Reassessing Risks in 2008
This is the time of year for bold projections – and one emerging meme is that politics is looming large on the global economy. With global banks turning to sovereign funds, wariness about trade and capital inflows in many developed and developing economies, centralization in several key developing economies, and commodity nationalism, it makes sense that attention is returning the role of politics. However another conclusion is that the stress in the financial markets reveals the need for better assessment of risks and ways to respond in a variety of sectors.
Last spring, former Treasury Secretary Summers warned that investors were being far too complacent about political risks. Throughout much of 2007, with the exception of the tight energy markets, which responded to each and every escalation of words between Iran and the US or assumed supply disruption, political risk did not seem to loom large. John Authers even noted that Iran’s taking of British hostages had little dampening effect on equity markets. With some exceptions, risks were thought to be contained locally and in sectors. That was then.
In the eyes of some analysts, that is now shifting. Government involvement in responding to and mitigating credit and macroeconomic stress is rising – whether domestic government or the savings of foreign governments. Perhaps it is the intersection of economic uncertainties with political challenges and the need for coordination and political will that may make the coming months seem different. I say ‘seem’ because few of these trends appeared overnight – but reassessing in a moment of stress can change outlook. Others (the World Economic Forum) suggest that changes in the financial markets may have exposed new risks which increase the vulnerability to unpredictable shocks – and lessen institutional strength to respond.
Several recent reports ask whether or how political tensions and the role of the state might affect national and global economies and the investment climate. The Economist suggested that although political risk has yet to deter investment, that may change in 2008.The Eurasia group placed the rising protectionism in the US and the potential spillover from the dangerous cycle of coercive policies from the US and aggressive response from Iran at the top of its list of political risks for 2008. In many cases the lack or lessening military threat (say in Iraq, Iran and in relations with Russia) reveals the gap between parties amid changing power structures.
Setting the stage for Davos, the World Economic Forum released its annual Global Risks Briefing. Responding to the current economic climate, fears of a US recession, and weakness and turbulence in financial markets this year’s report is much more cautious than the one a year ago.
Over the last year, a series of risk issues – from the liquidity crisis in the financial markets to the emerging concerns over the long-term security of food supply – have focused global attention on the fragility of the global system. An awareness of risk and risk management is increasingly viewed as a prerequisite for effective control in both the private and public sectors.
The WEF warns that financial market uncertainty, and the weakness of existing global institutions in assessing and responding to the unequal distribution of risks and adjustment to shocks might delay tackling other longer-term global challenges such as climate change, sustainable food supply.
Their set of key, linked risks reveal a more nuanced integrated view of political and economic :
1.“Systemic financial risk is the most immediate and, from the point of view of economic cost, the most Severe”. They argue that developments in the financial system and the increase in securitization decentralized risk ownership, making the transmission mechanisms more important. Finally, they suggest changes in the financial sector may have created new risks that leave the system more susceptible to other shocks (including geopolitical risks)
2. Food security, at the nexus of a number of issues from energy security to climate change and water scarcity, may be emerging as one of the major risks of the 21st century. Long- and short-term drivers – population growth, changing lifestyles, climate change and the growing use of food crops for biofuels – may be shifting the world into a period of more volatile and sustained high prices.
3. Extended Supply chains, which spurred economic growth, are under more stress. A recent EIA report on transit bottlenecks highlights only one vulnerable sector (energy) but the WEF is most concerned about risks to related but not directly linked supply chains. The report also draws attention to the vulnerabilities inherent in clustering supply chains in given regions and the challenges of defining implicit risks to these broader and deeper supply chains.
4. The tightness of the energy markets increases vulnerability to supply disruptions even as demand shows little sign of slowing. They warn “failure to develop a clear holistic policy approach [because of disparate effects of shocks] to management of both energy security and reducing carbon emissions may end up threatening both objectives…. Should the current situation continue, it is almost inevitable that the European Union will be vulnerable to future energy shortages and will fail to achieve its stated goals for reductions in carbon emissions. The situation in the US, while different, is no better: high investment in biofuel production may bring its own risks, while dependence on foreign energy supplies continues.”
Besides these overarching vulnerabilities, several political events, violence and uncertainty in countries like Pakistan and Kenya over the holidays bring up potential local and regional spillovers of and the difficulties of prediction. As many Kenyan bloggers have reminded us,
before the election fallout, the focus was on Kenya’s booming equity returns, investment and some significant IPOs. Now some doomsayers suggest events might “wipe it off the map from the point of view of international investors”. While that seems an overreaction, clearly the speed of escalation and economic fallout for Kenya and East Africa are significant. Pakistan’s strife similarly, redraws our attention to this area of South Asia with many political fault lines. It may just mean more due diligence and assessment of risks and returns. The FT (and others reported) that investment in Pakistani banks was not deterred by unrest. And China is showing interest in building a copper mine in Afghanistan – though some analysts have warned that Afghanistan will get a low share.
so the question remains, how good are we at pricing in and preparing to counter risks – including low-probability high cost events. The WEF report provides some suggestions to improve risk management. But with increasing integration this is clearly a more significant challenge going forward. Perhaps what this all shows is that we can’t and shouldn’t really separate economics and markets from political and social considerations. After all, the strength of both formal and informal institutions determine resiliency to shocks, be they to the banking system or to the energy supply chain.
No Responses to “Reassessing Risks in 2008”
The approach taken by the 2008 Global Risk Report for the World Economic Forum is a cause for both hope and concern. On the one hand, it is auspicious to see that it includes the world’s two most critical and urgent issues, food and energy security, among the four main global risks. But on the other hand the Report fails to assign those issues their real degree of severity, and perhaps more importantly, it does not seem to understand the real dynamics driving them.
To start with, the Report assertion that, of the four issues, “systemic financial risk is the most immediate and, from the point of view of economic cost, the most severe”, either has to be construed as revealing a serious lack of understanding of the immediacy and severity of the problems affecting the food supply, or else must be qualified as outrageous. Because the consequences of a systemic financial crisis, however severe, cannot be compared to the starvation of millions.
Notably, the Report states clearly – and correctly – that the growing use of food crops for biofuel production is a key driver of the increasing risk to food security. But although it initially states that “the consequences, particularly for the most vulnerable communities, may be harsh”, it ends the treatment of the subject stating that “the consequences of all these trends for perpetuating the escalation of food prices are difficult to predict.” Actually, the consequences are not so difficult to predict if the analysis is ultimately focused on food production levels rather than prices, because global food production is a direct determinant of the population level that can be sustained. I.e., if food production drops because of increased biofuel production, it will have as a direct consequence that fewer people will be able to obtain adequate nutrition. And to evaluate the potential share of global food production that could eventually be diverted to biofuels, and the timing for that, it is essential to correctly understand the dynamics driving the diversion process.
Quite simply, the main driver of the growth in biofuel production is the rise in the crude oil price. As biofuels are a direct replacement for petroleum products, their prices are directly proportional to those of the petroleum products replaced, plus or less differential taxes/subsidies. Therefore, a higher crude oil price increases the profitability of biofuel production while at the same time decreasing the profitability of food production. As a result, arbitraging based on profits per acre starts driving the allocation of agricultural production (and in turn of land) out of food production and into biofuel production. As more agricultural production (and land) is diverted into biofuel production and less into food production, biofuel production will increase and fuel prices will consequently tend to stabilize, while food production will decrease and consequently food prices will rise, until the profitability of food production becomes once again competitive with that of biofuel production and a new equilibrium state is reached where no further diversion occurs. But it is crucial to note that the food production level at this new equilibrium state is LOWER than that at the original state. (Notably, the Report does mention that “others believe that markets will gradually readjust to shortages as higher prices make it profitable again to grow crops for food”. But it fails to mention that the new equilibrium state occurs at lower food production levels.)
Not only is the above dynamics entirely logical, it is also supported by facts as shown in the recently published study “Fermenting the Food Supply – Modelling Biofuel Production as an Infectious Growth on Food Production” by Stuart Staniford, PhD, available at http://www.theoildrum.com/node/2431.
Once understood that it is the rise in the crude oil price what drives the biofuel boom through a simple profit-based arbitraging mechanism, the next step in order to assess the potential share of global food production that could eventually be diverted to biofuels is to evaluate the prospects for the oil price. Which must be done on both a short- and long-term basis.
For the short term, the current data and projections from both the US Energy Information Administration (EIA) as of Jan. 08, 2008 at http://www.eia.doe.gov/emeu/steo/pub/contents.html (table 3a) and the OECD International Energy Agency (IEA) as of Dec. 14, 2007 at http://omrpublic.iea.org/currentissues/full.pdf speak quite loudly:
World oil production
year 2005 2006 2007 2008
EIA 84.6 84.6 84.8 87.6 (wishful thinking?)
IEA 84.6 85.4 85.5
World oil consumption
year 2005 2006 2007 2008
EIA 83.7 84.8 85.9 87.5
IEA 83.9 84.7 85.7 87.8
Given the trend in global oil production for 2005-2007, and the fact that both the EIA and the IEA currently project 2008 global demand being respectively 2.7 Mbpd and 2.3 Mpbd higher than 2007 global supply, it is painfully clear that either global oil production breaks decisively from its recent performance and surges in 2008 – which looks improbable at best – or global oil demand will be brought down to convergence with supply, in turn either by a significant recession in the OECD or by an oil price that will surge deep into the triple digits in 2008, in euros as well as in dollars. The last possibility will have a significant short-term impact in global biofuel (and food) production, since, as shown by the cited study, “when oil prices spike up, a year or so later we have a new burst of ethanol capacity under construction (which then comes on stream 1-2 years after that).” And this impact will take place against the background of an already dire situation, as described by the Dec 17, 2007 FAO communique “FAO calls for urgent steps to protect the poor from soaring food prices” at http://www.fao.org/newsroom/en/news/2007/1000733/index.html.
For the long term, the determinant factor is a constraint from physical reality: the fact that global oil reserves are finite, and that as a result global oil production will eventually reach a peak and then commence a relentless decline. The peaking event is termed “Hubbert’s Peak” after the late Shell geologist M. King Hubbert, PhD, who in 1956 predicted that US oil production would peak in 1970 as it effectively did. Today, most analysts without vested interests are predicting global Hubbert’s Peak to take place in the 2010-2012 timeframe. Therefore, in the absence of a worldwide voluntary reduction of crude oil demand in line with the future peaking and subsequent decline of crude oil production, the long term prospects for the oil price are of a relentless rise. Which through the profit-based arbitraging mechanism described above will drive the world into successive new equilibrium states with higher biofuel production and lower food production. Obviously the process will eventually stop before 100% of the food gets turned into fuel. The question is, at what point? When we have a bidding war between the gas tanks of the global middle and wealthy classes and the dinner tables of the poor, where does that reach equilibrium?
Regarding global crude oil demand, the current path is the exact opposite of what would be required to prevent a relentless rise of the oil price, as the populations of giant emerging economies, particularly China and India, increasingly adopt the oil consumption patterns of the citizens of OECD nations. For which they obviously cannot be reproached: how could Americans ask the Chinese to keep riding bikes as they drive their SUVs?
To sum up, the prospects for global crude oil production – based on geological constraints -, plus the prospects for crude oil demand – based on human nature-, plus the profit-based arbitraging mechanism for diverting agricultural production into biofuels, all make for a very bleak picture for global food production levels. Indeed, as shown in the cited study, global biofuel production could be consuming half the global food supply within about six or seven years.
Of the three factors powering the process, increasing global crude oil production in the long term is physically beyond the reach of policy-makers (and while it could be increased in the short term, given the finiteness of reserves that would imply a steeper decline later). But acting in a concerted and collaborative way to stop and reverse growth in global oil demand is not. And given that the bulk of this growth comes from emerging economies, it is not conceivable to expect it to stop without the developed economies setting the example by drastically reducing their own consumption. As for the food/biofuels arbitraging mechanism, any government-induced price distortion that increases the profitability of biofuel production over that of food production through differential taxes/subsidies directly amounts to hastening the appearance and aggravating the degree of the coming food crunch.
Again, this is not an issue which the world can take years to study: it is already hurting, as per the FAO communique, and the factor that drives it – rising crude oil prices – is poised to make a strong hit in 2008 if a significant OECD recession does not materialize promptly.
And if world leaders decide that – while physically feasible – it is politically impossible to act in a concerted and collaborative way to stop and reverse global oil demand growth, whereby the prospects for world food production will be to decline to a level substantially lower than today’s, they must at the very least make those prospects openly and plainly known to everyone. For even if it could be argued that it is politically impossible to prevent the third horseman from coming back – this time driving a biofuel-powered SUV -, there can be no excuse for keeping people ignorant of the fact that he is coming for dinner. For their dinner.