Commodities Crash: A Market Economist’s Nightmare

Do you remember the first great internet investment bubble of the late 1990s?

Hundreds of millions of dollars were invested in astonishingly flimsy firms like Pets.com and drkoop.com. The NASDAQ market, host to many of the Initial Public Offerings (IPOs) that attracted funds to these companies, witnessed its composite index quintuple in value in just six brief years between 1995 (when it surpassed 1,000 for the first time) and 2001. But then, like all bubbles, the index valuation crashed, collapsing back to a value slightly above 1,100 by late 2002.

At the time of the crash, many American investors swore that they would never again be beguiled by future bubble markets, promising to restrict their funding decisions to more stable industry sectors. And yet, just a few years later, rock-bottom mortgage interest rates created a mammoth real estate bubble, supported by the irrational proposition that home investment valuations in the United States could never decline in absolute terms. Nevertheless, when that bubble burst in late 2008, it nearly brought the entire global economy down with it.

Have global investors learned their lessons about avoiding manic bubbles? Apparently not! In fact, yet another investment sector appeared to gyrate towards a crash last week, one so universally significant that it is giving market economists nightmares.

Silver and Gold and Oil, Oh My!

The sound of the largest crash last week came from the silver market. The value of silver, having soared by 57% during the first four months of 2011, suddenly reversed direction and fell more than 25% during the first five trading days of May.

And yet gold, too, went into a tailspin. After having jumped from $1,000 to $1,541 between September 2009 and April 2011, it suddenly slumped by close to 5% during the most recent four trading days. And oil, having soared from $33 per barrel in January 2009 to levels beyond $100 per barrel in February 2011, fell by almost 15% last week.

Pundits blamed these sudden lurches in commodity values on investment speculators who buy and sell vast quantities of these materials on the global markets. Unfortunately, though, firms that use these commodities for industrial and consumer applications must purchase them on the same global markets. Inevitably, when prices fluctuate so dramatically, corporate planning activities for the future — as well as their operations activities in the present — become unmanageable.

Ripple Effects

Gold, for instance, is more than just a glittering metal that is shaped into rings and necklaces. It is also an excellent conductor of electricity, and is therefore employed as an industrial component in many types of electronics equipment. Manufacturers of computers and cell phones thus feel their profits pinched whenever speculators drive up the cost of the precious commodity.

Silver, as well, is a strong conductor of electricity and heat, and is able to withstand extreme variations in temperature. Manufacturers of conventional batteries and solar energy panels rely heavily on it, and likewise see their profits vanish whenever the cost of silver increases. And in the nascent alternative energy industry, where losses are common even under the best of conditions, such cost bubbles can drive development projects (and entire firms) into bankruptcy.

Sharp increases in the cost of crude oil can, likewise, ripple through the entire global economy. Airlines simply retreat from markets that become impossible to serve profitably, cutting off tourist areas and business markets from their constituents. And, on a personal level, economically strapped families in cold weather states like Massachusetts and Michigan are forced to wonder how they’ll find the funds to heat their homes through frigid northern winters.

The Cost of Uncertainty

As market economists know, the true costs of such massive fluctuations in commodity values extend far beyond the expenditures that are required to procure the materials themselves. Indeed, the greatest costs of all may emanate from the uncertainty that is generated by such fluctuations, an effect that paralyzes commercial activity and drives up the cost of capital.

When the Chief Financial Officers of alternative energy firms witness the cost of traditional crude oil more than triple within two years, and then drop by almost 15% in a single week, they cannot help but wonder whether that cost might continue plummeting in the near future. If such declines actually continue, the cost of oil-based energy would likely fall so low as to make the cost of alternative energy unattractive by comparison.

Furthermore, banks and investors would perceive such alternative producers in a far more risky light, and would raise their interest and dividend demands accordingly. In other words, the cost of obtaining investment capital at alternative energy firms would soar at the very moment that their competitors’ operating costs would fall.

The result would be paralysis in the alternative energy sector, thereby locking our economy into the perpetual boom-and-bust price cycles of the traditional commodities sector. Can we afford to continue living with such outcomes? Perhaps not, because without stability in the price levels of commodities and other raw materials, no business can feel comfortable investing in growth plans for the future.