There is an old adage in commodities, that “the cure for high prices is high prices.” When prices of a commodity get high, you see reactions on both the demand and supply side that tend to lower prices back down. On the demand side, you get substitution - if beef is expensive, eat more chicken. You also get outright destruction of demand, both temporary (“I’m going to ride my bike to work this week because gasoline is too expensive”) and permanent (“I’m going to buy an electric car because gasoline is persistently too expensive”). The supply side tends to depend more on the specific commodity. In all cases, the first line of defense is existing inventories that can be drawn down. After that, it depends. In many commodities any non-inventory supply change takes a long time - the next crop cycle, a new mine, etc. In many metals, however, it is much quicker - you just recycle.

It’s interesting to compare this dynamic with other asset classes. Do high equity prices lead to less demand or more demand for equities? I’ll leave that question as an exercise for the reader.

For the adage to work, though, the physical world needs to cooperate. And one of the important things happening in markets right now is that impediments to the “cure” are preventing some high commodity prices from reverting.

Diesel is the shining example of this. Diesel prices are at all time highs. So where is the cure? On the supply side, inventories are already down to low levels. That leaves it to refiners to produce more diesel. But that’s hard to do when your refinery is getting hit by drone strikes, or cut off from the world by a war in your major egress pathway. Other global refineries are trying to pick up the slack by foregoing maintenance and running as hot as they can. Foregoing refinery maintenance is like forgoing necessary medical care…it might be ok for a while, but if it persists you get a disaster. Putting it all together, we doubt the supply side will ride to the rescue.

That leaves the demand side. Diesel demand is hard to dent. Imagine running a grocery store and telling your suppliers “don’t bother bringing us more groceries to sell, diesel prices are too high.” That’s not a thing. Academic research suggests that diesel elasticity in much of the developed world is close to 0 - meaning demand doesn’t really change with price. Instead, the burden of demand destruction gets shouldered by poorer countries, who in many cases use subsidies to shield their consumers from the very high prices that would cause the demand destruction. We are seeing some demand destruction across the globe, but not nearly enough to bring us back into a comfortable balance. Prices have more work to do.

In talking about markets, we use heuristics - things like “the cure for high prices is high prices” - as a way to help our simple human brains understand a complex world. When it comes to trading markets, though, it’s important to understand the linkages that are underpinning those heuristics, and to spot when they are breaking down.