Why we're stuck with insane prices

In the oil industry, major suppliers that were being counted on to increase production have announced production declines. Production fell 1% in Russia for the first quarter, for example. And suppliers who were being counted on to stabilize production have announced even bigger shortfalls. First-quarter production in Mexico dropped almost 8%.

And it helps establish scarcity economics as the rule of the markets if potential buyers become convinced that higher prices won't dampen demand. That happens fastest in markets for goods that buyers especially need. Most Asian consumers of rice, for example, can't choose to eat less without running a real risk of hunger or starvation. And there isn't a ready substitute for high-priced rice. What are they supposed to do, eat even-more-expensive wheat or corn?

A sense of inevitability

But the most profound effect of scarcity economics on prices comes in markets where buyers who were convinced that higher prices would cut demand come to believe that higher prices have little effect on demand. That has happened in the oil market in the past year. Oil at $80 a barrel and gasoline at $3 a gallon were supposed to cut demand and bring prices back down. But they didn't.

Judging from the futures market, where oil trades above $100 a barrel as far into the future as the eye can see, potential buyers believe today's high prices won't reduce demand anytime soon.

And because demand for oil hasn't declined, oil analysts now worry it will take a run above $175 a barrel from the current $119 before price reduces demand. (See my April 22 column, "Why oil could hit $180 a barrel.")

Once a scarcity market is established, it produces behavior by buyers that can lead to the very scarcity they fear. Hoarding, for example, can empty shelves. Of course, the emptying shelves themselves create panic buying that just empties the shelves faster.

Security at any price

And by taking supply off the market, hoarding produces shortages. During the gasoline crises of the 1970s, drivers who topped off their tanks daily out of fear there wouldn't be enough gas the next day helped cause those long lines at gas stations and, by moving a substantial part of the gasoline supply from the public market into their private tanks, reduced the available supply.

Scarcity economics also turns the relationship between low- and high-cost producers upside down. In a normal market, a low-cost producer sets prices low enough to sell out all of production and high enough to maximize profit without decreasing demand and endangering sales. In a scarcity market, the high-cost producer sets prices because buyers who fear they won't be able to get the goods they need will pay almost any price to ensure themselves of a supply.

You can see scarcity economics at work in today's fertilizer market, for example. Potash of Saskatchewan (POT, news, msgs) produces potash and nitrogen fertilizers. But with the world short 1.2 million metric tons of potash in 2008 and desperate for nitrogen fertilizer, Potash is seeing its already high margins soar to astounding heights. In announcing its first-quarter earnings, the company projected that margins in 2008 will be roughly 3.5 times as high as in 2007.

Price insanity becoming the norm

Think that's insane? As long as scarcity economics rules the fertilizer market, there's a good chance Potash will get its price, and other fertilizer makers will go along for the ride. The global scarcity has made high-cost, government-subsidized producers in India the price setters in the market: If you've got to have supply, you'll pay any price, right? That price and not Potash's production costs are now setting the market price.

Supply contracts for potash for the second half of 2008 are up for negotiation in Japan and India. Japan paid just $120 a ton for potash in its contract for the first half of 2008. China recently signed a long-term contract for $576 a ton. That was a $456-per-ton price jump. And even with that increase, the Chinese didn't get all the potash they wanted. The country is now looking at a shortfall that some experts peg as high as 40%, just when China is trying to increase food production to cut inflation in domestic food prices.

From 1989 through 2006, potash delivered in Asia sold for $200 a metric ton. According to the company, potash prices could reach $1,000 a ton by the end of this year. That has left Wall Street analysts who recently increased their projections to a range of $700 a metric ton struggling to catch up.

And yes, that all sounds insane. But insanity is "normal" when scarcity economics rules. Remember that when you try to figure out what price to pay for shares of any producer of fertilizer, copper, tin and oil these days.

Continued: Developments on past columns

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