Wednesday, August 1, 2012

Case Study in Supply and Demand: Will Fracking Enrich India's Guar Farmers?

The following post was originally published on Economonitor It is reproduced here for classroom use, along with a slideshow that demonstrate how the theory of supply and demand can be applied to events in the guar market. The slideshow is ready to cut-and-paste into your lecture. Follow this link for the classroom-ready slideshow.

A New York Times story last week featured a picture of a happy Indian farmer in his new house, a replacement for a miserable mud hut. His sister, a scarf modestly hiding her face from the photographer, extends her arm to show a new silver bracelet and ring. The house and the silver were bought with profits from guar, a crop for which India holds a global market share of 80 percent or more. The price of guar has soared recently, largely because it is a key ingredient in fracking fluid.

What is going on here? Will India’s near-monopoly of guar production be a lasting source of riches for India’s farmers? Will it be a lasting strategic headache for advanced economies, something like China’s monopoly of rare earth elements? A look at the factors behind the recent run-up in guar prices will show why the gains to India’s guar farmers are likely to be transient.

What on Earth is Guar?

Unless you are one of those health nuts who reads the list of ingredients on everything  you eat, you may never even have heard of guar. Guar is a small bean, Cyamopsis tetragonoloba, whose name means “cow food” in Hindi. In practice, though, not much is fed to livestock. Guar has other, more valuable uses in the modern world. It is the source of guar gum, a substance that forms a gel when mixed with water. Guar gum is a key ingredient of many industrial food products, from baked goods to ice cream, that need to retain moisture in order to have a long shelf life.

The ability of guar gum to form a gel also makes it useful in fracking. One of the environmental objections to fracking has been the reluctance of oil and gas producers to disclose the composition of the fluids they use for hydraulic fracturing of deep rock formations. (See this earlier post for a discussion of fracking and the environment.) The use of guar, which fortunately is nontoxic, has never been a secret, however. Halliburton alone, the leading supplier of fracking services, uses some 12 million pounds a month.

According to Halliburton CEO Dave Lesar, quoted by Bloomberg, guar gel can account for as much as 30 percent of fracking costs. From 2005 to May of this year, guar prices soared three fold to 35 cents a pound, helping to fuel a 25 percent increase in fracking costs last year, and further increases so far this year. Since May, however, guar prices have fallen back by half. What is behind the price volatility, and what lies ahead?

The Demand Side of the Market

When discussing demand, economists like to distinguish between the effects of price changes taken in isolation and the effects of structural changes that shift the relationship between price and demand over time—movements along demand curves and shifts in demand curves, if you remember that lecture from your Econ 101 course. The effects of price changes on the quantity demanded are measured by elasticity of demand—the percentage change in the quantity of a good demanded as the result of a 1 percent change in its price.

Guar is a good with no important final uses. As an input for industrial uses, is elasticity of demand depends on its share in total production costs, the availability of substitutes, and the elasticity of demand for the final products it goes into—oil, gas, and food products.

Together, those factors keep the elasticity of demand low. With regard to its use in energy production, demand for oil and gas is itself inelastic and there appear to be no good substitutes for guar in fracking fluid. Those considerations offset the fact that the share of guar in production costs, as noted above, is substantial. Demand for food products that use guar is more elastic than for oil and gas, and substitutes are available in some cases. For example, the U.S. company TIC Gums offers a product called Ticaloid GR4520 that it claims performs as well as guar gum for industrial baked goods, although at a somewhat higher cost. However that consideration is offset by the fact that guar accounts for only a small share of the cost common foods.

When elasticity of demand is low, short-run changes in market conditions can lead to large fluctuations in price, as happened in the guar market earlier this year. For example, according to a Reuters report, at least part of the price run-up in the spring of 2012 stemmed from Halliburton’s efforts to accumulate a 4-month stockpile to protect itself from possible interruptions of supply. Also, there were some problems in the futures market that led Indian regulators to suspend trading in March. Reports in the Indian business press suggested attempts to manipulate prices and corner the market. Those transitory influences have now passed, hence the recent decrease in prices.

In the long run, demand responds to trends that operate independently of prices. Over time, population growth and rising incomes throughout the world are likely to increase demand for both food and energy. For food, rising income typically brings substitution of industrial foodstuffs, including those that use guar gum, for home-cooked foods, that do not. At the same time, oil and gas produced by fracking seem certain to increase as a share of all energy. Fracking is as yet widely used only in the United States, but many other regions have oil and gas deposits that could potentially be tapped using the technology.

The Supply Side 

Assuming demand does hold up, the long-run prospects for Indian farmers depend on what happens on the supply side of the market. Key questions include how quickly supply increases in response to rising demand and where those supply increases take place.

In the short run, the supply of a farm crop like guar is moderately elastic. Within any region where guar is now cultivated, it can quickly be substituted for other crops that farmers would plant instead. Already Indian farmers have announced plans to expand acreage by at least a third for the fall harvest. True, actual yields will depend not just on the sown area but on the monsoon rains, which are late this year, so nothing is yet certain. To encourage risk-averse farmers to plant more guar, some Indian processors are promising a fixed income per acre planted regardless of the outcome of the harvest.

The more interesting question is whether India will maintain its large market share if prices continue to rise. India has a head start. Guar is a well established crop there, with varietals suited to the local climate. Farmers are familiar with methods of cultivation. There is a well-developed infrastructure to supply seeds, equipment, and processing services.

However, having a head start is a long way from having a natural monopoly. China, Australia, Argentina and the United States all have areas potentially suited to guar cultivation, and all now produce small amounts. Large-scale production has not been profitable at prices that have prevailed in the past, but a few years of higher prices would very likely change the situation. After a period of learning by doing, farmers elsewhere could certainly master guar cultivation. For example, one U.S. producer, West Texas Guar, Inc., has not only grown the crop, but is willing to share what it has learned about adapting guar to local weather conditions and farm equipment. The company even reports a bonus: when it rotates guar with cotton, cotton yields increase by some 12 percent.

The bottom line: Markets overcome monopolies when they are allowed to work

When we view the impact of fracking on the market for guar, it looks as if supply and demand are, in most respects, working as they should. In a widely cited paper Friedrich Hayek once described how the discovery of a new use for any good causes its price to rise. The price increase, in turn, sets of a cascade of substitutions in production and use, the discovery of substitutes for substitutes, and so on. That is what is happening in the market for guar now.

Much the same is true in the market for rare earth elements, where China has held a market share even larger than India’s share of guar. As discussed in this earlier post, China’s monopoly of rare earth elements is also being overcome by market forces. The difference is that the time scale is much longer for rare earths than for guar, because substitutes take longer to develop and because larger investments are needed to gear up production in new locations. The market for guar is capable of responding faster, so temporary shortages of that commodity have a much smaller strategic impact than recent shortages of rare earths.

However, there are some caveats. Markets are best able to do their job of overcoming monopolies when they operate in a favorable policy climate. Some policies, such as trade protection, overtly block competition, but even seemingly unrelated policies can have unintended consequences that are no less damaging.

Consider, for example, the effects of crop insurance. Already an established element of U.S. farm policy, crop insurance is likely to become more important as a result of the farm bill now working its way through Congress. Federally subsidized crop insurance protects farmers against both crop failures and low prices. In some cases, insurance coverage is so generous that—much to the dismay of conservationists—it is worth plowing up idle land to plant a crop that is certain to fail.
Since almost no one grows guar, there is no guar lobby to compete in Washington with the cotton lobby, the soybean lobby, or the corn lobby. With no lobby, guar is not covered by crop insurance, making U.S. farmers reluctant to plant it. As a result, when markets say “grow more guar,” the signal falls on deaf ears. Instead, farmers hear the siren song of subsidies, which say “grow more cotton,” even though the world appears to have enough, or more than enough, of that product.

In short, increasing demand for guar may be a modest boon to farmers in India; perhaps to farmers in Australia and Argentina; and perhaps even to U.S. firms like TIC Gums that produce guar substitutes. What is less likely is that Country and Western artists will, any time soon, be writing ballads about “them ol’ guar fields back home” in Texas.

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