Why we're stuck with insane prices

By Jim Jubak

If you think prices have become insane, you're right. But insanity rules markets for everything from oil to rice right now. In fact, insanity is the new "normal."

For example, why should oil sell for $119 a barrel, a whopping $55 a barrel, or 86%, higher than it did last April?

It's like the United States is suddenly out of oil, right? March crude oil reserves in the U.S. were actually 2.4 million barrels higher than reserves in February and only a trifling 3.4% lower than reserves in March 2007, according to the Energy Information Administration. An 86% jump in oil prices because reserves fell by 3.4%? I don't think so.

The global picture is similar. Global oil stocks held by developed economies came to 2.58 billion barrels at the end of March -- pretty much the same as at the end of 2007.

Global supply and demand is tight, with the latest projections from the International Energy Agency showing supply at 87.3 million barrels a day and demand at 87.2 million barrels. Tight, but supply is still ahead of demand.

Don't stop with oil prices, though. Look at rice, which recently cracked $1,000 per metric ton. The price of export-quality rice is up 173% in a year, even though global rice stocks will finish 2008 about 1 million metric tons higher than at the end of 2007, according to the U.S. Department of Agriculture.

Or copper, which is setting record highs just about every day and has climbed in price by 30% so far this year. Or aluminum -- up 28% this year. Or wheat. Or corn. Or, well, you name it.

Why normal rules don't apply

We've all heard the explanations. Demand for this or that has soared due to growth in developing nations, increasing production of biofuels or whatever, and supply has stumbled due to miners' strikes or an electricity shortage or a drought in Australia.

But lots of folks -- I get e-mail about this every day -- don't buy these stories. They see small production shortfalls, but still substantial stockpiles, and ask how this adds up to a 100% increase in the price of oil or rice or wheat in a year.

Well, it doesn't -- in a normal economy. But the global economy is now playing by different rules, the rules of economic scarcity, and the rules of scarcity say the normal relationship between supply and demand and prices doesn't hold. Yes, prices are insane. But this kind of price insanity is exactly how a scarcity economy works.

The concept of scarcity is central to the economics of normal markets. Most goods, whether bluejeans or peanut butter, don't exist in unlimited supply. The market rations those goods with prices that match supply to demand.

For example, at $3 a pair, consumers might demand 2 million pairs of sneakers, while factories can produce just 1.5 million pairs. At $8 a pair, demand might fall to 1.5 million. Consumers who wanted sneakers at $3, but don't at $8, delay or forgo buying sneakers, or wear sandals instead.

It starts in our heads

And in a normal market, if there isn't enough demand at $3 a pair, the price falls -- either in the short term through discounting or in the long term by companies going out of business -- until demand meets supply, and the market clears.

Scarcity markets play by different rules. In fact, scarcity markets exist because buyers believe the normal rules of supply and demand have broken down. Buyers in a scarcity market don't believe higher prices will depress demand or increase supply enough to allow supply to meet demand. In such a market, prices are driven by fear that there will not be enough supply at any price.

If, for example, companies that need copper to make electrical machinery, wire or pipes bid prices higher because they worry that current prices won't bring supply and demand into alignment anytime soon. They fear they won't be able to buy copper at any price when they need it.

Scarcity markets aren't created overnight. Potential buyers need to be bloodied by repeated experience on both the supply and demand side. Consumers of copper know that for each of the past six years, the copper industry has failed to deliver projected increases in supply.

In 2008 and 2009, according to UBS AG (UBS, news, msgs), the industry will fall short again. The bank projects production a shortfall of 800,000 metric tons over those two years.

Continued: A sense of inevitability

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