Tuesday, September 2, 2008

Internet Corn and Driving with the Rearview Mirror

A few years ago, when streaming internet video was just taking off, a tech savvy Iowa farmer put a web cam in his corn field, so that folks from all over the world could watch his corn grow. I am sure it was riveting entertainment. Maybe there was someone (somewhere) that watched with great rapture on those few hot July days where the corn grew 2.5 inches. Based on the data points associated with the growth rate of that corn on those days, an uneducated person or economist might have predicted that the corn would reach 15 feet tall by October.

In truth, most folks (even economists) know that corn won't reach 15 feet tall. It's a genetic thing. But this type of error - extrapolation of past observances into the future - happens all the time when trying to predict commodity market supply and demand. Watching previous months' supply rate or demand rate and forecasting based on these occurrences is commonplace...and it is a lot like driving a car by using the rearview mirrors. When the road is straight, it works great. But throw in an unseen curve, and the trip gets bumpy - quickly. I wish I could remember where I heard the quote: "All [economic] models are wrong. Some of them are useful."

It is the same thing for oil markets. Today, I want to focus in on the bully on the block, China. China has received a large amount of credit/blame for the recent bull market. Economists point to the 1.3 billion people that live there and note that the consumption in China has been going up about 10% per year. They also note that the Chinese use about 1/20th of the oil that US citizens use on a per capita basis. Based on those two data points, they predict an unmercifully compounding future consumption trend. And the market, driven by supply and demand, has reacted. In my opinion, the main driver of price from July 2007 to July 2008 was the worry that demand in emerging nations like China would outstrip the capacity for the oil industry to supply it. Indeed, even after a little "demand destruction" the market is still concerned that the recent demand growth rate is unsustainable.

What doesn't make much press is that China has problems of its own. Lots of problems. The communist government has built its economy upon making things. And those things must be bought by people. People in the US (by far the biggest consumer in the world) and other economies throughout the world. But now about half of the world's economies are teetering on the brink of recession.

The behemoth that is the Chinese economy is in trouble. The currency is weak, the stock market is flagging, and inflationary pressures are nipping at the central banks heels. So, I find myself asking the question: "Does something as complex as the economic growth of China deserve a straight line?" Alternatively, one could ask "Do the backwards looking economists really think that Iowa corn will hit 15 feet tall?"

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