Commodities Crash: A Market Economist’s Nightmare

Do you remember the first great internet investment bubble of the late 1990s?

Hundreds of millions of dollars were invested in astonishingly flimsy firms like and The NASDAQ market, host to many of the Initial Public Offerings (IPOs) that attracted funds to these companies, witnessed its composite index quintuple in value in just six brief years between 1995 (when it surpassed 1,000 for the first time) and 2001. But then, like all bubbles, the index valuation crashed, collapsing back to a value slightly above 1,100 by late 2002.

At the time of the crash, many American investors swore that they would never again be beguiled by future bubble markets, promising to restrict their funding decisions to more stable industry sectors. And yet, just a few years later, rock-bottom mortgage interest rates created a mammoth real estate bubble, supported by the irrational proposition that home investment valuations in the United States could never decline in absolute terms. Nevertheless, when that bubble burst in late 2008, it nearly brought the entire global economy down with it.

Have global investors learned their lessons about avoiding manic bubbles? Apparently not! In fact, yet another investment sector appeared to gyrate towards a crash last week, one so universally significant that it is giving market economists nightmares.

Silver and Gold and Oil, Oh My!

The sound of the largest crash last week came from the silver market. The value of silver, having soared by 57% during the first four months of 2011, suddenly reversed direction and fell more than 25% during the first five trading days of May.

And yet gold, too, went into a tailspin. After having jumped from $1,000 to $1,541 between September 2009 and April 2011, it suddenly slumped by close to 5% during the most recent four trading days. And oil, having soared from $33 per barrel in January 2009 to levels beyond $100 per barrel in February 2011, fell by almost 15% last week.

Pundits blamed these sudden lurches in commodity values on investment speculators who buy and sell vast quantities of these materials on the global markets. Unfortunately, though, firms that use these commodities for industrial and consumer applications must purchase them on the same global markets. Inevitably, when prices fluctuate so dramatically, corporate planning activities for the future — as well as their operations activities in the present — become unmanageable.

Ripple Effects

Gold, for instance, is more than just a glittering metal that is shaped into rings and necklaces. It is also an excellent conductor of electricity, and is therefore employed as an industrial component in many types of electronics equipment. Manufacturers of computers and cell phones thus feel their profits pinched whenever speculators drive up the cost of the precious commodity.

Silver, as well, is a strong conductor of electricity and heat, and is able to withstand extreme variations in temperature. Manufacturers of conventional batteries and solar energy panels rely heavily on it, and likewise see their profits vanish whenever the cost of silver increases. And in the nascent alternative energy industry, where losses are common even under the best of conditions, such cost bubbles can drive development projects (and entire firms) into bankruptcy.

Sharp increases in the cost of crude oil can, likewise, ripple through the entire global economy. Airlines simply retreat from markets that become impossible to serve profitably, cutting off tourist areas and business markets from their constituents. And, on a personal level, economically strapped families in cold weather states like Massachusetts and Michigan are forced to wonder how they’ll find the funds to heat their homes through frigid northern winters.

The Cost of Uncertainty

As market economists know, the true costs of such massive fluctuations in commodity values extend far beyond the expenditures that are required to procure the materials themselves. Indeed, the greatest costs of all may emanate from the uncertainty that is generated by such fluctuations, an effect that paralyzes commercial activity and drives up the cost of capital.

When the Chief Financial Officers of alternative energy firms witness the cost of traditional crude oil more than triple within two years, and then drop by almost 15% in a single week, they cannot help but wonder whether that cost might continue plummeting in the near future. If such declines actually continue, the cost of oil-based energy would likely fall so low as to make the cost of alternative energy unattractive by comparison.

Furthermore, banks and investors would perceive such alternative producers in a far more risky light, and would raise their interest and dividend demands accordingly. In other words, the cost of obtaining investment capital at alternative energy firms would soar at the very moment that their competitors’ operating costs would fall.

The result would be paralysis in the alternative energy sector, thereby locking our economy into the perpetual boom-and-bust price cycles of the traditional commodities sector. Can we afford to continue living with such outcomes? Perhaps not, because without stability in the price levels of commodities and other raw materials, no business can feel comfortable investing in growth plans for the future.

Google’s Gambit: Investing In The Wind

Politicians, environmentalists, and the private sector have been locked in debate for years over the future of America’s energy infrastructure. Should the largest economy in the world remain powered by oil, or should it switch to nuclear power? How about alternative energy sources, such as wind, water, and geothermal production processes? Or should America continue relying on oil as a primary resource, while simultaneously striving to develop domestic coal and natural gas supplies as well?

Of course, this choice of energy source and production method only represents the first challenge confronting America’s energy policy makers. They face a second challenge as well; namely, how should the energy itself be transmitted from the generation site to the user? Although the general public has always demanded cheap and readily accessible energy, it has no desire to live and work near gigantic towers of newly constructed power cables, fearing everything from property values declines to cancer epidemics.

An innovative solution, though, may have emerged last week from an unlikely source: the online search giant Google. With a single enormous investment decision, the firm may indeed have placed America firmly on the path to energy independence.

Harnessing The Power of The Wind

Most policy makers agree that renewable energy sources provide the most attractive long term potential for meeting America’s energy needs, considering their ubiquitous presence and lack of resultant environmental pollution. Ever since the Dutch first constructed wind mills to power their communal drainage systems and operate their milling factories, every breeze has carried the potential to power industrial societies, at least in the imaginations of romantic environmental visionaries.

Texas energy billionaire T. Boone Pickens has proposed the construction of gigantic wind mills throughout the wind swept Great Plains of the midwestern United States, but his plan has been stymied by the private ownership of prime locations, as well as community opposition to land-based transmission cables. And relatively small wind farms in the Atlantic Ocean, close to picturesque shorelines and islands such as Martha’s Vineyard, have been delayed by environmentalists and wealthy residents who prize their pristine ocean views.

What America needs is a series of wind farms that are as large as the land-based establishments proposed by Pickens, but that are placed far off-shore in the Atlantic Ocean to relieve the concerns of coastline residents. Such remote energy sources, though, would only be technologically feasible with an additional mammoth investment in the underwater sea cables that would be required to transmit the power to the mainland.

Enter Google!

This is where Google stepped into the debate last week, making a $5 billion investment in a proposed off-shore Atlantic Ocean transmission system that would span much of the eastern coastline of the United States, running from New York City to Virginia. Along with a matching $5 billion investment by the clean energy investment firm Good Energies, as well as a smaller stake by the Japanese trading firm Marubeni, the internet giant is placing a huge financial bet on the future direction of the American energy industry.

Why is Google so interested in America’s energy infrastructure? Its motivation should come as no surprise to any internet user; it must operate massive clusters of computer servers to provide its services to a web-surfing public, and those clusters require enormous amounts of energy for operational purposes. Nevertheless, although Google’s investment cannot be construed as a purely altruistic gesture, their decision may result in America’s long term gravitation from an oil-based economy to a wind-fueled one.

President Obama has long advocated that the United States government allocate significant research funds to the development of renewable energy resources. Many experts agree with the President about the wisdom of this strategy, noting (with some trepidation) the competitive investments now being made in China to capture the market for clean and environmentally friendly fuels. At a time when governmental resources are stretched thin, Google has decided to dedicate its significant private sector investment funds to a project that arguably supports the public interest.

Even Short Term Benefits

Interestingly, the project has been ingeniously designed to yield short term benefits as well. For instance, even before the off-shore wind farms are actually built and placed in operation, the transmission system will be able to carry power from the energy-rich southern states to the fuel-hungry northern regions. In other words, the system will be used to better match current supply and demand by utilizing a transmission capacity that is “out of sight and out of mind” to American citizens.

Will it ever be built? Will it successfully wean Americans away from their addiction to fossil fuels? Google itself has just placed a $5 billion bet on these questions, in the hopes that a successful investment will help our nation solve one of our most vexing challenges.