Understanding Supply, Demand And Inflation - Part I

Supply And Demand is a phrase that is very important to understand fully if you are to consider trading some economic indicators such as the CPI, which is incidentally being released for the Eurozone on Friday at 10:00. However supply-and-demand won’t explain everything unfortunately there is also inflation and then there are a myriad of other elements to consider.

“The CPI or Consumer Price Index is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.”

That is, the CPI is a measure of prices of a specified basket of goods, which is meant to approximate the overall price action of the broader economy. This is only an approximation, however, and is only likely to be accurate over long periods of time. Measured over a 20 year period, the CPI is likely to be very close to actual monetary inflation. However, over shorter time periods, such as a year or even shorter, all bets are off. The reason for this short-run discrepancy is that many factors can affect the price of goods and services that have nothing to do with the overall money supply. For example, was the run-up in oil prices last year inflation or was it merely supply and demand? In hindsight, it was obviously a supply-and-demand issue, not an inflation issue.

Thinking about the Oil Shock is a good way to explain the differences between supply and demand as well as the other external factors that may influence a price. Remember when Brent Crude Oil was at $147 in July and then crashed to its low of $36 in December what the heck happened there. Was it inflation was it supply-and-demand or what else was actually going on?

I am going to try and show that supply and demand are important factors in determining a price but that it is also important to understand that you need to understand what are the other potentially factors that appear to impact on the price.

Trading in hindsight is always 20/20 so using oil as an example will help, and having called the top on oil when it hit $100 dollars I wish that I had known about the other factors that influenced price at the time. Having said that I have learned from it!

The Oil Price
In July the oil price peaked at $147 with several analysts tipping a short-term target of $200. Since then, three main factors have been responsible for a 66% fall to $50; some well informed traders knew that these were the case as the price was going up but not everyone:

1) Global slowdown. Sure, it was already happening, but it took a bit longer for the oil barons to realise this.
2) The Dollar turned from least to most favoured currency; because oil is priced in Dollars a stronger Dollar means that even if the oil price falls it can maintain its value against other currencies. For example, if oil is priced at $140 and the EURUSD rate is $1.61, then oil is worth €87. If the EURUSD rate falls to $1.30, then oil could fall to $113 and still be worth €87. Of course, it’s fallen well beyond that now.
3) Many speculators, in particular the hedge fund community, suffered a lethal dose of massive investor withdrawals, and higher margin calls from their brokers. This had the effect of forcing speculators to sell ‘at any price’.

Over the longer term the price of oil is determined by supply and demand , so we will start by looking at each of those in turn:

Demand
The International Energy Agency cut its forecast for demand for both 2008 and 2009, and its price assumption from $100 to $80 for 2009. However, although the IEA cut its forecasts, it still sees an increase in demand going forward. The agency is projecting an increase of 120,000 barrels per day (bpd) for 2008 and a rise of 350,000 bpd in 2009.

The Centre for Global Energy Studies said that a year on year decline in global demand for oil in 2008 and 2009 was ‘a very real possibility for the first time in 25 years’.

OPEC cut its demand forecast for 2009 for the third consecutive month, to 86.68 million bpd. Click here to find out more on OPEC and its effect on the oil business.

China said its imports of diesel dropped to a 14-month low in October. To make matters worse, forecasts for future growth in China were revised down; the World Bank has just cut its 2009 forecast from 9.2% to 7.5%.

And to top it all, the world’s largest importer of oil, Japan, confirmed it was in recession.

Supply
The International Energy Agency warned that the world could face a major oil shortage by 2015 if investment in new capacity isn’t increased. But the markets will be ahead of that in their pricing.

Production from many existing fields is already falling faster than anticipated; fields in the North Sea, Alaska, Russia and Mexico are suffering faster than expected declines.

And with prices falling there’s less incentive for companies to undertake expensive investment in exploration and production ventures. Canada’s oil sands were profitable when oil was $100-$150 per barrel, but $50 per barrel makes that investment decision less clear-cut.

In November production by OPEC (ex-Iran) fell by 1.22million barrels per day, less than the amount of 1.5 million bpd agreed in October. This suggests that not everyone is playing ball; some members haven’t cut their supply by the agreed amount. This happens all the time, but makes a mockery of calls for further cuts.

So what we’ve got at the moment is falling demand, with the prospect of this carrying on in the short term, and falling supply, which isn’t much of an issue at the moment. The problems will arise when demand picks up and everyone realises that there’s no quick way of turning the taps back on.

Conclusion

So what conclusions can we make from looking back at this? Well, not much yet, the best bit is in part II, however it is clearly true to say that overall in relation to this example inflation didn’t play much of a part in the price bubble, but at the time the conventional wisdom said that supply and demand and inflation were all linked in together to create this super bubble. They were wrong it wasn’t, but then again to be a good trader you must buck conventional wisdom and ask the question all 5 year old do, Why, Why, WHY?
So in Part II we will look at what sort of influence inflation has to play when prices rise hopefully by the end we will all be experts at guessing how much our shopping basket will cost next month!

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