URSABLOG: Back to Basics

 

Every once in a while we see something in such a different light it can change ourmindscompletely. It may be something we read, or what someone tells us, but it shocks us into a new way of thinking. For some reason, this has happened to me more than once this week, and I am becoming increasingly thoughtful.

 

I started teaching the new session of Maritime Economics at the Institute of Chartered Shipbrokers this week. We startedwith the basic economic tool kitand were looking at factors of production, the price mechanism and so on. We then looked at those old favourites, supply and demand.The classic way of reviewing supply and demand is to see what happens to the quantity of supply and demand when the price changes, and how this changes market clearance. It has been such a long time since I looked at this with fresh eyes. It is obvious, all other things being equal, that when the price falls demand increases, but in shipping of course we tend to look at it the opposite way. We want to see the effect on pricing when the supply increases or decreases. We want situations where demand rises so that we get paid more, we want a market out of balance  (in our favour of course) for a long time because we can’t control the pricing to any meaningful extent.

 

I have lost count of the times that analysts use price trends in commodities market to predict freight market volumes. If the price is going up, they argue, this is because demand is increasing, therefore supply will increase and in the long run volumes of cargo will increase, and consequently freight rates. A fair enough assumption I suppose, but it is only one side of the coin. What if an increase in price is because  supply is tight? Rather than listen to the shipping analysts, maybe we should listen to what the commodity experts are saying, like Julian Kettle, vice-chairman of metals and mining at Wood Mackenzie: 

 

We are in the upswing of a classic commodity cycle but this time — while demand is strong — it is being driven by supply constraints rather than a sudden surge in consumption that the industry just wasn’t ready for.

 

Supply is the reason that commodity prices are rising not demand. There may be a lot of excitement in copper with the advent of electric cars, but rising prices now are about a lack of investment in mining, not a sudden upswing in demand. This is not 2003 and the start of a new supercycle. This is 2017 where China is facing different challenges than those of fifteen years ago. China is still important, but the decisions it makes as it cuts pollution and rationalises heavy industry is crucial. How this plays out following the end of the Communist Party Congress last week is far from clear.

 

Increasing supply of commodities in the face of continuing low prices and increasing environmental regulation remains problematic. Take for example the Carmichael project in Queensland’s Galilee Basin in Australia, one of the largest untapped coal reserves in the world. Adani, the Indian conglomerate wants to mine there, and has received all the necessary approvals from the authorities, but is unable or unwilling to fund the railway and port development. The fact that the coal will be shipped from Abbot Point, a port near the Great Barrier Reef may have something to do with it. Adani has turned to the state owned China Machinery Engineering Corportaiton (CMEC) to ask if they will do it. Progress of talks is unclear, but everyone is wary of the potential damage to the very visible Great Barrier Reef, even before they start predicting what effects to long-term demand further environmental regulation will bring.

 

Demand for coal is derived of course from energy and steel making concerns, the most important being in China. Steel making is being rationalised in China as the leadership tries to get rid of state subsidised “zombies” which creates a lot of the barriers to clearing up pollution, corruption and inefficient industry. This has already created the world’s second largest steel producer as Shanghai Baosteel took over Wuhan Iron and Steel Group, China’s fifth-largest steel producer by volume, last year.

 

Other new things are happening too: the “zombie” Dongbei Special Steel, plagued with excessive debt, poor profitability has defaulted 10 times in the last year on US$ 1.1 billion worth of bonds. Now Shen Wenrong, the most successful private steel tycoon in China has agreed to become the largest shareholder after investing the equivalent of US$ 680 million in the failing company. This is very rare: the north east region of China is full of state owned businesses, and their dominance has been paramount. What happens next is unclear but surely it will involve a market driven approach to demand of steel products, rather than just making steel for the hell of it. The filing in the stock exchange explicitly links the investment to the Communist party’s drive to reform and consolidate state-owned enterprises:

 

In terms of creating a model paradigm for SOE restructuring under the ‘New Normal’, the plan has important social and economic significance.

 

This deal has all the hallmarks of a legally approved corporate takeover, but politics is behind it too. Mr Shen’s investment has “both commercial and political motives”, according to an unnamed executive quoted on the Caixin financial news website. The price of steel, and profits depends on the government’s larger campaign to shut down excess capacity in steel and other commodities. Better to be an approved private steel investor making profits inside the Party’s tent, than outside the tent competing with state owned zombies.

 

This should mean that prices of steel will rise as the supply is restricted. This means, in the long run, that volumes of steel making raw materials will be restricted too, and the price of sea transport, freight rates, will be restricted too. But this is theoretical, and there are too many other factors to consider to start confidently predicting anything.

 

In the lesson, we went on to look at demand for shipping (GDP, GNP and other fairy tales), demand elasticity, and derived demand elasticity. I was finding it a struggle to find realistic examples in shipping to illustrate the text book theory. Later on I realised why: the study of “traditional” economics, and by that I guess I mean classical and neo-classical models, starts from the wrong premise, the wrong cause and effect. How we can look at shipping based on models based on price when our success or failure is driven by supply and demand.

 

You will tell me the solution simple, just invert the method: start with the supply and demand, and then you will get the price. I will then give you a list of around 100 variables that affect supply and demand, including politics, all interconnected, then throw in the fact that future is unknown, and then ask you whether you can work it out. I will also add, that our actions, however small we think they are, change the market as we go along. The situation is continually changing, and so our assumptions have to continually change too.

 

Does this mean economics is pointless? No, I don’t think so. Martin Stopford in his masterly Maritime Economics barely mentions theory, he mentions facts, patterns and uncertainty. This is the wiser approach I feel.

 

Many of my assumptions have been challenged this week, professionally, personally and emotionally. I am very thoughtful, but in a refreshingly positive way, because I can see that things are not just cause and effect, and what we do changes the very life we live as move through it. The solution for life? We can choose to be happy, despite what the world throws at us. The solution for shipping? We can choose to be positive, despite market conditions. Either way, I have concluded that human beings are not just rational, but sentimental too, but more than that, that we are defined by our actions, past, present and future, and we have to be accountable for them, and more importantly, then act on them wisely.

 

Simon Ward