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Popular Delusions on Grain (SocGen Research Piece)

Popular Delusions on Grain (SocGen Research Piece)

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Published by Nicholas Yeager
“With 7% of the world’s land and water but 22% of the world’s mouths to feed, China’s fight to retain grain self-sufficiency was always going to be a losing battle.”
“With 7% of the world’s land and water but 22% of the world’s mouths to feed, China’s fight to retain grain self-sufficiency was always going to be a losing battle.”

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Published by: Nicholas Yeager on Oct 11, 2010
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10/17/2010

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Macro Commodities Forex Rates Equity Credit DerivativesPlease see important disclaimer and disclosures at the end of the document
17 September 2010
Global Strategy
 Alternative view
www.sgresearch.com
Popular
Delusions
 A structural shift is set to imbalance grain markets and increase global instability
Dylan Grice
(44) 20 7762 5872dylan.grice@sgcib.com
Global Strategy Team
Albert Edwards
(44) 20 7762 5890
albert.edwards@sgcib.com
Dylan Grice
(44) 20 7762 5872
dylan.grice@sgcib.com
The 1973 spike in world oil prices is usually attributed to OPEC’s spectacularly successfulembargo. But commodity markets face disruptions all the time and the effects are short lived.Why did the 1973 oil markets disruption lead to
permanently
higher real prices? The OPECembargo was merely the
trigger
. The
cause
was a structural shift which saw a rapid surge inthe import needs of oil’s biggest consumer, the US, as its oil production peaked in 1970.Today, the grain market’s biggest consumer - China - is undergoing a similar shift.
 
On the 6
th
October
 
1973 – the holy Jewish holiday of Yom Kippur that year - the fourthand most intense Arab-Israeli war started. Egyptian jets launched surprise attacks on Israelicommand posts on the eastern side of the Suez and the Sinai, while Syrian planessimultaneously attacked from the north. It would be the most serious Arab-Israeli conflictever, threatening at one stage to spill over into a full-blown nuclear conflagration betweenthe Soviet Union and the US.
 
Fortunately, a cease-fire was brokered before it came to that. But by then theindustrialised economies were in disarray suffering simultaneous recession and inflation.Indeed, this spectacular use of the “oil weapon” which Kissinger said
“altered irrevocably the world as it had grown up in the post war period” 
would be the most lasting effect. Thepsychological effects of the
“OPEC shock” 
continue to linger in the public’s mind today.
 
But the “oil weapon” might not have been as potent as has generally been assumed.Indeed, it
failed 
 
 miserably 
when used during the six day Arab-Israeli conflict of 1967. Thenthe US had so much spare capacity the embargo simply brought the Arab nations to theedge of financial ruin. The reason it worked so spectacularly in 1973 was that the US sparecapacity was now gone. Indeed, US oil production had already entered into permanentdecline and its import dependency was surging (chart below, grey line).
 
So the spike in oil prices may have been triggered by OPEC’s embargo, but the violenceof the move and the continued volatility was caused by a permanent structural shift. A similar shift seems to be playing out in grain markets today.
The 1970s spike in oil prices was made possible by surging US oil dependency
10%20%30%40%50%60%05101520253035404550
           1           9           6           1           1           9           6           2           1           9           6           3           1           9           6           4           1           9           6           5           1           9           6           6           1           9           6           7           1           9           6           8           1           9           6           9           1           9           7           0           1           9           7           1           1           9           7           2           1           9           7           3           1           9           7           4           1           9           7           5           1           9           7           6           1           9           7           7           1           9           7           8           1           9           7           9           1           9           8           0           1           9           8           1           1           9           8           2           1           9           8           3           1           9           8           4           1           9           8           5           1           9           8           6           1           9           8           7           1           9           8           8           1           9           8           9           1           9           9           0
Arabian light crudeUS oil dependency (netimports as % of consumption)Stable US oildependency1967 OPEC embargoduring the six day warhas
no effect 
on oilprices1973 OPEC embargoworks like a dream ...(and oil prices never returnto pre-embargo levels)Sudden increase inUS oil dependency
Source: SG Cross Asset Research
 
Popular Delusions
17 September 20102
Real commodity prices should decline over time as technological advancement lowers thesupply costs without affecting the basic utility of the commodity. A bushel of wheat today ispretty much the same as a bushel of wheat five thousand years ago, except that it costs afraction of the labour to produce. Temporary bottlenecks shouldn’t change this long-termdownward trajectory, and should cause only temporary price increases until new supply canbe brought to market. A famous example of a temporary shock was that suffered by agriculture markets in 1972 aftera catastrophic Soviet harvest forced Brezhnev to secretly tap world markets in an operationwhich became known as the “Great Grain Robbery.” The Soviet Union was one the largestconsumers of grain in the world and its sudden, forced and mercifully short-lived plunge intothe world grain markets as a large buyer caused prices to nearly triple (see chart below).
What a temporary shock looks like – the CRB food index after the Great Grain Robbery
050100150200250300350400450
         0         1          /         0         9          /         6         8         0         1          /         0         7          /         7         0         0         1          /         0         5          /         7         2         0         1          /         0         3          /         7         4         0         1          /         0         1          /         7         6         0         1          /         1         1          /         7         7         0         1          /         0         9          /         7         9         0         1          /         0         7          /         8         1         0         1          /         0         5          /         8         3         0         1          /         0         3          /         8         5         0         1          /         0         1          /         8         7         0         1          /         1         1          /         8         8         0         1          /         0         9          /         9         0         0         1          /         0         7          /         9         2         0         1          /         0         5          /         9         4         0         1          /         0         3          /         9         6         0         1          /         0         1          /         9         8         0         1          /         1         1          /         9         9         0         1          /         0         9          /         0         1         0         1          /         0         7          /         0         3         0         1          /         0         5          /         0         5         0         1          /         0         3          /         0         7         0         1          /         0         1          /         0         9
Nominal food pricesReal Food prices
CRB foodindex spikes
after
poor Sovietharvest... but realprice declineresumes as shock dissipates
 
Source: SG Cross Asset Research
But the shock was largely temporary, as poor harvests tend to be. There was an aftershock in1977 as the Soviets endured another poor harvest but the bull market in agricultural producewas over. Prices remained in a tight range for the next few decades and failed to keep pacewith inflation.The shock to energy markets was more serious. It was driven by the
 permanent 
peaking of USoil production in 1970 which pushed the US dependency ratio (imports as a % ofconsumption) from 20% to 40% in barely three years. The permanent nature of that shift isreflected in the permanent rise in real oil prices: the subsequent oil glut of the 1980s crashedthe market and ruined many leveraged players, but even in the depths of the globalcommodity bear market in the aftermath of the Asian crisis in 1997,
 real 
prices were 70%higher than they had been before the OPEC shock of 1973 (see sequence of charts below).This implies an interesting hypothesis: the 1970s bull market in energy wasn’t caused by theOPEC embargo but by the strain of the market’s largest consumer suddenly and permanentlyincreasing its dependency on the oil available for export. The implication is that had OPEC
 not embargoed 
oil during the Yom Kippur war, real oil prices would eventually have risen anywaybecause underlying conditions required it.
 
Popular Delusions
17 September 20103
US oil production permanently peaked in the 1970s
1,0001,5002,0002,5003,0003,5004,0004,500
         1         9         4         9         1         9         5         2         1         9         5         5         1         9         5         8         1         9         6         1         1         9         6         4         1         9         6         7         1         9         7         0         1         9         7         3         1         9         7         6         1         9         7         9         1         9         8         2         1         9         8         5         1         9         8         8         1         9         9         1         1         9         9         4         1         9         9         7         2         0         0         0         2         0         0         3         2         0         0         6         2         0         0         9         P
US Oil production(000 barrels)peaks in 1970
 
Source: IEA 
… leading to a rapid doubling of US import dependency …
0%10%20%30%40%50%60%70%
         1         9         5         8         1         9         6         0         1         9         6         2         1         9         6         4         1         9         6         6         1         9         6         8         1         9         7         0         1         9         7         2         1         9         7         4         1         9         7         6         1         9         7         8         1         9         8         0         1         9         8         2         1         9         8         4         1         9         8         6         1         9         8         8         1         9         9         0         1         9         9         2         1         9         9         4         1         9         9         6         1         9         9         8         2         0         0         0         2         0         0         2         2         0         0         4         2         0         0         6         2         0         0         8
    U    S   n   e   t   o    i    l    i   m   p   o   r   t   s   a   s   a    %   o    f   c   o   n   s   u   m   p   t    i   o   n
US dependency onworld oil surges
 
Source: IEA 
… and pushing
real
oil prices to a new long-term equilibrium
020406080100120
         1         9         6         8         1         9         7         0         1         9         7         2         1         9         7         4         1         9         7         6         1         9         7         8         1         9         8         0         1         9         8         2         1         9         8         4         1         9         8         6         1         9         8         8         1         9         9         0         1         9         9         2         1         9         9         4         1         9         9         6         1         9         9         8         2         0         0         0         2         0         0         2         2         0         0         4         2         0         0         6         2         0         0         8
    R   e   a    l    A   r   a    b    i   a   n    L    i   g    h   t    P   r    i   c   e   s    (    2    0    0    9    $    )
Pre-embargoprice was$10 p/barrelDepthsof Asiancrisis sees real oilprice trough at $17
 
Source: BP Statistical Review

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