An extract from my book “Commodities: 50 Things You Really Need To Know”
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Chapter 8: The role of expectations
“…A scarcity or abundance of crops affects the exchange of the world, and tends to forecast future prices, and to give some clue to future production…”
“In the business world, the rear view mirror is always clearer than the windshield.”
The role of expectations is vital in understanding how demand and supply react to a change in the price of a commodity. This point was first illustrated through the Cobweb Theorem, developed in the 1930s. The theory shows how supply and demand responds in a market where the amount produced must be chosen before the price is observed. Agriculture is a great example of where the theory might apply, since there is an interval between planting and harvesting. For example, because of unexpectedly bad weather, farmers go to market with an unusually small crop of wheat, resulting in higher prices. If the farmers expect these high price conditions to continue, then they will plant more wheat relative to other crops in the following year. When the farmers then go to market with the second year’s harvested crop, supply will be high, resulting in a drop in the price of wheat. And so it goes on. If farmers then expect low prices to continue, they will reduce the planting of wheat for the subsequent year, resulting in a return to high wheat prices yet again.
Very short-sighted of those farmers, you might say.
Critics of the Cobweb Theorem have argued that rational farmers should be able to work out what the equilibrium level of supply should be, given current information about supply and demand. It is argued that farmers should base their price expectations on how they expect the market is likely to work, rather than just reacting blindly to price movements.[ii] However, expectations are not informed predictions of future events, because you can’t have information about the future. As Keynes argued during the Great Depression, the future is not subject to risk but uncertainty, and “It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain.”
Any change is difficult to embrace and variables like commodity demand and supply are very difficult to understand, let alone predict. As much as you or I like to think of ourselves as forward-looking, the truth is that we are all backward-looking to some degree, and we update our perception of the world only gradually (something called adaptive expectations).
Take the example of oil. In the first few years of the 21st century, painful memories of the long period of low prices in the 1990s held back plans to expand production, even as prices surged. More recently, the production and investment plans of the major oil companies appear to have been based on the assumption that the period of high prices experienced between 2011 and mid-2014 would be sustained indefinitely. When prices have been high and rising for some time, it becomes an entrenched assumption that these high prices will persist for the foreseeable future and vice versa.
In order to understand the demand or supply response in all commodities, it is important to realise that it is a joint function of prices, time and, finally, expectations. Prices are closely related to costs, and time is closely related to the delay in adjusting demand or supply to a change in the market. The important factor that is largely fuzzy is expectations. Expectations over future prices may begin to stabilise when the spot price volatility of a commodity falls, but may escalate in markets where the response of other producers or consumers is uncertain (see Chapter 7 on commodity cycles and Chapter 22 on commodity price volatility).
In the event that commodity prices rise, there may be a significant delay until production begins to respond. As explained in Chapter 7 the decision to invest in projects requiring large-scale investment (like developing a mine or an offshore oil field) are based on commodity prices assumed from feasibility studies and debt and equity raisings. These long-run commodity price assumptions tend to lag behind current commodity prices – strong evidence of adaptive expectations in action.
Price expectations are also important in determining demand over the longer-term period. High prices (and the threat, or at least the expectation, of even higher prices) affect both the consumer’s behaviour and the investments by business. For oil, high and rising prices may spur substantial investment in fuel efficient vehicles and other equipment, as well as changes in behaviour and the substitution of cheaper fuels for oil.
The impact of high commodity prices may become deeply entrenched through the introduction of legislation. For example, it would very difficult to undo the US 2005 Energy Policy Act, the 2007 Energy Independence and Security Act and the Corporate Average Fuel Economy (CAFE) regulations.
Commodity markets have always operated this way. Instability and disequilibrium, rather than the opposite, are the norm.
The essential thing:
Price expectations influence both demand and supply.
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