Download Oil and Backward Sloping Supply Curves

Kinked Demand and Supply
Curves, and Oil
03 Feb 2015
Kinked Demand and Supply Curves
2
John Maynard Keynes on Defunct Economists…

The ideas of economists and political
philosophers, both when they are right
and when they are wrong, are more
powerful than is commonly understood.
Indeed the world is ruled by little else.
Practical men, who believe themselves
to be quite exempt from any intellectual
influence, are usually the slaves of some
defunct economist. Madmen in authority,
who hear voices in the air, are distilling
their frenzy from some academic
scribbler of a few years back.
– John Maynard Keynes
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Defunct Economist I. Silvio Gesell (1862 - 1930. German Empire).
Negative Interest rates
Definition: Gesell Tax
Banknotes are only legal tender if the
they bear the stamp of the government.
People pay for the stamp. In effect, a
negative interest rate (Switzerland)
In modern fractional reserve banking,
this is easily achieved by instituting a
negative interest rate on reserves held at
the central bank and is in place in
many countries around the world
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Defunct Economist II: Thorsten Veblen (1857 to 1929, USA). Veblen effect
Definition: Veblen Effect
Abnormal market behaviour where
consumers purchase the higher-priced
goods whereas similar low-priced (but
not identical) substitutes are available. It
is caused either by
(i) the belief that higher price means
higher quality, or
(ii) by the desire for conspicuous
consumption (to be seen as buying an
expensive, prestige item)
Source: BusinessDictionary
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Oil and Bonds… it’s mostly about Oil
Source: Barclays Research
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Traditional Demand-Supply Dynamics: Monotonic Functions
D
S
P
p0
q0
Source: CPAM, and (Alfred Marshall! )
Q
7
Example – China and the Commodities Super-cycle:
D D1
S
Rightward shift of
Demand curve
P
Rightward shift of
Supply curve as
industry adjusts
p1
p2
p0
q0 q1 q2
Source: CPAM
S2
Q
8
Oil Market in Surplus by 1m barrels per day
Dinelastic
P
Selastic
p0
Huge Price
response
p1
0
Source: CPAM
q0 q1
Small Quantity Change
Q
9
Kinked Demand Curves: Veblen effects etc. Two equilibria
D
S
P
Fad
pfad
p0
q0 qfad
Source: CPAM
Q
10
Kinked Demand Curves: Trap for Suppliers – don’t be fooled!
D
S
P
Fad
pfad
Unstable
Equilibrium!
p0
q0
Source: CPAM
qfad
Q
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Kinked Demand Curves: Huge sudden price drops, gluts!
D
S
P
Fad disappears
pfad
Price drop
preal
Excess supply
qfad
Source: CPAM
Q
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Kinked demand Curves – business and investment Implications
 Do not expand supply if in a fadish industry or business (new
restaurants, Swatch watches)
 Watch capex in a new business
 Watch Veblen effects in the industries in which we invest. Beware on
the market’s new darlings
 Novelty, new businesses? Beware of the hot new thing – is it
sustainable (e.g. Google going to compete with Uber)
 Let the queues build and settle for a while before acting
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Oil – backward sloping Supply curve. Multiple stable equilibria
P
Dinelastic
Sbackwardsloping
High equilibrium
Low equilibrium
p0
q0
Source: CPAM
Q
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Oil- Multiple Equilibria, because of politics, bizarre industry structure
 Fundamental fair value for oil? Analysis usually based on a simple
demand-supply metrics
 Problem with view: More than one price can be consistent with the
so-called fundamentals
 Supply curve may be ‘backward-bending’ in places, meaning that
there may be certain situations where lower oil prices encourage
more supply. How?
 (i) Oil producers generate more supply to generate additional cash
flow. Could be targeting a certain level of government income
 (ii) to hurt high cost producers not sticking to quotas
 (iii) for political reasons
Source: Bank Credit Analyst
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US oil rig count. Low oil prices having a supply effect?
Source: Bloomberg
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Result of backward-sloping oil Supply Curve
 Demand and Supply intersect more than once
 This implies no single equilibrium price for oil. Rather, a number of
possible prices
 Market could have moved from a high price equilibrium to a low-price
equilibrium in the short run
 If this indeed happened, the market’s attention on many things that
normally drive oil prices may prove meaningless
 To restore old equilibrium: Saudi Arabia abandons it’s new oil
strategy (unlikely), or
 Oil demand rises over time (becomes less inelastic) to absorb the
new production
 Oil prices can thus fall or rise more than is expected. VOLATILITY!
 Oil prices perhaps not yet at their lows… because despite their
plunge, both the Brazilian real and the Russian ruble are 30%
and 60% above their 2004 real trade weighted levels. No
capitulation yet
Source: Bank Credit Analyst
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Multiple Equilibria in the Oil market and Demand Response
Source: Bank Credit Analyst
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Oil and Sasol etc - Conclusions
 Cannot rely on traditional Demand-Supply dynamics
 Oil price at present volatile, with price jumps as a possible feature
 Must be wary of any macro-economic forecasts which overly rely on a
sustained weak oil price (Recency effect)
 Sasol cannot be bought and sold based on long-term profit drivers.
Cannot take a huge bet on not owning any Sasol. The market will have
it in their portfolios to hedge; not all investors will look at the long-term
profit drivers
 A company like Sasol is probably the only company on the JSE that
hedges against the oil price (BIL and GLN to a lesser extent), especially
the ZAR oil price. It will be owned for hedging purposes
Source: CPAM
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Brent – 10% rally in past week
Source: Bloomberg
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Sasol ZAR Price – up 20+% since mid-January
Source: Bloomberg
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THANK YOU!