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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 3 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 4 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 5 Oil and Bonds… it’s mostly about Oil Source: Barclays Research 6 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 11 Kinked Demand Curves: Huge sudden price drops, gluts! D S P Fad disappears pfad Price drop preal Excess supply qfad Source: CPAM Q 12 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 13 Oil – backward sloping Supply curve. Multiple stable equilibria P Dinelastic Sbackwardsloping High equilibrium Low equilibrium p0 q0 Source: CPAM Q 14 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 15 US oil rig count. Low oil prices having a supply effect? Source: Bloomberg 16 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 17 Multiple Equilibria in the Oil market and Demand Response Source: Bank Credit Analyst 18 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 19 Brent – 10% rally in past week Source: Bloomberg 20 Sasol ZAR Price – up 20+% since mid-January Source: Bloomberg 21 THANK YOU!