Chapter 9. An All-Too-Common Tragedy

In his 1968 essay “The Tragedy of the Commons,” published in Science magazine, biology professor Garrett Hardin reintroduced an economic phenomenon that has prevailed among mankind probably since the first herders roamed the land with their flocks. In 1832, the topic was formally introduced by Oxford economist William Forster Lloyd. In Two Lectures on the Checks to Population, he discussed an economic paradigm that has puzzled centuries of observers: how to solve the problem of eventual destruction that nearly always confronts commonly held resources. This dilemma still exists today and can present potential opportunities for investors who identify their solutions.

The tragedy of the commons comes from a nineteenth century inquiry from William Forster Lloyd. It concerned lands held in common in England, and the relative state of cattle and grounds compared to cattle and grounds that were privately owned. Lloyd observed that the relatively “puny and stunted” cattle and “bare-worn” land of the commons contrasted with the healthy, thriving cattle and grasses of the adjoining privately controlled enclosures of land. Lloyd theorized (and his theory was expounded on by Hardin in the twentieth century) that the herdsmen of the commons would continue to add cattle to the point of overcapacity. Behaving in their own self-interest, they had ample incentive to seize as much reward as possible from the public resource and to force the consequences on the remaining herdsmen. In other words, when a natural resource is held in common and shared by many, each individual has outsized incentive to exploit the resource and little or no incentive to assume the responsibility to conserve. A herdsman who does not take as much as he can will lose out to another herdsman who will. Once this process ignites through the self-interested behavior of one participant, other participants observe the prior’s behavior and, in their own self-interest, compete for as much as possible of the commonly held resource. This cascading behavior continues until the public resource becomes exploited to the point of exhaustion. Contrast this with the privately owned model of herdsmen and their land, where the herds-men have tremendous incentive to protect the finite allocation of the resource. In the privately held model, the herdsmen recognize that in order to maximize their interest, they must conserve portions of land by rotating the herd so that the land’s nutrition can be efficiently allocated both now and in the future. The contrast in human behavior in these two settings has proven timeless rather than a novelty of centuries past. As Professor Hardin pointed out in later work, satellite images taken of Africa in 1974 revealed a peculiar 390-square-mile dark patch of land surrounded by light-colored, barren land. An investigation revealed that the dark patch was lush with foliage, surrounded by a fence, and privately owned. So whether we are discussing the commons of England in the 1800s or the expanse of Africa in the twentieth century, this thread of human behavior prevails and is timeless.

Human Behavior Is Timeless

Not only is this behavior timeless, but also the contrasting results from the exploitation of public versus private resources can manifest themselves across a number of media. One modern example can be seen in the use of earmark spending or tax exemptions that are common in legislation created in the United States Congress. In this case, rather than land, the primary resource is publicly provided tax revenue that is held in common and exploited by members of Congress. If a Congressman were asked if he supported earmarks slipped into bills, he would likely denounce the practice. On the other hand, these same politicians enthusiastically participate in creating these earmarks, because they understand that the practice will occur either way. If they do not participate, their constituents may lose the benefits of these resources. If that happens, the politicians may not be reelected. In other words, members of Congress believe they must compete to obtain as much as possible of the common resource, lest the other politicians wrest away more of the funds for their own constituents in other states. For taxpayers who feel that their hard-earned money is exploited or wasted, this is an all-too-common tragedy. Since politicians seek the favor of their voters, it is easy to see why this universally deplorable behavior occurs in a competitive, unbridled fashion. One specific example of this behavior hard at work can be seen in the use of public taxpayer money to rescue failed financial institutions in 2008 and 2009. In the case of the financial crisis, lenders including Fannie and Freddie (and probably others that thought they were too big to fail) knew they were backed by public resources. Therefore, they pursued their own course of greed, risk, and profits to the point of nearly exhausting the entire financial system. Whether the investment banks were wagering behind closed doors that they were too big to fail remains conjecture. However, in the end, the consequences of their reckless exploitation fell on the general public and their provision of financial resources held in common. As we can see, this behavior and this paradigm of the selfish exploitation of public goods have transcended both time and a multitude of resources. The bottom line is that this is simply a matter of human behavior that occurs repeatedly.

For our purposes, we will return to the world of natural resources. We will identify another clear modern-day example of this paradigm and seek to profit from its rather predictable outcome. In this case, we turn to the most obvious present-day example of the tragedy of the commons: the world’s oceans.

The declining state of the world’s fisheries has been a long time in the making and is becoming less of a secret in this age of instant global communication. Still, thanks to the human condition and the predictable outcome of profiteers vigorously exploiting a commonly held resource—in this case, the ocean—we can anticipate the world’s fish stock being exploited in a relentless effort toward, but hopefully stopped well short of, exhaustion.

To be sure, this process is well under way. The world’s oceans are, for all intents and purposes, vast and shared by all in spite of countries’ wishes to gain increased private control of these frontiers. With that said, fishermen have openly exploited the world’s fisheries with reckless abandon for centuries. Clearly, advances in technology and the industrialization of societies during the twentieth century accelerated the rate at which fishermen could haul in their next catch. In time, the effects of these advances have revealed the full extent of this exploitation. Figure 9.1 shows that fish production from capture out of the world’s oceans grew at a steady rate of 4.4% from 1950 through 1989. This period represents the heyday of exploitation, when fishermen around the world could increase their hauls over time. Growing consumer demand due to rising standards of living in the U.S. and other developed markets was met with little problem through this practice. In the wake of this bonanza, however, from 1989 through 2007 the rate of exploitation began to take its toll. The rate of fish capture in these 18 years collapsed annually to a yearly decline of –0.5%. Basically, in predictable fashion, the world’s fisheries became overexploited. The situation has worsened over the past several years, with actual production 8% below its peak in 1989.

Figure 9.1. World fish production by capture

Source: FAO

The problem of overexploitation is punctuated by a not-so-coincidental sharp 46% increase in the number of fishers in the world, starting with the peak of production in 1989 and going through recent years. The problem, as expected, has been a large rise in the competition to obtain fish from the commonly shared world’s oceans. Simply put, after decades of expansion, beginning in the 1990s too many fishers were chasing too few fish (see Figure 9.2).

Figure 9.2. World fishers

Source: State of the World Fisheries and Aquaculture 2008

During the past several years, this decades-long activity has finally reached a point where the world’s fisheries by and large cannot produce anything material beyond their current output. Figure 9.3 shows the FAO’s assessment of the world’s fishery resources in the 2009 publication “State of the World Fisheries and Aquaculture 2008.” This report stated that only 20% of the world’s fisheries could “perhaps produce more.” This 20% includes the designations of underexploited (2%) and moderately exploited (18%). This leaves the remaining 80% of the world’s fisheries as effectively tapped out and unable to produce anything more.

Figure 9.3. Status of fishery resources

Source: State of the World Fisheries and Aquaculture 2008

Strong Demand Underscores the Overexploitation

Importantly, this overexploitation of the world’s oceans is not occurring based solely on the paradigm of sharing common waters. Rather, we must be careful to acknowledge that a sound demand driver is prompting this exploitation as the world continues to consume increasing amounts of fish. For instance, from the short period of 1980 through 2003, world fish consumption doubled, based on a steady 4.1% compound annual growth spanning the decades from 1961 through the early 2000s (see Figure 9.4). The presence of strong demand set against this economic paradigm is what paves the way for an investment opportunity. But before we explore the opportunity, let us review these demand drivers.

Figure 9.4. Worldwide fish consumption

Source: FAOSTAT (data available only through 2003)

Two significant modern-day trends have propelled this meaningful growth in demand. The first comes from the growing demand from the developing markets, which continue to consume increasing amounts of fish based on their rising standards of living. Given that fish is a source of protein, the relationship at play is no different from our related discussions of protein consumption, such as poultry, in the emerging markets being driven by growing affluence. As an example, Figure 9.5 shows the exponential rise in the per capita consumption levels of seafood in China, developing Asia, and the overall developing world. The rise in per capita consumption in China that followed the opening of its economy after decades of stagnation has proven dramatic.

Figure 9.5. Seafood fish per capita consumption (kilograms per year)

Source: FAOSTAT

In similar form, if we examine the overall growth in tons of seafood consumption in the developing world, we can see that the rate of growth in these economies was 5.9% from 1961 to 2003 and lay well above the 4.1% world average (see Figure 9.6).

Figure 9.6. Fish consumption in developing countries

Source: FAOSTAT

In addition to the developing markets in general, the growth rates in developing Asia have been even higher at 6.2%, compounded over a four-decade span (see Figure 9.7). This higher growth rate is likely driven by the traditional role of fish as a staple in Asian diets; its consumption often varies across Western diets.

Figure 9.7. Fish consumption in developing Asia

Source: FAOSTAT

The growth in the developing markets is impressive but not totally unprecedented, because fish consumption has been more prevalent over time in the Asian region. On the other hand, some might be surprised to discover that the developed markets too have been eating more seafood. If we examine per capita consumption trends in the U.S. from the early 1970s through the early 2000s, Americans have clearly been adding more seafood to their diets (see Figure 9.8). The reason for this behavior in the United States is that people have turned to seafood as a healthy alternative. Specifically, research has shown that incorporating seafood into a diet significantly helps reduce the risk of heart disease. For instance, a 2006 study from the Harvard School of Public Health found that consuming one or two servings of fish per week reduced the risk of a heart attack by 36%.¹ So in both the developing-market and developed-market economies, increasing fish consumption appears to coincide with growing affluence. Higher standards of living prompt larger discretionary incomes in the developing markets and healthier choices in the comparatively wealthy developed markets.

Figure 9.8. Per capita fish consumption in the U.S. (in pounds)

Source: NOAA

So far, we have described an overexploited resource of wild fish in the world’s oceans, driven by the existence of a shared resource, as well as strong underlying demand drivers from both the developing and developed markets. The first conclusion we can reach is to acknowledge that the world’s fisheries have been thoroughly prospected for product, and supply will remain relatively fixed going forward. The second conclusion is that demand will remain strong over the next five to ten years thanks to the consumption drivers of rising standards of living in the developing markets and increased health consciousness in the developed markets. Despite the dire picture for the world’s fisheries, it seems unlikely that the darkest scenario of an eventual total collapse will ever be realized. At a minimum, the world’s fisheries that lie within the general jurisdictions of the developed world are receiving some relief through the issuance of quotas for fishers. This form of regulation was tried with general success in New Zealand and is now being replicated in various forms by other nations. The reason this form of regulation provides a better alternative than the free-for-all approach is that the quotas represent an allocation of the resource in the form of property. When the fishers treat their quotas as a form of property ownership, they in turn alter their behavior toward a more efficient form of exploitation, including acts of conservation. The change in behavior represents a shift from exploitation at all costs for near-term gain to one of responsible exploitation. This shift is accompanied by stewardship, because the fisher now has added incentive to ensure the longevity of the resource. However positive this outcome may be, we are still confronted with a basic question: Where will the consumers of tomorrow obtain their seafood fish if the production of the world’s oceans has peaked?

A Tragedy Leads to an Opportunity

Luckily, the world has found an answer in the business of aquaculture, or fish farming. Aquaculture is really no different from livestock production in the beef, poultry, and swine industries, except that in this case the farming occurs in captive areas of the sea. The industry has existed for several decades and has enjoyed years of growth, registering an 8.6% compounded growth rate from 1950 to 2007 (see Figure 9.9). During the past several years, this industry has come increasingly to the fore thanks to the poor state of the world’s fisheries.

Figure 9.9. Total aquaculture production

Source: FAOSTAT

Despite the steady growth seen over the past 60 years, the industry has only recently become a significant player in the role of human food consumption. Despite the latecomer status, supply from this source has stormed onto the scene as FAO estimates suggest that in 2007 the aquaculture industry supplied 47% of the fish consumed globally compared to just 3.9% in 1970. Most importantly, though, because of the factors of growing demand and overexploitation in the supply, which we discussed earlier, nearly all future growth in fish supply for consumption will also come from aquaculture, rather than the world’s oceans. In fact, this trend has already begun in the wake of the stagnation in wild capture during the early 1990s. At the same time, we must be careful to recognize that the term aquaculture is a (no pun intended) catchall for many different species of aquatic animals. Figure 9.10 shows that the aquaculture market is diverse, encompassing fish products ranging from freshwater fish to mollusks and crustaceans.

Figure 9.10. Aquaculture production by species

Source: State of the World Fisheries and Aquaculture 2008

Although the entire category should enjoy growth in the coming years, the subcategories of diadromous fishes and marine fishes are particularly relevant from a growth perspective and likely will receive investors’ attention. Diadromous fish, or fish that travel between salt water and freshwater, such as salmon and trout, have strong commercial value, as do the marine fishes. The higher value of these products relative to the overall market is easy to see if we compare quantity in tons versus value in U.S. dollars (see Figure 9.11). Put another way, diadromous and marine fishes comprise considerably more of the market in U.S. dollars versus their representation in volume.

Figure 9.11. Aquaculture market by tonnage and U.S. dollar

Source: FAOSTAT

With that said, commercialization of these aquaculture categories has responded well to the overexploitation of the world’s fisheries, and production has posted strong growth rates since the early 1990s, as shown in Figure 9.12. In short, the business has risen from near obscurity to becoming a considerable portion of overall production in these fish proteins over the past several decades.

Figure 9.12. Aquaculture production of diadromous and marine fishes

Source: FAOSTAT

From 1990 through 2007, the marine fish category has grown in volume by 11.1% per year, and the diadromous category has grown at 8.3% per year. This growth in the industry has been enabled by continued advances in aquaculture farming techniques that have persistently driven the cost of production lower. For example, if we look at the cost of production since the early 1990s (see Figure 9.13), the cost of production in salmon farming has dropped by approximately 50%, meaning that the price of salmon has also dropped. One important takeaway from this trend is that salmon has become incrementally less expensive over the past 15 to 20 years thanks to these lower costs. Therefore, salmon is more competitive with the remaining proteins in the market, such as beef, poultry, and swine.

Figure 9.13. Inflation-adjusted price and production cost in the Norwegian market

Reprinted with permission from Marine Harvest, Salmon Farming Industry Handbook 2009.

The other important observation from an investment standpoint is the cyclical nature of prices in the market. As shown in Figure 9.13, prices tend to rise above the cost of production for approximately three years and then approach breakeven or even loss-making levels. This is likely due to the three-year production plans and the recurring collapse in prices. Producers will add capacity as long as prices exceed the cost of production, until prices eventually decline from oversupply. The bargain hunter for investments in this space and many other commodity markets typically reaps the highest benefits from investing ahead of the cycle while the firms are at breakeven or are suffering losses due to supply-led price collapse. Despite this built-in timing device, many investors instead do the opposite and invest when the market looks prosperous, just prior to a collapse.

Irrespective of investor folly, the salmon farming industry is largely relegated to a handful of countries and regions, including Norway, Scotland, Chile, and Canada. All these major markets have experienced significant harvest growth rates during the past few decades, but Chile stands out with a 21% compounded annual growth rate, as shown in Figure 9.14.

Figure 9.14. Salmon farming compound annual growth from 1990 to 2008

Source: Marine Harvest, Kontali Analyse

The historic growth rate of the Chilean market registering twice the level of Norway and Scotland did not occur by chance. The Chilean market for aquaculture and salmon farming in particular has specific competitive advantages. One deep competitive advantage of the Chilean market is its relatively stable water temperature. It varies annually by approximately 4 degrees Celsius, versus the other competing regions, where the water temperature may vary by as much as 10 degrees. Since Chile’s average temperature is more stable and, on average, a few degrees higher than the remaining major producing regions, its fish tend to grow faster by approximately three months. Likewise, in the Chilean market, the farmers can release smolt (young fish) throughout the year. The other regions, such as Norway, must adhere to a seasonal pattern when the water becomes warmer. The bottom line is that producers in Chile can grow fish faster and also produce more fish in any given year thanks to these competitive advantages.

Despite these advantages, Chile’s rapid growth and emergence as a significant industry player came at a tremendous cost. In the typical “commodity style, grow at all costs, and add capacity while it is profitable” fashion that is found across all farming businesses, the Chilean producers ignored industry best practices. Ignoring best practices led to unbridled growth and capacity additions. Across the Chilean industry, farmers adopted rather weak industry practices, which led to a massive outbreak of a biological disease called Infectious Salmon Anemia (ISA). The ISA outbreak in Chile during mid 2007 devastated the industry and resulted in substantial layoffs, culled harvests, and financial losses for producers in that market. Perhaps this situation will be remedied in time. But there is no easy fix to a disease outbreak of ISA—which incidentally highlights an important risk factor to consider.

On the other hand, this phenomenon actually may have provided the industry with a meaningful boost to its broader supply-and-demand cycle. Given the scope of the problem in Chile, the removal of supply among these producers due to culling has actually helped offset the ill effects of the global recession and the resulting declines in demand. So although the Chilean situation has been a disaster, and most producers have been losing money in these operations, it has actually been somewhat of a mixed blessing. Profits in other regions have picked up in response to declining supplies in Chile. To bring the Chilean supply shock into perspective, the overall supply of salmon is expected to fall 75% from 2008 to 2010 by some estimates. The reduction in supply volumes has already begun to affect pricing in salmon, because production declines have outpaced any decline in demand due to a softer economic backdrop. While projections and estimates vary by source, there is a fairly wide consensus that the problems in Chile will affect supply volumes in the years to come. Based on most expectations, supply volumes are expected to decline during 2009 and 2010 as farmers in Chile continue to sort out these biological issues with their supply (see Figure 9.15).

Figure 9.15. Farmed salmon, coho, and sea trout supply estimates

Source: Fondsfinans

In the meantime, estimates from industry executives highlight the severity of the Chilean issue. Aulie Michelet, the CEO of Marine Harvest, a large Norwegian producer with operations in Chile, has stated in interviews with Bloomberg² that it could take until 2014 or 2015 for production volumes in Chile to resume their prior levels. Until then, the demand for salmon and seafood of all varieties should continue marching on in step with the demand drivers present in both the developing and developed markets. Set against this demand backdrop, it seems probable that the market could become and remain undersupplied, creating a bullish environment for aquaculture producers with operations in other locations such as Norway. Because many of the publicly traded large producers have operations across the major markets, they too could benefit from this market paradigm, notwithstanding continued weakness in their Chilean operations. In any event, thanks to the unique set of circumstances surrounding the world’s fisheries and demand drivers across all markets and economies, we can have some confidence that growth will continue in this industry over the coming years. This growth represents an opportunity for investors who can look beyond the near-term problems in the Chilean supply.

Endnotes

¹ Christy Feig. “Seafood benefits outweigh risks, government says.” CNN.com, November 2, 2006.

² Meera Bhatia. “Marine Harvest Chief Says Salmon Supply Squeeze Will Persist.” Bloomberg, August 20, 2009.