Chapter 1: The Future is Scary

“An uncertain future leaves us stranded in an unhappy present with nothing to do but wait.”

Daniel Gilbert

The year was 2011. For the second time in less than four years the price of wheat, corn and other agricultural commodities had risen sharply. Agricultural prices had rocketed to the highest level in real terms for almost three decades.

The rising cost of food had played a role in provoking uprisings against several authoritarian regimes, while adding millions to the number who go to bed hungry each night. Companies sounded the alarm and the world’s largest economies put “food security” at the top of their to-do list.

A confluence of factors led to the spike in food prices, such as drought in Russia and Argentina, floods in Canada and Pakistan and high oil prices. A weak US dollar and an increased consumption of grains and other agricultural commodities from China, India and other emerging economies also spurred demand. But what made the crisis worse was panic.

A study by the Food and Agricultural Organization (FAO) of the United Nations (UN) found that over thirty nations – including Russia, Ukraine and Argentina – introduced bans on the export of agricultural products. The aim of these measures was to insulate their citizens from the sharp increase in prices and to make sure there was enough food to go round. This was entirely rational from the perspective of governments worried about the reaction of their citizens to higher food prices. However, these export bans, coupled with panic buying by importers spooked into restocking their grain reserves, helped fuel the spike in prices.

Few things matter to basic human existence more than the yields of staple crops such as wheat and corn. Until very recent history, the struggle to provide enough food to eat was the focus of much of human activity. Starvation was an ever-present threat because even the best years rarely yielded much of a surplus to carry over as an insurance against leaner times. In the worst years, only the rich and powerful could be sure of a full stomach.

Fear of food scarcity is a recurring theme throughout history, with doomsayer’s always willing to predict catastrophe. In the late 1800s, Thomas Robert Malthus thought that famine, disease and war were necessary to bring the number of people back in line with the capacity to feed them. As recently as the 1970’s, Paul Ehrlich and many other commentators believed that overpopulation would cause disaster, that billions would die, that developed countries would disintegrate and that India was beyond saving, etc.

Fast forward to the present day and while concerns over shortages of many commodities – from corn to cobalt and from lead to lithium – continue to be a feature of modern life in the early twenty-first century, oil is the current primary driver of our fears for the future. Volatility in the price of the world’s most essential commodity is perilous. It causes tax revenues for countries that heavily rely on the export of crude oil to swell and shrink unpredictably, and it spreads uncertainty to every sector of the global economy that relies on affordable transportation. Uncertainty over the price of crude oil and its availability pervades our entire economic system.

Humans don’t like uncertainty, especially when it comes to the most basic requirements to sustain us. And so, since Man’s first existence, we have tried to see patterns in the sun, wind, rain and stars. We have created rules of thumb for what tomorrow’s weather will bring, and whether God or other omnipotent powers above would unleash a storm or an earthquake. All of which we hope will tell us what tomorrow will bring, whether we will have enough food to last us the winter.

As with commodity markets as it is in all areas of life, we just can’t live without some kind of prediction. All decisions reflect some view of the future, even if it’s a sense that things will be much like they are now – that too is a forecast.

In the face of such uncertainty we have often turned to others who we believe have the knowledge, expertise and skills to look to the future and warn us whats on the horizon. These soothsayers continue to be in demand today.

So who uses commodity predictions and what are their incentives? Typically commodity predictions are used by four distinct groups; governments and central banks; producers of raw materials (eg, an oil exploration company); manufacturers and investors.

Governments and central banks

In a June 2008 speech, titled “Outstanding Issues in the Analysis of Inflation”, US Federal Reserve Chairman Ben Bernanke singled out the role of commodity prices among the main drivers of price dynamics. In turn, he underscored the importance for economic policy of both accurate forecasting of commodity price changes and understanding the factors that drive those changes.

Indeed, uncertainty over the future price of oil is thought to be one of the main causes of uncertainty in inflation projections – complicating decisions over future monetary and fiscal policy. Work by the European Central Bank found that a 20% change in the oil price can affect inflation by approximately 0.4–0.8 percentage points (depending on the initial level of the oil price).

Why is this important for policymakers? Well, when a central bank sets the level of interest rates, they know it may take 18–24 months before the impact is seen in the economy. If, based in part on their expectations for future oil prices they think inflation will rise over the next year then they may decide to increase interest rates to stop inflation from filtering through the economy. If they are wrong and inflation doesn’t rise as much as feared, then they will have unduly stymied economic growth.

Producers of raw materials

The outlook for commodity prices are also important for companies that supply commodities. Forecasts of the trajectory of prices over the next few months and years will drive decisions affecting billions of dollars of investment in commodity production. One of the first things an intelligent asset allocator must do is make expected return forecasts for the commodity producing assets that they own. However, volatile commodity prices make it difficult for long-term investors to assess both a company’s current value and its future value.

This is a particular risk when you consider junior mining and energy exploration projects. These projects can be perilous, often taking place in inhospitable and unstable parts of the world. An optimistic (frequently sky high) price trajectory is generally used to justify the risk that investors are taking. This may leverage billions of dollars worth of capital, but at high risk. Even if the mine operators are successful in bringing a product to market, investors may still be disappointed with the future payoff.

While the outlook for commodity prices influences how billions of dollars are invested in grand projects, it also affects how individual farmers spend their much more meagre but no less important amounts of money, capital and hard work. Therefore, the outlook for agricultural commodity prices is extremely important for farmers. If the farmer is wrong, then he may have toiled away at the land or nurtured his livestock for many years only to find a glut when it’s ready for market. He may then have to resort to storage or, worse, the produce being wasted.

Take the example of a sugar cane farmer. He will do what everyone else does. First, he will take the current price as a reference and then try to work out what factors could move the price up or down over the coming months and years to the point at which he expects to harvest. Second, the farmer might talk to neighbouring farms – how much are they growing this season and what, therefore, is the risk of oversupply? All in all, he gathers as much evidence as he can, including taking the views of commodity forecasters, to help him decide how much to plant.

That is only one part of the equation, however. The farmer will also have to take a view on what the future cost of fertiliser and harvesting will be. Will oil prices rise? If it does then it will also increase the price of fertiliser and the cost of running harvesting machines.

Manufacturers

Processors and manufacturers also need to take a view on the price of their main raw material. Commodities are generally not produced for their own sake, but for the products that can be manufactured from them. Take the example of sugar again. Both sugar cane and sugar beet need processing in a factory before the sugar can be consumed. By agreeing to buy sugar cane or beet from a farmer, the factory owner is hoping to sell the sugar it refines from it at a profit. The owner needs to form an opinion as to how much they should sell forward and how much they should leave until the sugar is produced.

Not all manufacturers have the same incentive to understand the factors affecting their raw materials. For some firms, materials may only be a small percentage of their overall costs or they may be reliant on several raw materials, reducing the time they can allocate to analysing each commodity market. Meanwhile, they may be one of many end customers for a particular commodity producer, reducing the impact they may have in negotiating terms.

The typical end consumer, you and I, at least subconsciously rely on forecasts in forming expectations over whether fuel prices will be cheap or expensive. For instance, this may affect your decision when you come to buy a new car. Do you buy a small fuel-efficient car or a gas-guzzler?

Investors

The outlook for commodity prices is important to investors in commodities and the companies exposed to them, but it also affects all investors no matter what asset they invest in. To understand why remember that no economic variable is more important to investors than inflation. The outlook for inflation affects the performance of equity markets, government bonds, currencies and many other financial assets. Conventional wisdom is that inflation is directly related to how much money the central bank prints. American economist Milton Friedman said: “Inflation is always and everywhere a monetary phenomenon.”

Yet a better guide to inflation (at least when looking out over the period of a year) has been the price of commodities. Swings in oil markets and the market expectations of long-term inflation have moved in lockstep. Arend Kapteyn, Chief Economist of the investment bank UBS, calculates that 84% of the variation in US inflation since 2002 is explained by shifts in oil and food prices.

Commodity forecasts are often used to decide on what positions to take in commodity futures and what investments to make in commodity producers’ equities. Often prices may jump after a bullish forecast is published, because traders bid up prices in the expectation that other traders and investors will do likewise. However, that poses risks to the investor. He or she will not know if the person or institution providing the forecast has any “skin-in-the-game” and, even if they do, if it may change in the days, weeks and months ahead. There is no guarantee that the forecaster will tell you that their view of the market has changed.

The information vacuum present in commodity markets creates a strong incentive to seek those who we perceive as having access to superior data and insight. What do we do when the future is so uncertain and so much rides on it? We look to the experts. Dan Gardner, in his book “Future Babble: Why Expert Predictions Fail – And Why We Believe Them Anyway”, highlights how turning to someone who will provide you with a forecast is half the battle: “Expert predictions do away with complexity, incomprehension, and uncertainty. In their place was the gentle buzz of knowing. All one needed to do was to pick an expert and listen.” The simple act of having something to hang on to provides the basis for action.

For the farmer, this means that he can feel that he is making a rational decision on what crop to plant next season. For the investor, it may be another part of the narrative he can use to inform or justify his retirement investment decisions. For others, such as the managers of our biggest companies, the forecasts may help to justify billions of dollars of investment.

Gardner goes onto say that rejecting the pseudo certainty of experts’ predictions is a scary prospect for most people: “And if you do that – and you can’t accept superstition, religion, or conspiracy theories – what are you left with? Nothing. And that’s frightening.”

But would you trust an expert without a track record? Would you trust a doctor without any certificates to diagnose your ailments, a dentist who had no track record of pulling teeth, or even a financial advisor who could not demonstrate that he had the best interests of his clients at heart? I wouldn’t! So how can you trust financial market pundits as if they are some kind of oracle without first analysing their track record? The next chapter provides the first step in restoring that trust.

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