Starting with the foods we eat, continuing with the metals we use in all kinds of objects, to the energy we need to fuel our transportation and heat and light our homes, commodities are indispensable to our daily lives. By some estimates, $10 trillion of commodities are produced and consumed every year around the world.
Commodities have changed hands since the dawn of human history. Along the way, before reaching the end user, commodities are subject to broadly three types of transformations.[1]
First, production and consumption rarely happen in the same place. Consumption centers are typically far away from production locations. To bridge this gap, various forms of transportatation are used - wires for electricity, pipelines for oil and natural gas, and rail, trucks, and ocean tankers for many commodities.
Just as there is a mismatch in place, the timing of supply and demand often does not align. For example, natural gas is produced at a relatively steady rate throughout the year, while heating demand is highest in the winter and cooling demand spikes in the summer with a relatively low demand in the spring and fall. Agricultural commodities are produced seasonally with relative steady demand year round. Electricity is a big exception where demand and supply must match at every instant.
A third metamorphosis happens when a commodity truly changes form into another commodity, as in oil to gasoline, natural gas to natural gas liquids, and various fuels to electricity. Expensive plants are needed for the conversions such as refineries, fractionators and power plants.
Thales of Miletus needed access to olive presses to convert olives to olive oil. In addition, olives needed to be transported and stored before this final conversion could take place. Similarly, most commodities are subject to all three types of transformations until they reach their final destination.
These metamorphoses make quantitative analysis of commodity markets different from that of markets for financial assets like stocks, bonds, and their derivatives. The physical constraints on space, time, and form add an additional dimension not present elsewhere.
In this blog we are going to explore various commodity transformations from an economic perspective. How much should one pay for transportation, storage and conversion? What are the risks involved? Stay tuned…
Notes
- ^Craig Pirrong, The Economics of Commodity Trading Firms, Trafigura Research, 2014