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Why we have low Commodity prices

July 8, 2015 - 14:54 -- Admin

By Gail Tverberg

Australia’s economy would be in a lot better shape if commodity prices were higher. Its mineral exports would rise, as would its exports of coal and natural gas.

Why are commodity prices lagging? Ultimately, the question comes back to the question, “Why isn’t the world economy making very many of the end products that use these commodities?” If every poor person in Africa could suddenly afford a car, we would see a lot of demand for products that go into making and operating automobiles. Of if governments around the world were expanding their road systems and their public housing systems, there would be a high demand for the products that go into paving roads and building public housing. Obviously this isn’t happening. If the world economy were growing rapidly, we expect a lot of demand for commodities.

Ultimately, what is happening is that the world economy isn’t growing very much. Because of this, there is little demand for the commodities, so the prices of commodities lag. Many people who work for commodity companies lose their jobs, leading to the type of economic slowdown Australia is now experiencing. The issue that is behind this problem is what I call “our growing inefficiency problem.” Let me explain how this happens.

Suppose we want to make a product. The product could be a barrel of oil, or an ingot of steel, or a college education for a young person. We use inputs of various kinds, these inputs are transformed during some sort of process, and we get an output.

Base case

In the case of a barrel of oil, the inputs would hours of workers time, plus fuels of various types used to operate machinery of various types to extract the oil, plus various inputs for refining the oil and shipping the oil to its final location. In the case of a college education, from the person of view of the person buying the college education, the input is the cost of the education. This cost of the education really buys a lot of things: professors’ time, time of administrators, cost of heating and lighting buildings, and many other things.

Our economists would like us to think that the economy is getting more and more efficient. I would represent this situation as the following:

Increased efficiency

In this case, the same inputs are producing more and more outputs. If this were happening from oil, the same dollar amount of inputs, which buy a quantity of worker hours plus other resources, would be producing more and more oil. We would find that more and more oil could be extracted for the same inputs, making the finished product cheaper.

If the same situation were happening for a college education, we would find that universities would be finding ways to make their tuition dollars go farther. Perhaps they would be getting rid of administrators, so that tuition could be lowered, and the university could sell the same product more cheaply.

Clearly, if a factory develops a more efficient machine for producing a product, say shoelaces, then it may be possible to produce the shoelaces with fewer inputs. Most likely, the saving would be in worker hours, while the amount of other materials would stay close to the same. The result would be cheaper shoelaces, and more shoelaces produced per worker hour. This would be considered increased efficiency.

The opposite situation, however, is what we have been seeing recently. We have been seeing a lot of what I call “Growing Inefficiency.” This situation leads to more and more inputs being used to produce the same output. Clearly, we wouldn’t do this on purpose, but sometimes nature gives us a push in this direction.

Growing Inefficiency

In the case of oil, the situation may be that the inexpensive to extract oil has already been taken. There is still a lot of oil available, but it is deep under the sea, or it requires fracking, or it requires an expensive refining process not used in the past. With respect to iron and other ores, the situation is likely to be that the quality of the ores becomes lower, so that the metal must be separated from more waste material. More workers are needed to extract the larger amount of ore and separate out the waste material. In the case of the university, the situation may be that the school wants its professors to write more academic papers. The university cuts back on the teaching load of each professor, to enable this process, resulting in the need for more faculty. The new emphasis on research this adds costs, but the education received by the student doesn’t really change very much, except that it becomes more expensive.

In recent years, the world has been finding itself in an increasing number of situations where inefficiency is creeping in. For example, we are becoming increasingly aware that pollution is a problem. There are often higher-cost workarounds, such as substituting a different fuel or adding special filters. These changes add costs to producing the end product, say electricity. Admittedly, we are getting more healthful air, or better quality water, but most consumers find that they need to cut back on buying other goods, if they are to have enough money left to buy the now more healthful electricity.

As the economy becomes less efficient, it tends to grow more and more slowly. Essentially, we are not getting as much output for the same amount of input. Economic growth tends to slow. It is this slowdown in economic growth that is pulling down the prices of commodities and leading to lay-offs among those who work in commodity sectors. Clearly, the solution to our problem with growing inefficiency is increasing efficiency, but this difficult to obtain when nature is conspiring against us. Deeper wells, lower quality ores, and increased problems with pollution all lead to higher costs of producing close to the same end product. Ultimately the economy gets squeezed. Workers, on average, find that they are producing less, and the economy begins to contract. Lower commodity prices are a sign of the headwinds the economy is now reaching.

About the author:

Gail Tverberg has an M. S. from the University of Illinois, Chicago in Mathematics, and is a Fellow of the Casualty Actuarial Society and a Member of the American Academy of Actuaries.

More of Gail’s work can be found on her blog Our Infinite World.

 

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