THIRD QUARTER 2016
In Depth ...
Supply and Demand
Supply and Demand – Painful Corrections
Supply
Surplus
Price
I
n this issue of In Depth we want to discuss the
challenges and opportunities many industries face
due to structural excessive supply. This abundant
supply has persistently exceeded aggregate demand for
products and services. Industries such as agriculture,
mining, shipping, HMOs, retail stores, and
manufacturing equipment face significant supply/
demand imbalances and are beginning to consolidate
or worse.
Historically, massive liquidity injections into the
banking system (we have previously discussed the
effects of zero and negative interest rates globally)
would have been more stimulative to the demand side
of the equation for both consumers and businesses.
Traditionally, inflation would be our biggest concern at
this stage of the recovery.
However, in this cycle, and to the consternation of
policy makers, easy money conditions have plowed
capital into the supply side of the equation creating
deflationary pressures; overbuilt industries have
become more overbuilt. These deflationary pressures
have dampened economic growth and negatively
impacted aggregate demand. We simply have too
much supply and not enough demand in many
industries, challenging profitability and balance sheets.
Demand
Equilibrium
Shortage
Quantity
demand pull against each other until the market finds
an equilibrium price. The equilibrium price, or market
clearing price, is the price at which the producer can
sell all the units he or she wants to produce, and the
buyer can buy all the units desired. However, multiple
factors affect both supply and demand, causing them
to increase or decrease in various ways.”
Structural Excess in Supply
Oil: The oil supply/demand equation has been well
documented over the last two years. The tipping point
came in mid-2014 when U.S. oil production, led by
shale oil, was nearing about 9.5 million barrels per day
(bpd). That was up from about 5 million bpd ten years
earlier. Paradoxically, as prices began to fall, global
production accelerated.
The law of supply and demand ties into almost
every economic principle in one way or another.
What is the Law of Supply and Demand?
For a comprehensive definition we turn to Investopedia
which states, “The law of supply and demand defines
the effect the availability of a particular product and
the desire (or demand) for that product has on price.
Generally, a low supply and a high demand increases
price, and in contrast, the greater the supply and the
lower the demand, the lower the price tends to fall.
One of the most basic economic laws, the law of
supply and demand ties into almost every economic
principle in one way or another. In practice, supply and
Source: International Energy Agency
Why? Two reasons. First, 80% of global production
comes from sovereign nations largely insensitive to
the supply/demand economics and in desperate need
for revenue. Second, capital markets were feverishly
seeking borrowers and were willing to continue
g
funding oil production despite obvious signs of
structural decline.
Agricultural Products: Agricultural products
ranging from dairy, corn, wheat, cotton, and soy have
seen record production for four straight years. Why
is that a problem? Excess supply has driven the price
below the level at which farmers can be as profitable.
Much of U.S. agriculture is federally subsidized to
keep the industry solvent. But record crops, driven
by the combination of favorable weather and better
farming and seed technologies, are now being massively
subsidized by the federal government. Furthermore,
U.S. farmers are facing increasing competition from
foreign challengers.
As a result, we are beginning to see the textbook
sign of pain: consolidation. Fertilizer and seed
companies have begun to announce mergers of huge
proportions. While painful, this also sows the seeds for
future investment opportunity (pun intended)!
Shipping: Shipping is one of the largest industries
in the world but is seldom discussed. Global trade,
at least until recently, has been growing faster than
global GDP for over 20 years. The entrance of
China into the WTO in 2001 only accelerated this
phenomenon. The shipping industry took this trend
and extrapolated the need for more ships well into
the future. Easy money conditions created all too
willing funding for their construction. As global GDP
decelerated in mid-2014, ship builders and operators
continued to build.
In September however, Hanjin, the largest South
Korean ship operator, filed bankruptcy. Again, this
is a very painful but necessary step as this industry
begins rationalizing supply. Unfortunately this process
usually takes years. We are carefully watching the
secondary effects of this supply/demand correction
and its effects on rails, trucking, and end markets.
Near-term concerns are significant because of the way
retail manages its just-in-time inventory — just in
time for the holidays!
Machinery: A challenging environment for
equipment makers has emerged recently. They are
fighting slowing demand from customers as the global
slump takes hold in a wide range of commodities,
from oil to corn. The cost of bulldozers, dump trucks,
backhoes, wheel loaders, excavators and farming
combines can range from $300,000 to $750,000. In
this difficult environment, operators are forced to lease
or rent machines and equipment instead of buy.
One of the major issues is that machinery gluts
often last for long periods of time because high-price
equipment can last for 25 years or longer. Adding to
this pain is the strong U.S. dollar which has slowed
demand from African and Asian markets that were
once big buyers of used heavy equipment.
Retail Shopping Square Footage — “Overstored”
Online and mobile shopping requires warehouses, not
store fronts. Walmart recently announced it will close
154 U.S. stores this year. Macy’s is in the process of
shuttering 40 locations; Kohl’s will close 18. The U.S.
is simply “overstored” — especially when we compare
ourselves to the rest of the world. Demographic
and shopping changes have resulted in a struggling
industry.
The likely scenario is that the number of smallerformat stores will increase in an effort to boost
productivity. Many storefronts of the future will act as
showrooms for the online purchaser to see and touch
products. In the meantime, investors will need to be
very selective in owning retail properties. Only those
with the right combination of location and offerings
will thrive.
Our View
The last eight years have produced significant winners
but have also posed considerable challenges to some
industries. None of the industries mentioned above are
in permanent jeopardy. Supply/demand imbalances
reoccur through economic cycles. At Quest, we are
always looking for investment opportunities to present
themselves. It is our opinion that understanding where
we are in the supply/demand cycle will advantage our
investors.
MUSINGS
According to John Zimmer, co-founder of Lyft, in his Medium
article titled, The Third Transportation Revolution, "we’re on
the cusp of nothing short of a transportation revolution...the
end of urban private car ownership."
In 2011, researchers estimated that there are at least 700
million parking spaces in the U.S. In total, that's more than
6,000 square miles of parking — bigger than the state of
Connecticut.
The average vehicle is used only 4% of the time and parked the
other 96%.
Quest Investment Management is an independently-owned investment advisory firm focused on growth investing for institutional clients.
Contact: questinvestment.com 503-221-0158 [email protected] | One SW Columbia Street, Suite 1100, Portland, OR 97258