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Blue moon economics

As the United States sinks into a financial vortex and begins to drag the rest of the world with it, commentators are reaching for every form of hyperbole available. Former chairman of the U. S. Federal Reserve Board Alan Greenspan characterized the current trouble as "the most wrenching since the end of the second world war."

So unexpected and extreme have recent financial trends been that even the man who warned that derivatives are "financial weapons of mass destruction," legendary investor Warren Buffett, has encountered difficulties when his companies waded into the derivatives market.

Concern about a cascade of failures among financial institutions led the Federal Reserve to make loans to the beleaguered investment bank Bear Stearns Cos. by invoking authority it last used in the 1960s.

All of the events of recent weeks including the wild swings in both the stock and commodities markets are signaling the advent a rare full-blown, long-term credit crisis not seen in, well, a blue moon. Some are saying we haven't seen anything like it since the 1930s. As frightening as such pronouncements are, they all imply a rare but cyclical crisis that is understood to be severe, but ultimately of limited duration. Yes, such a crisis only occurs once in a blue moon, but when it does, despite all the damage that results, it eventually comes to an end.

All of this may turn out to be true, but only if the cause of this economic crisis is strictly as advertised, namely, too much credit given to too many people at prices too cheap for too long until many overreached and could not make good on their obligations. The problems appear to extend all the way from the humblest subprime mortgage holder to major financial institutions at the center of Wall Street.

Certainly, the reckless expansion of credit is one important cause for the crisis. But another cause seems to be hidden in plain sight. There is another market on high boil that both Wall Street and the public seem to be ignoring, the commodities market. Grains, energy and gold have been making spectacular new all-time highs. And, even as one trader managed to lose $140 million for his commodities broker employer in the wheat market, eyes remain riveted on Wall Street and the stock market.

There are all the usual explanations for the commodities bull market including that 1) growth in China and India is providing enormous new demand for basic commodities, 2) we are simply going through a normal cyclical upswing in commodity prices, and 3) new investment vehicles such as hedge funds and exchange traded commodity funds have made it easier for more people to speculate in the commodity markets. All of these things may be true.

But there are also other very disturbing causes. What is now being called a once-in-a-thousand-years drought has gripped Australia, one of the world's four remaining grain exporters. (The other major exporters are the United States, Canada and Argentina.) The result last year was an Australian wheat crop that was cut in half. That helped to send grain prices soaring. Is the drought related to global warming? If so, then there is reason to believe that the problem isn't temporary and that it may spread to other grain growing regions around the globe.

Another cause for rising grain prices may be that damage to the soil caused by decades of industrial farming is catching up with us. The rate of increase in global grain production has slowed dramatically. And, even though absolute grain production has continued to rise, yield per capita has been in a gradual decline for more than two decades. Whatever the reason, increases in grain production are not keeping up with population growth.

As for the high price of oil, it may indeed be due to high demand in Asia. But another cause may be slowing rates of discovery that have led many to conclude that a peak in the rate of world oil production may be no more than a decade away. And, as oil prices have risen, there has been a scramble to produce liquid fuel substitutes such as ethanol from sugar and corn and biodiesel from soy. This has led to higher demand and record prices for both corn and soy and to elevated prices for sugar. If the tightness in the oil market is due to an approaching oil peak, then the price trend in these energy crops is unlikely to abate soon.

There is, of course, the central role of oil in the world economy and the financial implications that an oil peak would have. First and foremost, it would mean very high energy prices for as far as the eye can see. It could also mean financial turmoil for importing nations such as the United States, turmoil that may already be manifesting itself in the form of a credit crisis.

Even the prices of crucial industrial metals such as copper, lead, nickel and zinc have risen sharply. Copper, for example, has risen from a low of 60 cents a pound at the beginning of the decade to a recent price of around $3.50. More worrisome are rare metals used in important consumer and business products and processes such as platinum used in catalytic converters in cars, indium used in LCD displays, and rhodium used for critical electrical contacts which have been up as much as 500 percent, 1,000 percent and 2,000 percent, respectively.

All of this is supposed to stimulate supply and bring down commodity prices. But, this is simply not happening in the oil industry where large international oil companies have been unable to replace their oil reserves despite their high levels of exploration and development spending. As this new picture of harder-to-find oil has emerged, these companies have instead begun to focus on buying other oil companies and on buying back stock which, of course, does nothing to increase oil supplies. It is true that substantial oil resources remain underground in OPEC countries. But these countries have little incentive to produce much more oil than they do today. Why not leave reserves in the ground and get higher prices later as the money is needed?

Nowhere is the problem of finding additional supplies of energy clearer than in the North American natural gas market. Natural gas production has been stuck on a plateau of about 27 trillion cubic feet of annual production since 1998. To quote from a previous piece of mine:

But, it's not for lack of trying. From a low in early 1999 of 397 active gas drilling rigs in Canada and the United States combined, the count has vaulted to 1,753 active gas rigs for the week just ended [January 18, 2008]. And, the high rig count is not just a recent phenomenon. Combined gas rig counts first reached 1,000 in the year 2000 and fluctuated between about 700 and 1,300 from then until mid-2005. At that point they broke through the 1,300 level and never looked back. The simple fact is that natural gas in North America is getting harder to find; and when we do find it, it is coming in smaller quantities that flow at slower rates than in the past. That's why we are having to drill so many wells just to run in place.

So much for the idea that high prices will automatically bring on supply. High prices may be able to stimulate drilling, but they cannot alas create natural gas.

For metals, prices have come down, but not to their previous levels. And, as for food, farmers have been shifting what they grow depending on which grain prices are going up. But, there is little room left to add acres unless conservation programs are completely abandoned.

The question then is this: Are we merely experiencing a cyclical, albeit once-in-a-blue-moon event that will resolve itself in lower prices for all the commodities that make our modern society possible...or are we facing a long-term struggle for the declining resources of the globe, a struggle that will potentially endanger our lives and completely transform our society? The answer may be no clearer than the moon when it plays hide and seek on a cloudy night. On other hand, the moon that I can make out on such an evening doesn't seem to be the least bit blue.

Editorial Notes: James Howard Kunstler's post today is on a similar theme: Black Swans Everywhere.

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