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Where is inflation?

September 29, 2017 Leave a comment

Since the GFC in 2007/8 the developed economies have been awash with stimulatory forces including quantitative easing, record low interest rates and increased government spending. This has led to accelerating growth levels driven by an increase in Aggregate Demand – C+I+G+(X-M). Business and consumer confidence has also increased and this has come about by the decline in financial and economic risk.

Supply ShockSo you would assume with stronger aggregate demand that the capacity constraints in the supply of goods and services accompanied by shortages in the labour market would lead to inflationary pressure. Yet in some countries core inflation has actually fallen and this creates a dilemma for central banks as although there is growth in their economy the inflation rate is below their target band. A reason for this could the supply side shocks (Aggregate Supply to the right – see graph). The following maybe the cause:

  • Globalization keeps cheap goods and services flowing from China and other emerging markets.
  • Weaker trade unions and workers’ reduced bargaining power have flattened out the Phillips curve (see below), with low structural unemployment producing little wage inflation.
  • Oil and commodity prices are low or declining.
  • And technological innovations, starting with a new Internet revolution, are reducing the costs of goods and services.

NZ Phillips Curve

Sources: Project Syndicate, Economicsonline.co.uk

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AS & A2 Revision – How PED varies along a demand curve

September 21, 2017 Leave a comment

Been doing some more revision sessions on CIE AS economics and went through how the elasticity of demand varies along a demand curve. Notice in Case A that the fall in price from Pa to Pb causes the the total revenue to increase therefore it is elastic – the blue area (-) is less than the orange area (+). In Case B the opposite applies – as the price decreases from Pa to Pb the total revenue decreases therefore it is inelastic – the blue area (-) is greater than the orange area (+). In Case C the drop in price causes the same proportionate change in quantity demanded, therefore there is no change in total revenue – it is unitary elasticity. Remember where MR = 0 – PED = 1 on the demand curve (AR curve).

China stops subsidising farmers

August 2, 2017 Leave a comment

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


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:

CAP Int Price1. 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.


 

 

 

Oil and contango

April 19, 2017 Leave a comment

There are very high levels of oil storage at present are the main reason for oil prices to go below US$50. Why are the storage tanks so full reports The Economist?

1. OPEC’s agreement with non-members such a Russia to cut production from 1st January attracted a lot of demand to take advantage of future price increases. This did produce higher prices which win turn encourages more supply as American shall producers started to pump more oil. American oil rigs have increased in number from 386 in 2016 to 617 in 2017 producing 400,000 barrels of oil a day more than the low levels in September 2016. Much of the oil has gone into storage terminals.

2. Before OPEC cut production it increased output and exports. A lot of this oil went into storage in the USA as refineries there were down for maintenance reasons.

3. Futures prices of oil are closely related to the level of inventories. It was hoped that the OPEC cut in production would push the futures market into ‘backwardation’ – short-term prices are greater than long-term (futures) prices which means that purchasers will use the oil rather than storing it. However with the release of US storage levels the immediate price of oil fell in comparison to longer-term rates – referred to as “contango” which makes it worthwhile to buy oil and store it. It is estimate that the price of storing a barrel oil is 41 cents per month compared to contango of 65 cents for the same period. Therefore you make 24 cents on each barrel. See video below from EKTInteractive.

So the more oil stored the lower the short-term prices go – the challenge is to break the loop. Maybe oil output cuts beyond June may force some to release their inventory.

Source: The Economist 16th March 2017

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The market for sand

April 16, 2017 Leave a comment

Sand Demand.pngSand has become an integral part of the global economy and also the most extracted material. It is used in the construction industry where it is part of the process in making concrete and asphalt. Fine sand tends to be used to produce glass and electronics.

Demand
Since the GFC in 2008 Asian countries have been the big users of sand with China consuming up to 40% of world supply (Asia 70%) building 32.3m houses and 4.5m kilometers of road between 2011 and 2015. See graph from The Economist.

Although hard to believe, sand is becoming scarce as desert sand is too fine for most commercial purposes. Furthermore the cost of transporting sand can be very expensive in relation to the price and reserves need to be located near construction sites to make it more economical. By contrast Singapore and Qatar are big importers of sand to assist in their construction programme (especially the latter with the Football World Cup in 2022). Sand is also demanded to create more living area in a country. As is well documented, China has built fake island on coral reefs in the South China Sea. Japan has also claimed a lot of land by dumping vast amounts of sand.

Limited supply
Sand is being extracted at an increasing rate and this is having an impact on the environment  with water levels in lakes being lowered and beaches in resort areas of the Caribbean and northern Africa. Indonesia and Malaysia have now banned sand exports to Singapore as a result of thinning coastlines. But with limited supply comes a higher price and with a higher price the black market starts to become prevalent. In India the illicit market for sand is valued around $2.3bn a year. Also the rising price of sand will lead developing-country builders to source alternatives to sand

Sand – elastic in demand as there are substitutes:
*Sand could be classifies as elastic as there are substitutes:
*Mud can be used for reclamation
*Straw and wood to build houses
*Crushed rock to make concrete.

Global Outlook
With the continued growth of construction and manufacturing output global demand for sand is forecast to increase 5.5 percent to 291 million metric tons in 2018, with a value of $12.5 billion. Whether the supply can cope with this increase demand is another question. Higher prices will make illicit mining more attractive.

Sources: The Economist 1-4-17. Freedonia – World Industrial Silica Sand

Categories: Supply & Demand Tags: , ,

‘Trading Places’ movie – short-selling explained

January 18, 2017 Leave a comment

The 1983 movie ‘Trading Places’, staring Eddie Murphy and Dan Aykroyd tells the story of an upper class commodities broker Louis Winthorpe III (Aykroyd) and a homeless street hustler Billy Ray Valentine (Murphy) whose lives cross paths when they are unknowingly made part of an elaborate bet.

There is a great part in the movie when they are on the commodities trading floor that explains price and scarcity. Winthorpe and Valentine are up against the Duke Brothers in the Frozen Concentrated Orange Juice (FCOJ) futures market.

How a futures market works
As opposed to traditional stock/shares futures contracts can be sold even when the seller doesn’t hold any of the commodity. For instance a contract of $1.30 per pound for a 1000 pounds of FCOJ in February indicates that the seller is compelled to provide the produce at that time and the buyer is compelled to buy the produce.

Here’s how it worked in the movie

The Duke Brothers believe they have inside knowledge about the crop report for the orange harvest over the coming year. They are under the impression that the report will state the harvest will be down on expectations which will necessitate greater demand for stockpiling FCOJ – this will mean more demand and a higher price. Therefore at the start of trading the Dukes representative keeps buying FCOJ futures. Others saw they were only buying and wanted in on the action, those that had futures were not willing to sell so the price kept rising. However the report was fake and Winthorpe and Valentine had access to the genuine report which stated that the orange harvest had not been affected by adverse weather conditions. Knowing this they wait till the the price of FCOJ reaches $1.42 and start to sell future contracts.

Then when the crop report is announced and it indiates a good harvest investors sell their contracts and the price drops very quickly. The Dukes are unable to sell their overpriced contracts and are therefore obliged to buy millions of units of FCOJ at a price which exceeds greatly the price which they can sell them for. In the meantime Winthorpe and Valentine for every unit they sold at $1.42 they only have to pay $0.29 to buy it back to fulfill their obligation. This results in a profit of $1.13 per unit.

Oil prices increase – OPEC reduces supply 

December 6, 2016 Leave a comment

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.

oil-2000-2015

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*

opec-production-cuts

* 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.

supply-demand-oilIn 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.

 

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