The bottom has fallen out on shipping rates, putting the world’s ship owners and ocean shipping companies in dire financial straits. For the dry bulk carriers that haul grain, iron ore, coal and similar commodities, charter rates as of February 2012 are down over 94 percent from May 2008. Rates for container ships have not fallen as drastically, but are down 55 percent from two years ago. Only oil tankers have seen little change.
Why such drastic changes? The explanation would be familiar to Minnesota hog and beef producers and to aeronautical engineers as well. All of these are “goods” in which production cannot be changed instantaneously and for which both supply and demand are “inelastic.” Simply put, even if prices change dramatically, the quantities producers are willing and able to sell and that buyers are willing to buy don’t change very much. The result is a repetitive cycle over time that oscillates from gluts and low prices to dearths and high prices.
Consider beef production, familiar to many Minnesotans. Start with prices at some given level. Then there is some change in demand, say in exports sales to Asia. One of the features of such products with inelastic supply and demand is that even a small change in the quantity purchased can move prices a great deal. And higher prices make farmers want to produce more.
In a simple factory, it is often possible to increase output by adding another shift of workers and buying more of readily available raw materials. But to produce more cattle you need more breeding stock. So farmers wanting to increase output don’t sell as many young females – heifers – as they would normally. And they may hang onto older cows that they usually would cull.
These actions to increase output cut the number of both young and old animals going to slaughter. This reduction in quantity supplied drives prices even higher, increasing incentives for producers to expand herds even more.
But cattle are subject to biological cycles of breeding, gestation and sexual maturation. It takes some years before the number of bred stock cows rises and, with it, the output of slaughter animals.
But when many producers respond in the same way to the signal of higher prices, and all of these additional cows have calves, the increased supply makes the price of beef start to drop. As it drops, farmers and ranchers increase culling of older cows and market more heifers instead of breeding them. These additional sales push prices down faster and further, accentuating the liquidation and causing even lower prices. Eventually smaller herds reduce supply and prices recover. And then the whole cycle repeats, over a period of eight to 10 years.
The hog cycle is similar, but since their gestation and maturation lags are shorter, the whole cycle takes only a third of the time of cattle.
Ships don’t reproduce, so the ocean shipping cycle is simpler. Again, start at some average level of business and freight or charter rates. Demand for shipping then increases, perhaps because China is buying more grain, coal or iron ore. Rates rise. Shipping companies and owners want more ships, but it takes at least a couple of years between ordering and delivery. And global shipyard capacity is finite, so if lots of new ships are ordered, delivery times can lag even more.
In the meantime, rates stay high, giving many the impression that the industry is in a new era. New construction orders keep going to shipyards. But eventually these new ships enter service and the situation quickly becomes one of overcapacity.
The fixed costs of ships are high, so owners will charter them to others at low prices. Any revenue is better than none. Shipping operators cut rates to the point where they barely cover variable costs like labor and fuel.
Eventually the low prices drive some ship owners or operators into bankruptcy. Older ships, especially those with lower fuel efficiency and high maintenance costs, get scrapped. Reduced capacity allows rates to rise. And eventually the whole cycle starts again.
Note that a decrease in demand, such as China importing less beef or less ocean-shipped coal at a time when the inherent cycle is driving prices lower, will make the drop in meat prices or shipping rates even more extreme.
A similar phenomenon occurred with aeronautical engineers. Thousands were needed in World War II, but then many were laid off in 1945 and some moved into other careers. Then, in the early 1950s, Boeing, Douglas, Lockheed and Convair all wanted to develop jet passenger planes and needed engineers. The supply was limited and salaries went up.
College-bound students noted this, and more chose to become aeronautical engineers. But they had to finish four-year degrees.
By the time they did, the increased supply was restraining salaries. Again, some moved into other careers and new freshmen opted for other majors. Then, as the space program geared up in the 1960s, shortages of these engineers once again pushed up salaries. And the cycle continued.
In aeronautical engineering, fluctuations in demand played a greater overall role than in livestock or shipping.
But all three are examples of the “cobweb model” developed by Nicolas Kaldor, a Hungarian-British economist famous for his work in both micro and macroeconomics. (The name of the model derives from a graph showing the phases of the cycle.)
One key question for economists is whether farmers or ship owners and operators are fully rational in their decisions. Since livestock and ship cycles are so well documented, why rush over the cliff like lemmings? Opinions on this vary, with “efficient market” enthusiasts arguing that cycles will be generated even when decision makers are rational and well-informed.
Talk to farmers and shipping managers themselves, and the reality sounds a bit more human. They can sound a bit like Charles Prince, the former Citigroup CEO who argued, “when you are at a dance, as long as the music keeps playing, you gotta keep dancing” – even as he led that company to the edge of the abyss in 2008.