SpawnPoint - Where Game Begins

In the past few days, the prices of most of the mainline commodities  have plummeted. This — and the spikes of the past two years — is nothing new. It is simply the nature of commodities.(Luckily, I sold off some Gold recently!)

With most products, if the price goes up, consumers are less likely to purchase the item in question. Not so with energy. If the price of a gallon of gasoline doubles, consumers pretty much have to grumble and bear it. So even though the price of gasoline has nearly tripled in the last three years, demand for it in the United States has only recently begun to trail off — and even that only by single-digit percentages. Food is less elastic than most products (because you have to eat) but more elastic than oil (because you can always eat something cheaper).

And oil’s inelasticity is becoming entrenched. Oil is a dirty and inefficient means of generating electricity and was abandoned in the developed world ages ago as a power fuel — in wealthy countries it is now primarily used for transport fuels, mostly gasoline and diesel. In the past few years, much of the developing world has made that shift as well. Since transport fuels have even fewer substitutes, they tend to exhibit less elastic demand patterns than power fuels; so oil on the whole is becoming a more inelastic commodity.

But there is more to it than the “simple” law of elasticity. The bottom line is that the impact of rising price volatility is more significant than the phenomenon of rising prices, especially since volatility goes both ways. The nature of the global energy industry has changed greatly in the past 15 years, and while some of the changes are tending to push prices up, nearly all of them have an even greater effect on price volatility.

The technologies the energy industry is bringing to bear are impressive by any measure, but all of these new projects require a lot more capital and skill to develop than the fields of yesteryear. And, as with the entrance of the former Soviet Union (with its transportation issues) into the market described above, this means that the magnitude of any given disruption is greatly magnified by the huge sums already sunk into the presale production process (that now stand a chance of being wiped out in a flash). The market then responds with panic.

But the events of the past week have revealed a firm, but little-known, fact about the commodity markets. Volatility means that prices can change rapidly. Volatility does not mean that this direction has to only be upwards.

In 2001, after Sept. 11, the markets started to price in an American war with an oil producer and prices rose by 2 percent within two days. When it turned out that a global slowdown was more likely than a war with Saudi Arabia, prices dropped — again by about a third — within about a week.

The effects of rising price volatility are more significant than the persistence of rising prices because volatility cuts both ways. Expect more price rises — and falls — to come.