(Endowment Like Fund Management)
June
12, 2008
This is the ELF Capital Management,
LLC Market Comment for the month ended May 2008. If you do not wish to be included in our
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Habits, Bubbles, Inflation, Oil and Global Trade
“If a
foreign country can supply us with a commodity cheaper than we ourselves can
make it, better buy it [from] them with some part of the produce of
our own industry, employed in a way in which we have some advantage. The general industry of the country, being
always in the proportion to the capital which employs it, will not thereby be
diminished… but only left to find out the way in which it can be [best] employed
[to] the
greatest advantage.”
Adam Smith, The Wealth of Nations – published in 1776
When Adam
Smith published this passage in his book, The Wealth of Nations (1776), he was
describing the significance of land, labor and capital as the most prominent
factors contributing to a nation’s wealth.
His ideas became as popular as they were controversial because they were
contrary to economic policies practiced in
One only
has to watch CNBC’s Kudlow & Company, to become acquainted with the brilliant
and esteemed Larry Kudlow’s prime motto and tribute to Adam Smith’s work, that:
“Free-market
capitalism is the best path to prosperity”.
In a
free-market economy, much like we have in the
Free market
capitalism, however, is not without its challenges to economic well-being (AKA,
prosperity). In my humble opinion,
challenges to prosperity occur when habits and bubbles cloud rational
self-interest to the detriment of a nation’s quality of life. And, quality of life diminishes when the
effects of inflation outpace disposable income (gross income less income taxes
on that income). To help explain these
challenges, let me introduce some additional economic theories that were later
developed from Adam Smith’s initial work.
These are the concepts of comparative and absolute advantage and the law
of diminishing returns (David Ricardo, 1815).
Comparative
advantage is said to be the most influential driver for believing in global
(international) free-trade. When defined
in terms of productivity differences, comparative advantage is often confused
with the concept of absolute advantage.
To illustrate: If the US has
higher productivity and resources for agricultural production than the Middle
East, while the Middle East has higher productivity and resources for producing
crude oil, economists would say that the US has an absolute advantage in
agriculture production and the Middle East has an absolute advantage in crude
oil production. From this, it should be logical
that if the US focused on agriculture production and the Middle East focused on
crude oil production, then resources could be shifted from lower productivity
industries to higher productivity industries and the total combined output of agricultural
products and crude oil would rise – hence, comparative advantage. With greater output, and after an appropriate
trading pattern is introduced, both countries could end up with more of both
goods than before, meaning that both countries can gain from trade.
As a result, one
might believe that the solution to the current spikes in food and oil prices
can be solved from increased international trade – trading more food for
oil. The fact of the matter is that both
of these commodity complexes have long been advantaged by international trade
and we as consumers have greatly benefited from it. Nevertheless, our gains from it now seem less
evident and offer less impact.
Diminishing
returns? The law of diminishing returns
in economics states that if one factor of production is increased while the
others remain constant, the overall marginal returns will decrease after a
certain point. Thus, for example, if
more and more wells are added to an already producing oil field, at some point
each additional well will add relatively less output (supply) than a
predecessor well did, simply because there is less and less of the fixed amount
of existing oil field reserves in the Middle East to work with.
Currently, we are
seeing greater crude oil demand coming from a broader base of global consumers
and the push for greater production from our international trading partners has
reached the point of diminishing returns.
Supply is not currently
keeping pace with demand and oil and
agriculture prices are rising everywhere as a result. We can see this in the “bubble-like” ascent
of oil and food prices. Since 1998, the
price per barrel of crude oil has gone from $11.91 (nominal) to $137 today – a
10 year average annual compounded inflation rate exceeding 125%. The
In a 2005 report
coming from the Rand Corporation (www.rand.org),
“the Green River Formation, which covers parts of
Yet drilling for more
oil doesn’t have be the sole solution to these challenges – even if it is
definitely more certain and impactful.
We need to foster innovation for more efficient uses of oil; and,
promote a steady incentive for developing alternative energy sources. However, these are only long-term solutions
that will give us little to no relief over the short-term. The longer we wait to push for these
initiatives, the longer it will take for supply and demand solutions to
exist. Let your politicians know this!
Oil is an incredible
staple commodity that is used for more than transportation and heating. It is used in so many products that
efficiently preserve our other natural raw materials and resources that I am
hard pressed to not see its by-products in any of my surroundings. Oil by-products are used in creating
plastics, paints, fabrics, insulation, asphalt roads, detergents, lubricants, medicines,
food preservatives, cosmetics, packaging and fertilizers – just to name a few. Yet, greatest consumption of oil does, in
fact, come from heating and transportation uses.
How can we find
relief over the short-term? Well, there
may be several ways…
Reduce
consumption. The first way, and quite possibly the easiest, is to simply
reduce your usage of petroleum products.
Up to this point, consumers have been lax to reduce consumption in the
face of higher prices (in economic terms – demand has been almost perfectly
inelastic to price changes). When gas
prices spiked last summer, many people complained, yet few made any effort to
change their routines or consumption habits.
My good friend and colleague, Dr. Dan Elash, suggests that people do not
generally change their habits unless they feel enough “pain” to prompt them
toward change. Dan is a Ph.D. in
Psychology who has spent a career as a qualitative business analyst and
management consultant to executives and business owners nationally. If that kind of help interests you, Dan can
be reached through our offices.
Dan asserts that
people develop routines when they find comfortable ways of operating on a
regular basis. Routines allow one to go
through life – “on auto pilot” – in a reasonably effective and efficient
way. When things change, we are willing
to absorb a reasonable amount of pain while fostering the hope that things will
return to normal. However, once we
realize that the change is going to last, we have a dilemma. We realize our need to change. The upshot is that when we do choose to effect
change in ourselves, we develop new routines relevant to the new
environment. The result is that we can
find more effective and efficient ways to accommodate our lifestyles.
It has been
interesting to see how my oldest son is handling higher gas prices. He travels over 100 miles, round trip, to
work as an energy trader for a small “green” energy producer. As his firm trades energy 24/7, he
recommended they allow him to work four 10 hour shifts rather than five 8 hour
shifts. They accommodated him.
Invest in a socially
responsible way. This author thinks that speculative investment has played a
large role in the parabolic “bubble-like” rise in crude oil and agriculture commodity
prices of late. Yes, despite the
argument that speculators can only participate in the futures markets and are not
taking physical delivery of crude oil or wheat, etc., I think that speculation
has posed a significant negative disruption to pricing in these markets. (As a side note: it has been reported that
available tanker vessels are in very short supply these days, which leads me to
believe that some speculators may actually be storing oil in offshore
containers.)
Futures markets have
always served as a leading indicator for the spot markets and sellers have no
idea whether the demand they see represents buying for consumption or for
speculation. At the same time, as
mentioned above, we have been seeing near perfect inelastic demand across the
globe. These factors only seem to shift
prices higher for an unchanged or modestly higher level of true consumption. Given this almost perfect inelastic demand and
due to our dependence on oil, speculators can easily “game” (manipulate) these
markets and they may very well have.
Don’t get me wrong,
speculators play a positive role in providing liquidity to the markets and I am
a great believer in the virtues of opportunistically diversifying one’s
portfolio. However, when this kind of
investment leads to rampant inflation, the result can hardly be considered
“rational self-interest” as the effects of inflation are detrimental to most
other asset classes and to quality of life around the globe. It would seem that a call for socially
responsible investing, as opposed to potential government intervention, would
also be a positive “path to prosperity”.
Exert political pressure. Call for government to allow greater
exploration and development initiatives.
Our politicians are there to serve the public interest – we are the
public. If we can persuade our
government to show the markets that significant new supply will be coming,
you’ll see speculation come out of the market; a reduction in any country’s building
and hoarding of strategic reserves; and, prices will come down.
On a more positive
note, the sentiment driven correction that began last October and bottomed in
March has caused a number of dislocations in the equity markets that are ripe
for a significant advance. All we need
is for all these headwinds to become tailwinds.
Allowing greater development our
Finally, in
our last market letter we announced that our firm changed its name to ELF
Capital Management, LLC. This month we
are proud to announce that we’ve moved into newly appointed offices in the
downtown area of
Sorry for
such a long letter this month…
Our returns for May 2008
were down 0.33% for the month.