold onto their passport. There is a broad consensus in Norway that the fund should not make money from companies that take people’s lives.

Norway and coase theorem

Another way Norway is trying to influence global warming is by using its sovereign wealth fund to change behaviors of other countries. Ronald Coase argued that bargaining between parties could produce a mutually beneficial and efficient solution to problems like pollution. An example of this was the a deal between Liberia and Norway. Norway will give $150m in aid in return for Liberia stopping the destruction of its forests.

Stick and Carrot

The stick approach of trying to force Liberia to stop cutting down its trees might give way to a more effective carrot approach by paying Liberia to do so. This makes both sides better off. Liberia still gets the aid and Norway gets to preserve biodiversity and take a small step against climate change.

5 or 6 more China’s

The reality is that the planet can’t stand another 5 or 6 China’s but developing countries still need to grow and, like their developed country counterparts, it will involve greenhouse gas emissions. If we are to curb global emissions developing countries will have to leapfrog to new technologies as the burning of traditional fossil fuels will just exacerbate the problem. However developing countries have neither the resources nor the incentive to reduce dependence on fossil fuels on their own as their main focus is economic growth. Whilst developed countries have a lot to lose from developing-world emissions it is in their interest to pay the latter to curb emissions e.g. Norway paying Liberia not to chop down its trees. Although this looks a simple enough policy politicians will not be so enthused by it as money that is paid overseas to cut climate change is not very popular with the electorate and therefore the government.

China stops subsidising farmers

In 2000 the Chinese government introduced price supports for farmers with the floors raised annually to stimulate production even when global prices fell. There were three reasons for price supports:

1. ensure production of key commodities
2. provide a degree of food security
3. improve the well-being of farmers

China starts to abolish minimum prices

The last three years has seen the Chinese authorities start to abolish minimum prices for the following commodities – cotton, soybeans, corn and sugar. Without the minimum price the supply on the domestic market has dropped – grain production fell for the first time in 13 years. Remember with the minimum price being above the equilibrium it encourages producers to supply more but the demand will drop at the higher price.

When the minimum price was in operation the Chinese authorities had been stockpiling significant amounts of food and have been able to compensate for the reduction in supply from the farming community. However once these stockpiles have been diminished the only other alternative will be to import food which will be a positive for farmers from Brazil, US and Thailand. This might be sooner than later as the Chinese government is facing capacity challenges as warehouses and silos are overflowing but still China is not able to meet its domestic needs. According to the US Department of Agriculture, China is sitting on 54% of the world’s cotton stocks, 45% of the world’s corn and 22% of the world’s sugar reserves, but many analysts think that a lot of this stock is starting to perish.

Self-sufficiency in feeding the Chinese population still remains a priority for Beijing but after 2014 authorities have stated that they need to make rational use of the global agricultural market and import various food products. However China still spends a lot on supporting its agricultural sector:

2016 – $246.9 billion = 2.2% of GDP. Four times the average of OECD countries.

Although money is still spent on price supports a growing share is going into ways to improve productivity with R&D etc. China is in a position that they could revert back to the price supports if they feel the pain of reform is too great, but analysts think that they will be more accepting of global supply.

Source: China Cut Agricultural Subsidies and American Farmers Have a Lot to Gain

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EU example

This policy of subsidising farmers is not unlike that of the European Union – see previous blog post ‘CAP reforms unlikely to benefit New Zealand farmers.’ – with the introduction of the Common Agricultural Policy (CAP). At the outset of the EU, one of the main objectives was the system of intervention in agricultural markets and protection of the farming sector has been known as the common agricultural policy – CAP. The CAP was established under Article Thirty Nine of the Treaty of Rome, and its objectives – the justification for the CAP – are as follows:

1. Raise and maintain farm incomes, through the establishment of high prices for food. Such prices are often in excess of the free market equilibrium. This necessarily means support buying of surpluses and raising tariffs on cheaper imported food to give domestic preference.
2. To reduce the wide fluctuations that often occur in the price of agricultural products due to uncertain supplies.
3. To increase the mobility of resources in farming and to increase the efficiency of all units. To reduce the number of farms and farmers especially in monoculturalistic agriculture.
4. To stimulate increased production to achieve European self sufficiency to satisfy the consumption of food from our own resources.
5. To protect consumers from violent price changes and to guarantee a wide choice in the shop, without shortages.

CAP Intervention Price

An intervention price is the price at which the CAP would be ready to come into the market and to buy the surpluses, thus preventing the price from falling below the intervention price. This is illustrated below in Figure 1. Here the European supply of lamb drives the price down to the equilibrium 0Pfm – the free market price, where supply and demand curves intersect and quantity demanded and quantity supplied equal 0Qm. However, the intervention price (0Pint) is located above the equilibrium and it has the following effects:

1. It encourages an increase in European production. Consequently, output is raised to 0Qs1.
2. At intervention price, there is a production surplus equal to the horizontal distance AB which is the excess of supply above demand at the intervention price.
3. In buying the surplus, the intervention agency incurs costs equal to the area ABCD. It will then incur the cost of storing the surplus or of destroying it.
4. There is a contraction in domestic consumption to 0Qd1
Consumers pay a higher price to the extent that the intervention price exceeds the notional free market price.

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The Doughnut Model of Economics

A recent book entitled “Doughnut Economics: Seven Ways to Think Like a 21st-Century Economist” by Kate Raworth of Oxford University’s Environmental Change Institute, offers an alternative to the all too familiar policy of economic growth to solve the issues of poverty, inequality, unemployment in the global economy. Simon Kuznets, who normalised the measurement of economic growth, stated that national income cannot be a accurate measure of total welfare in an economy as it only measures annual flows of money and not stocks of wealth and their distribution. Raworth states that the current model of endless economic growth using up the finite resources of the planet is not the way forward. Most textbooks refer to the circular flow as the model of the economic system – households, firms, banks, overseas markets and the government which bears little relationship to reality today. Instead Raworth goes beyond this simple circular flow model and includes social and environmental issues – energy, the environment, raw materials, water pollution etc.

The Doughnut
Raworth’s circular flow consists of two rings – see graphic below.

Inner Ring – this consists of the social foundation and those things we need for a good life – food, water, health, education, peace and justice etc. People living within this ring in the hole in the middle are in a state of deprivation.

Outer Ring – this consists of the earth environmental limits – climate change, ozone depletion, water pollution, loss of species etc.

The area between the two rings is the “ecologically safe and socially just space” in which humanity should strive to live. As stated in The Guardian review, the purpose of economics should be to help us enter that space and stay there. As the graphic shows we breach both rings as billions of people live below the poverty line and climate conditions, biodiversity loss, land conversion etc are at concerning levels. The video below is a useful explanation.

Copper prices on the rise with strike action

Over the last few years Chinese demand (or weakness of) has been the main cause of volatile commodity prices. Copper has been one of those commodities but supply factors have also been influential in pushing copper prices to their highest level in the last two years. Strikes and supply disruptions (see graph below) in two of the world’s biggest mines will have a significant impact:

Escondido in Chile (the largest in the world) and Grasberg in Indonesia.

Both mines account for 9% of mined copper supply. One-month shutdown at both mines removes 140,000 tonnes which equates to 0.7% of world output. In both mines labour contracts are up for renewal and they account for 14% of production. The video below from Al Jazeera looks at the strike action by miners at Escondido in Chile where workers are rallying against cuts to pay and benefits by owners BHP Billiton which are designed to  improve productivity. However, in the last three years productivity in the mine is up 48% and the labour force has been cup by 17%.

Add to this more demand from China and there is only one way copper prices can go – it is up 20%.  Resolutions to labour relations are needed in both Chile and Indonesia if supply is to be restored to pre-dispute levels. Furthermore the outlook for copper demand is strong with its importance to electric vehicles and wind and solar energy units. In the long-term, depletion of copper ores will also put pressure on prices northwards.

Source: The Economist 16th Feb 2017. Al Jazeera 23rd Feb 2017

Oil prices increase – OPEC reduces supply

The Organisation of Petroleum Exporting Countries (OPEC), is a cartel of 12 countries made up of Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela.

Recently OPEC countries have proved skeptics wrong by deciding to cut oil production. Previously OPEC seemed quite content maintaining oil supply levels even with low oil prices – maybe with the intention of driving prices down and putting companies with high costs of extraction out of business. But the collapse in oil prices since June 2014 – see chart –  has battered the economies of oil-producing nations as some investment projects are no longer financially feasible and this could result in a new supply shortage within a few years.

However a deal signed in Algiers in September has seen OPEC countries will reduce production for the first time since 2008 by approximately 1.2 million barrels per day (bpd) which means its production is around 32.5 million bpd – see table below:

Agreed crude oil production adjustments and levels*

* Reference base to crude oil production adjustment is October 2016 levels, except Angola for which September 2016 is used, and the numbers are from Secondary Sources, which do not represent a quota for each Member Country.

From the table the big cuts in production are from Saudi Arabia, Iraq, UAE and Kuwait. Iran is allowed to raise output by 90,000 barrels as they have sought special treatment as it recovers from sanctions. It is unclear whether the Opec cuts were wholly contingent on the planned 600,000bpd cuts by non-Opec members, including a 300,000bpd cut by Russia. Mr al-Sada of OPEC said the agreement would “definitely help rebalancing the market”, enabling the industry to “come back and reinvest” in new production capacity to ensure future security of supply.

In simple economics this reduction in supply of a very inelastic product should, in theory, increase the price of oil and on the news of the cuts oil prices surged as much as 10pc to hit $52-a-barrel – see graph opposite.

 

Fishing – Tragedy of the Commons

The  Tragedy of the Commons was a title of an article by Garrett Hardin in 1968 although the phrase is more commonly used to name the effect which it describes. It explains what can happen when a number of individuals share a common resource and each individual is presumed to act rationally and in his own interest.

For instance if there 10 different farmers grazing a piece of land then there is an incentive to add one more cow to your herd as you gain all of the benefit of this extra cow and you only have to suffer 1/10 of the cost resulting from the increased degradation of the land. Thus although it is in each individual’s self interest to increase the size of your herd, in the long run the land use will be depleted. This concept can also be transferred to CO2 emissions where countries emit emissions in order to grow their economy but don’t consider the long-term impact of global warming on drought and disease.

Recently a lot of attention has focussed on the fishing industry which is worth $16 billion annually. International law states that 64% of the surface of the oceans are defined as ‘the common heritage of mankind’ although with the advent of technology and bigger and faster fishing trawlers the last 50 years has seen a significant depletion of stock. Approximately 90% of fishing areas are fished to sustainable limits or beyond.

Stopping overfishing

Property rights has been the traditional policy to try and overcome the tragedy of the commons. This gives exclusive rights to coastal states to police and maintain territorial waters but the looting still continues – since 2010 the proportion of tuna and tuna-like species being overexploited has increased from 28% to 36%.

Reducing subsidies is seen as the most pressing policy as they come to $30 billion a year of 70% are given to more developed countries. In giving subsidies you reduce the running costs of operators but it also brings certain fishing fields within reach for trawlers from developed economies. Only 10 countries received the money from high-seas catches between 2000 and 2010 and that is with Africa having more fishermen than Europe and America combined.

Closing off more areas fishing is another alternative and it has been suggested that 30% of oceans should be designated as ‘marine protected areas’. Countries could also take responsibility by creating marine reserves within their territorial waters.

Aquaculture the controlled farming of fish could be the answer – in 2014 more fish were farmed for consumption rather than caught in the oceans. But this area needs a lot more government support as feedstocks are often poor and storage facilities inadequate.

Source: The Economist July 16th 2016

After oil what’s next for Saudi Arabia?

With oil prices being at historically low levels, oil exporting countries have been struggling to generate the revenue that was once apparent not so long ago. In Venezuela, for instance, oil accounts for 95 percent of Venezuela’s export earnings and plummeting world prices have severely hit the government’s revenue stream. The Middle Eastern countries with their abundant supply of oil and the ease at which it extracts it, are starting to look at alternative revenue streams as the rent from oil is no longer sufficient to sustain public goods and services. As noted in The Economist the Arab world can be divided into three broad categories:

1. Resource-rich, labour-poor – Gulf sheikhdoms with lots of oil and gas but few people;
2. Resource-rich, labour-abundant – Algeria and Iraq, that have natural resources and larger populations;
3. Resource-poor, labour-abundant – Egypt, that have little or no oil and gas but lots of mouths to feed (see chart).

To a degree the whole Arab world is an oil-driven economy: all three groups tend to rise and fall with the price of oil. However although some countries have significant reserves of wealth this does not offer an alternative to weaning them off their dependence on the oil industry.  Saudi Arabia’s Vision 2030 intends to be free of oil dependence by 2020 and among the proposals is a plan to launch a new defence company, combining Saudi industries under a single company and be floated on the Saudi Stock Exchange.

The country plans to list less than 5 per cent of Aramco (Saudi Arabian Oil Co), which is worth more than US$2 trillion. The sale of Armco would be big enough to buy Apple Inc., Google parent Alphabet Inc., Microsoft Corp. and Berkshire Hathaway Inc. – the world’s four largest publicly traded companies. The plan is for the government to be a lot more prudent in its spending and making sure that the budget deficit doesn’t exceed 15% of GDP which is a very high figure. Furthermore using the private sector to provide education and health care as well as selling valuable land to developers, will reduce the burden of the State. But this will bring about significant social change that the population of Saudi Arabia may not be prepared for. As The Economist said:

A generation of men that expected to be paid for do-nothing government jobs will have to learn to work. The talents of women, who already make up the majority of new university graduates, will have to be harnessed better. But for now even the limited reforms to give women more opportunities have gone into reverse. To achieve its goals, Saudi Arabia will have to promote transparency and international norms, which will mean overcoming resistance from the powerful religious establishment and the sprawling royal family.

Source: The Economist – May 14th 2016

Resource Curse

For most economies that have natural endowments like oil (Saudi Arabia) or minerals, there is the risk of the economy experiencing the ‘resource curse’. This is when a natural resource begins to run out, or if there is a downturn in price, manufacturing industries that used to be competitive find it extremely difficult to return to an environment of profitability. According to Paul Collier, Nigeria has a resource curse of its own, the civil war trapin which 73% of the low income population have been affected by it, as well as a natural resource trap- where the so-called advantages of a commodity in monetary value did not eventuate – on average affecting only 30% of the low income population. It seems that in Nigeria there is a strong relationship between resource wealth and poor economic performance, poor governance and the prospect of civil conflicts. The comparative advantage of oil wealth in fact turns out to be a curse. governments and insurgent groups that determines the risk of conflict, not the ethnic or religious diversity. Others see oil as a “resource curse” due to the fact that it reduces the desire for democracy.

Click here for more on the Resource Curse from this blog

Commodity Currency – Aussie dollar overvalued.

Below is a video from the FT that I showed my A2 class this morning. The significance of it is the Australian dollar and how its value is strongly linked to iron ore prices. Recent growth in China has exceeded expectations and this has led to a rebound in commodity prices especially iron ore. The belief is the AUS$ is higher than the equilibrium level suggests and that this rate will not be sustainable. There are two reasons for this:

1. Commodity prices have accelerated which has led to more demand for AUS$ which might not be sustained.
2. Higher relative interest rates has made the AUS$ strong as ‘hot money’ has been attracted in the country. The Reserve Bank of Australia (central bank) has recently cut the cash rate (interest rates) to 1.75% and there is talk of a further cut this year.

Crude problems for Nigeria and Russia

With the fall in the price of oil to under US$30 a barrel, two oil exporting economies in particular have been adversely affected – Nigeria and Russia.

Nigeria

• Oil accounts for 10% of GDP but 70% of government revenue and almost all of Nigeria’s foreign earnings.
• Government revenue has fallen by 30% from this time last year
• Foreign reserves are down by $9 billion in 18 months
• Growth rate for 2015 was 3% which was down from 6% in 2014
• Nigerian bank loans are exposed to ups and downs of the oil market. At present about 24% of Nigerian bank loans are to oil and gas producers and struggling power companies. This exposure could lead to a banking crisis in Nigeria.

How is Nigeria tackling the problem?

The Economist outlined 3 responses to the crisis of which the first is the only realistic measure:

1. An expansionary fiscal policy to stimulate aggregate demand
2. Protect its hard currency reserves by blocking imports
3. Try to crack down on inflation by keeping the naira pegged at 197-199 to the US$.

Nigeria is fortunate to have low levels of public debt – 19% GDP – but it is not helped by high interest rates but high interest rates means that 35% of government revenue is taken up by servicing its debt. Lower oil prices would be the catalyst to a serious debt problem.

Russia

Russia’s exports and government revenue are heavily dependent on the price of oil. Since the oil peak in June 2014 GDP has shrunk by approximately by 4%. The Russian budget assumes an average oil price of $50 a barrel, which was to have produced a deficit of 3% of GDP. However the budget deficit rises by roughly 1% of GDP for every $5 drop in the oil price and with the current oil price around $30 a barrel the deficit would probably rise to 7% of GDP.

If the economy does start to run out of cash the option of printing money may be tempting. But with inflation at around 13% this would further fuel inflation and also mean a further weakening of the rouble which wold make Russian imports more expensive for firms and households. Russian economic data does not look healthy:

• real wages fell by 9% in 2015 and 4% in 2014
• GDP per person was $8,000 in 2015 in contrast to $15,000 in 2013
• 2 million fell into poverty on 2015
• the share of families that lack funds for food and clothing rose from 22% to 39%
• retail sales have dropped by 13% last year

Opportunity

The 25% fall in the inflation adjusted exchange rate in the past year brought with the opportunity to diverse away from oil. The weaker double makes exports more competitive and now that labour is cheaper in Russia than in China there is great opportunity. However, it is not going to come from foreign investors as foreign investment has fallen from $40 billion in early 2013 to $3 billion in June quarter of 2015.