Commodities: Influencers & Forwards
Overview
This is a brief module that will look at:
- What influences the price of a commodity
- Global markets, local impact on commodities
- Forward markets
What Influences the Price of a Commodity
When it comes to commodities the first key take away is that the standard influencers of price action are a bit different. The general market forces of “supply and demand” that are commonly at work in a typical financial contract take on an entirely different role when it comes to commodities. When calculating the price of an FX forward the implied cost of interest rate differentials are taken into account (in other words the carry cost). Similarly when we evaluate the price action of bonds we conclude that the price of the bond is the present value of all its future cash flows, discounted at some desired rate of return.
With commodities though, this calculation gets a bit more complex. The price of a commodity is primarily driven by supply and demand.
You will recall that commodities are different to other financial securities in that it represents something that Mother Nature creates and influences. In other words the actual physical availability of the underlying commodity is not guaranteed.
Let’s take grain for example, if there is no rain then the crop yields will be very low resulting in supply to be less than usual. On the contrary a flood could do equal amounts of damage, so conditions need to be “just right” to experience the optimum level of production.
So with this as backdrop it is clear that although there is some sort of baseline price for each commodity driven by the traditional supply and demand forces at work in any market, the momentary variances in price could be quite extreme when some of these unpredictable events occur, influencing the physical supply or reserves available for any particular commodity.
It's important to note that each year holds its own opportunities and challenges with commodities especially agricultural markets. There are so many factors influencing grain prices such as weather, which plays a critical role in estimates for supply and demand, and politics, export/import restrictions/bans, macroeconomics (oil price & exchange fluctuations), and logistics (inland or ocean/choke points/strikes etc.). Each commodity has its own price drivers since they differ, however, the aforementioned are the most prevalent across all commodities.
Global Markets, Local Impact
Another interesting concept which is particularly prevalent with commodities is the fact that although prices trade on a global platform, access to this market is not as easy. When one trades bonds or shares, or any financial asset or security for that matter, there truly is no real global constraints holding one back from accessing different markets.
As an example, to transact in AB InBev shares is equally easy when done on the Johannesburg Stock Exchange or the London Stock Exchange. This ensures that global prices remain somewhat in line.
The concept behind it is called arbitrage. Arbitrate refers to the ability to make “practically risk free” profits. Using our example of AB InBev, the implied price of AB InBev shares traded in Pounds, at any given level of exchange rate is fairly close to the Rand equivalent price of AB InBev shares on the JSE.
If there was a big discrepancy arbitrageurs will buy shares in the UK and sell the shares in South Africa or vice versa to capitalise on any momentary mismatch in pricing. After all, it all refers to shares of the very same company, so the two markets should be in check.
In the commodity markets this is not always the case though, and for good reason.
Consider a South African farmer of maize sitting with the following dilemma. Due to a bumper harvest this year, there is more maize than needed in South Africa. As such, the price of the maize has fallen. All the silos are filled up with maize and nowhere to go.
Offshore though is a different story all together. Due to a severe drought in the heartland of America, the crop sizes for maize under produced to a large extent. So much so that there is a huge shortage of maize in the States.
As a result of this the offshore USD denominated maize prices are far higher than the maize prices currently observed in South Africa. When considering that South Africa already sits on surplus stock, it is quite obvious that our farmer will jump at the opportunity to sell maize offshore, and as an added bonus be able to obtain far better prices.
This also plays into the example given of AB InBev, by our farmer selling stock offshore, it should have the following beneficial outcomes:
1. Reduce the supply in South Africa, which should cause prices to drift higher.
2. Increase the supply in the States, which should be able to now service the demand and lead to lower prices.
3. The net result should be a global balancing of relative price levels, correct?
Quite often this is not the case. In reality, our local farmer cannot get enough maize out of the country fast enough to service this demand and will have to sit on the side-lines while his profits disappear. This could be due to a combination of the following:
• Not enough railway infrastructure to cart all the maize from the silos to the ports.
• Not enough port capacity to clear and load dry bulk ships at the speed required to service the demand before prices stabilise as a result of other countries supplying the US with their own excess.
Just another example of how interesting the commodity market can be, trying to bridge the gap between the capacity of real world bricks and mortar vs. the demand of the financial markets.
Forward Markets
The forward market for all financial contracts are based upon the “cost of carry” to take the position from the current value to the future spot value date. For the most part, this is no different for commodity contracts.
Forward - Traditional Financial Security
• Spot rate + Cost of Interest
Commodity Forward
• Spot rate + Cost of Interest • Storage • Insurance • Transport • Inspection
In other words, one would derive any particular forward dates price, by working out the cost of acquiring the commodity today at spot, and then adding on top of this, the funding cost of money. For commodities though the cost of moving the position into the forward also includes something not present with financial contracts, and that’s the costs incurred when handling physical goods.
In this instance one would have to account for:
• Storage Costs • Lease rates • Insurance rates • Inspection rates
However, once all the costs have been taken into account one would be able to calculate and agree on the cost of a forward based off current prevailing spot levels. For the party who enters into the future transaction, the future contract represents an obligation to transact at the agreed price, and at the pre-agreed future date.
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