Monday, 19 May 2008

The Year Of Hunger

How will 2008 be remembered in the future? As we head towards the point half way through the year, events are already starting to take shape. 2007 saw the increase in world food prices of 37%, which have continued to rise during 2008 (up to another 20% so far this year). It would appear that the rising cost of basic foodstuffs is likely to be a key issue this year.

The rise in food prices has been the result of a combination of three factors. First, on the demand side, rising incomes in Asia – and in India and China in particular – have increased demand for foodstuffs. More grain, especially rice, is demanded for human consumption. Additionally, as incomes increase, so does the demand for meat, which in turn increases further the demand for grain to be used as animal feed. One of the consequences of globalisation has been the rising incomes that are now being constrained by rising prices. The situation is exacerbated by the drive towards bio-fuels – particularly in the US. The US policy on bio-diesel is now starting to distort the global market for maize (corn in the US) and add to the volumes of grains demanded.

Second, on the supply side, as a reaction to rising food prices, a number of producer nations have imposed restrictions on their grain exports. Argentina and Ukraine are restricting the export of wheat, whilst India, Vietnam, and Thailand are restricting exports of rice. These restrictions on the supply of foodstuffs are acting to tighten further a market that is already tight. On top of this, a number of natural disasters have served to ensure that world food prices remain tight later in the year. For example, Cyclone Nargis is responsible for the salination of the rice paddy fields of the Irrawaddy Delta, which will transform Burma from being a net exporter of rice to being a net importer of rice in 2008.

The third factor has been the market distortion caused by speculation in the futures markets for soft commodities. The Washington Post describes food as “the new gold”. It states that “Investors fleeing Wall Street's mortgage-related strife plowed hundreds of millions of dollars into grain futures, driving prices up even more.” (See article). This has served to push world food prices even higher.

The impact of high and rising food prices are now being felt around the world. In the developed world, rising food prices – combined with rising energy prices - have led to the return of inflation as a policy issue. This has given the monetary authorities something of a dilemma. On the one hand, the credit crunch would call for a loosening of monetary policy, whereas, on the other hand, the return of inflation would call for a tightening of monetary policy. If the monetary authorities get the policy response wrong, there is the clear prospect of the return of stagflation in the G7 economies. Potentially, if inflationary expectations are rekindled, it could take half a generation to resolve that issue.

In the developing world, we can now see the effects in terms of popular discontent. Food riots have already removed the government of Haiti. As the food crisis progresses, we can reasonably expect further popular discontent – particularly in those nations where rising food prices are likely to lead to mass hunger. The Economist estimates that a billion poor urban consumers – one sixth of humanity - will go hungry this year (see article). The prospect of a series of destabilising political events across the globe is a factor that is likely to make 2008 a much riskier time in which to do business.

This is why we are starting to think of 2008 as the year of hunger.

Monday, 12 May 2008

The New Nationalism Revisited

We recently posted about the New Nationalism that is developing as a counterpoise to the process of Globalisation (see post). Since then, Cyclone Nargis has devastated much of the Irrawaddy Delta in Burma (Myanmar) and has given us a glimpse of the New Nationalism in action. Despite an overwhelming need for external aid, the Burmese authorities have been very reluctant to allow into the country much of the international aid that is on offer. The rest of the world cannot understand this. In our Globalised world, in which countries are interconnected with each other, people are finding it hard to understand why this aid is being refused.

Things look differently if we view the situation from the perspective of the Burmese government. Foreign aid is rarely just that - a gift. It is very common for aid to be accompanied with conditions, which can often be quite impossible for the recipient. For example, if aid were tied to democratic reforms, then we can see why the Burmese government might not want that aid. The delivery mechanism for the aid is often through the military infrastructure of the donor countries. We can see why, after being lambasted by the US for years, the Burmese authorities are reluctant to give the US military access to the country. There is also the suspicion of foreign NGOs, who, in the past, have been associated with a political agenda tied to regime change. Again, we can see why the Burmese authorities are reluctant to give foreign NGOs access to the country.

We are left with the position that the Burmese authorities are grateful for the aid delivered, as long as there are no strings attached to the aid, but they will undertake the distribution of the aid. This calculus baffles the west. Western governments cannot understand how the Burmese authorities are prepared to allow tens of thousands of their citizens to die from thirst, hunger, and disease rather than to open up the country to foreign aid. However, in the context of the New Nationalism - of which this is an extreme case - it makes perfect sense.

It is a price worth paying to remain disconnected, or so the Burmese authorities appear to calculate, from the rest of the world.

Friday, 9 May 2008

The Cost Of the Black Stuff

With the price of oil pushing through the $120 per barrel level, many are now asking how high the price of oil can go. Whilst oil at $120 per barrel is high in nominal terms, it is by no means clear that the price of oil is that expensive in real terms. The cost of $120 per barrel is in 2008 dollars. If we were to translate cost of oil in the early 1980s (the previous record price of oil) into 2008 dollars, then the cost of 1980s of a barrel of oil in 2008 dollars would be $94 using the producer price index and $118 using the consumer price index.

However, these price indices do not account for the growth in purchasing power since the early 1980s. In 1981, the annual average income in the G7 nations would have bought 318 barrels of oil. Given the annual average income in the G7 nations today, in order to limit the purchase to 318 barrels of oil, the price would have to rise to $134.

Alternatively, in 1980, in the US, 8% of disposable income went on energy. Today it is 6.6%. For the relative cost of energy to increase to 8% of US disposable income today, the price of oil would have to rise to $145 per barrel. Again, in 1980, spending on oil as a percentage of global output was 5.9%. Today it is 3.5%. For the spending on oil as a percentage of global output to reach the level of 1980, the price of oil would have to rise to $150 a barrel.

In nominal terms, the current price of oil looks expensive. In real terms, it is looking about right. And in terms of purchasing power, the current price of oil looks relatively inexpensive. For the future prospect of the price of oil, there are two critical uncertainties – one on the demand side, and one on the supply side.

On the demand side, much depends upon how extensive the downturn in the US economy will be and the extent to which the world economy has decoupled itself from the US economy. If the downturn is hard, and if the global economy is still coupled to the US economy, then the demand for oil is likely to weaken sufficiently to soften the price of oil. If the US downturn is not that severe, or if the world economy is less dependent upon the US, then we can expect demand for oil to remain robust, and to further harden the price of oil.

On the supply side, we need to look at the petro-economies – particularly the ‘low absorbers’ (those economies that do not absorb the oil revenues, but channel them into foreign investment). From the perspective of the low absorbers, the traditional investment routes (bonds, equities, and property) currently appear to have high risk and relatively low returns. A far better investment, given the price elasticity of demand for oil, is to simply leave the oil in the ground. It has a relatively low risk, and is currently yielding far better returns than any other investment.

If this takes hold as a production strategy for oil suppliers, then a restricted supply of oil will add to the pressure for its price to harden. However, there is also an incentive for the high absorbers to increase their oil production because, by definition, they would like to spend their oil revenues rather than invest them. This would act to soften the price of oil as stocks are released into the market. The critical uncertainty on the supply side is whether or not the low absorbers or the high absorbers will gain the upper hand.

In 2006, we came across a US analyst, Stephen Leeb, who was writing about oil at $200, and the economic implications of this. It would appear that Goldman Sachs has recently taken up this thinking, and are now talking of oil between $150 and $200 per barrel by the end of 2008. For this to happen, on the demand side, either the US downturn would turn out to be not too severe, and/or the global economy would have decoupled from the US economy; and on the supply side, the oil producers would have concluded that oil has more value to them in the ground rather than out of it. As we have seen, oil at $150 per barrel is not necessarily expensive in terms of purchasing power. If we take this view, then the price of oil has quite some way to go.

From a longer perspective, do your scenarios consider how your world view might change if oil were to increase in price to, say, $200 per barrel or beyond?

Wednesday, 7 May 2008

Putting the 'B' back into 'BRIC'

In a recent post (see post), we highlighted how Brazil has become the 'forgotten BRIC nation'. It would seem that we are not the only ones who have noticed the quiet rise of Brazil. In a recent article from McKinsey (see article), the case for Brazil is restated. The article is on the optimistic side, and a more balanced presentation would include more of the case against Brazil. However, it does act as a corrective against our oversight in this area.