An interesting phenomenon came to my attention today. Perhaps somewhat conspiracy-theory-esq, yet interesting at the same time. It deals with production, destruction, and market valuation.
Investment-wise, I’m a pretty boring ETF-only kind of guy. I don’t care to do all that much research, and day trading isn’t my thing (and statistically, it should not be many people’s thing…). But from time to time I still do a bit of reading on various market sectors to see what drives them and what doesn’t. Mostly out of morbid curiosity.
Today (09-Sept-2008) started off interesting, with a nearly 1% gain in the first couple hours of trading. However, it then fell sharply, to about -0.7% by 11:30am. A pretty wild fluctuation, but such things happen. What caught my attention, however, was this little nugget of news:
Natural gas (-4.2%), gasoline (-2.9%), and crude oil (-2.1%) are all posting steep losses as it appears that Hurricane Ike will spare most production facilities in the Gulf of Mexico. (From NASDAQ.com’s live market analysis)
Steep Losses because your production facilities _Aren’t_ destroyed? Perhaps I’m too simple, but to me, it should be those very production facilities that produce the profits and gains of the sector. Without them, there’s nothing to sell, and no way to make any progress.
However, we also have to take into consideration what the market investors did over the interval. Apparently (I’m guessing here, since I can’t be bothered to actually look up the stats), many many investors drove _up_ the share price of those sectors on the expectation that some of the facilities would be damaged, thus reducing supply. ECON 101 might suggest that a constant demand + a reduced supply = increased cost. I believe such a model it too simple though, because of oil drilling’s relatively high barrier to entry and relatively limited number of suppliers (an oligopoly, if you will).
Taking it a step up further still (speculations upon speculations), I’m not quite sure I can soundly explain how a cost increase would turn into more profits. The damaged facilities would need to be repaired and inspected (an additional cost). So in order to profit, the prices would have to be disproportionately high, such that the total additional revenue from the price increase was in excess of repair/replace costs. And if that’s the case, simple market theory would imply that less-damaged companies would be able to sell at a lower cost (less damage to repair, more overall production) while sill maintaining the same margin.
So either it was expected that the less-damaged companies would simply jack up rates to their more damaged counterpart’s rates (yielding disproportionately high profits), or they were expecting all companies to experience similar damage rates, and all raise their prices far in excess of repair costs (again, yielding high profits). Maybe there are other alternatives that I’ve failed to notice?
Sadly, both of those appear to involve some slightly dishonest practices… hopefully there is another explanation I simply overlooked (massive insurance company payout in light of damage? massive handout from the government in light of damage?) that also takes into account the market’s apparent expected price increase…
And I’m not even a Big Oil conspiracy theorist! 🙂