Commodities, Windfalls And Capital Misallocation

The New York Times recently published an article about Guar (, a mundane crop that has been grown in north-western India for centuries. The reason the article caught my attention is because my family has been one of the beneficiaries of this boom

My ancestors are from the Indian state of Rajasthan and my family has roots in a small town in northern Rajasthan called Sri Ganganagar. Sri Ganganagar was established by Maharaja Ganga Singh of the erstwhile princely state of Bikaner in 1927. Ganga Singh was instrumental in building an irrigation canal that brought water from the river Sutlej in the state of Punjab to the erstwhile princely state of Bikaner. The arrival of the canal converted Sri Ganganagar into the biggest agricultural center in the entire state of Rajasthan (most of which is desert).

When India became independent from the British in 1947, the country split into two, India and Pakistan. Sri Ganganagar is located less than 50 kilometers away from the India-Pakistan border. Because of its proximity to the border, Sri Ganganagar has never attracted industry and probably never will. It is an agricultural mandi(market hub) and will probably always remain just that.

The main crops grown in Sri Ganganagar are wheat, cotton, mustard and guar. In fact Sri Ganganagar is the biggest guar growing region in India and therefore the world. Guar traditionally was the lowest crop in the pecking order of potential crops in the region. The bean is hard as rock, can be stored for years and never gets spoilt. As the New York Times article above explains, the boom in hydraulic fracking created a new use for guar that completely upset the market's equilibrium.

Crop that was sold for $1000 a tonne a year ago started commanding a price of $6000 a tonne a few months ago. Farmers, traders, speculators and almost all participants in the guar chain came into windfall gains that exceeded their wildest imagination. Participants of this chain (and agriculture in India in general) have never had surplus capital to allocate or invest.

This region does not have affinity for investing in gold and the population does not particularly understand or have faith in financial instruments like debt and equity. The only thing they invest surplus capital in is land. This works most of the time because not everyone comes into surplus capital at the same time. However, the guar boom changed all that. Almost everyone in Sri Ganganagar came into money at the same time and the price of land reached the stratosphere. Land close to the railway station started selling for $100 a square foot.

This is the part where my family comes into the picture. We've owned ancestral land in Sri Ganganagar that we've wanted to sell for a long time. We had explored selling it a few years ago and struggled to get a single bid after keeping the land on the market for an entire year. When I found out about what was happening with guar in Sri Ganganagar, I did a price check for our land and found that prices were double of where we had wanted to sell a few years ago. We put it on the market and found a buyer within 30 days. We were able to close the transaction and receive the sale proceeds in less than 90 days of concluding the sale transaction.

I believe that people in Sri Ganganagar are grossly misallocating their windfall gains and that the entire town will suffer when the tide goes out. I do not know how much higher guar will go from here and how much longer land prices will continue to rise. However, I do know that in the not too distant future, guar will crash and the land market will return to its erstwhile position of no bids. The pain this time around will be unbearable.

The reason I believe that the guar story will end badly is because all commodities (soft and hard) are cyclical. Sudden dislocations magnify the cyclicality of those commodities and the ensuing slumps can be very deep, very severe and devastating.

Let me explain this with an anecdote on vanilla. The African island nation of Madagascar is the world's largest producer of natural vanilla. About 10 years ago Madagascar suffered a severe drought that destroyed the country's entire vanilla crop. This created a major supply dislocation in the market. Before the dislocation, vanilla that costed a farmer $5 per kilogram to cultivate was sold for $10 per kilogram. However, the dislocation caused the price of 1 kilogram of vanilla to rise to $400 per kilogram. This created windfall gains for those who managed to salvage their vanilla crop. Because a new vanilla plant takes 3 years to produce its first output, the dislocation in the global vanilla market lasted for 3 years.

However, as it happens in all commodities, whenever the commodity experiences a dislocation, a supply and a demand response kicks in. In the case of vanilla, the high prices of vanilla and the sudden scarcity forced even the bluest blooded chocolate, beverage and ice cream manufacturers to start shifting to synthetic vanilla.

India has similar climate to Madagascar in certain regions and vanilla can be grown successfully in India. Since the price of vanilla stayed high for 2 - 3 years, many farmers in India started planting vanilla in the hopes of cashing in on the riches. The crop was similarly planted in many countries that had never grown vanilla. Just as the newly planted crop from India and other countries was about to start enetring the market, the crop in Madagascar was also fixed and came into the market creating a supply glut.

The reduction in demand for vanilla and the supply glut crashed the market for vanilla. Indian producers never did get to travel on the road paved with gold. It has been 10 years and the market for vanilla is yet to recover. It probably never will. Natural vanilla will probably become and remain a niche crop to be consumed by the minority die-hard organic food consumers of the world.

In industrial commodities, the iron ore market experienced a similar demand shock due to China's overzealous fixed investment driven boom. The dislocation kicked in a major supply response all over the world. Vale of Brazil built the largest ever bulk cargo ship in the world to transport iron ore and coal. It is likely that sometime in the not too distant future, demand will plateau or even decline. Supply will overwhelm demand and the market will get completely destroyed.

In summary, the guar boom is temporary and beneficiaries should take their windfall gains and allocate it prudently elsewhere. One should not get carried away by the emerging market commodity demand story and always remember that it takes both demand and supply to set a price and the market for a commodity can never be understood or evaluated based on characteristics of only supply or only demand.

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