Commodities: Value and Price Are Two Different Concepts

There is a vast difference between value and price. The current price of a commodity is the amount a buyer pay and seller receives in the marketplace. In the physical commodity markets, prices are often not transparent as deals occur on a principal to principal basis. When it comes to futures markets, the current price is the last published price by an exchange like the Chicago Mercantile Exchange (CME) or the Intercontinental Exchange (ICE).

In the world of futures, there is total transparency as buyers and sellers meet under the guides of an Exchange that reports the most current price level to the public.

Determining the Value of Commodities

There are often many opinions if the current price of a commodity is cheap, expensive or a fair value level. The current price is always the correct price because it is the level that a buyer is willing to pay and a seller is willing to receive. However, value is often a different consideration. Some market participants may believe that a price is cheap because it has been moving lower and when the price moves higher over time others may believe that the price is expensive.

When it comes to value, what is cheap to one person may be expensive to another; it all depends on their point of view. Value is a measure of importance, worth, or usefulness. Therefore, to determine the current value of a commodity it is crucial to compare the raw material to another that is in some way related.

All commodities have some things in common. They are all members of the raw material asset class. They are all staple resources and all can be bought or sold. However, some commodities have stronger relationships with others. As an example, while corn and gold are both commodities they have little in common.

The same goes for oil and cattle. However, platinum and gold are both precious metals and oil and natural gas are both energy commodities. Within the same commodity sector, different commodities can often serve as substitutes for another. In these cases, comparing the price level of one commodity to another can often yield important value clues as to whether a commodity is historically cheap or expensive.

Inter-Commodity Spreads

One of the best value tools in the world of commodities is the inter-commodity spread, which measures the price differential of two related raw material prices over the course of history. A great example of an inter-commodity spread that can help us to determine value may be the price spread between platinum and gold. Over the past four decades, platinum has traded at an average of a $200 premium to the price of gold. The range in the spread between the two metals has been as high as a $1200 premium for platinum in 2008 and as low as a $350 discount for platinum under gold in 2016. While it is a matter of conjecture to say that one metal is cheap or expensive at any moment in time, one could surmise that based on history, platinum was expensive when compared with gold at a $1200 premium and it was cheap when compared with the yellow metal at a $350 discount.

Conversely, when it comes to gold it was historically cheap compared to platinum in 2008 and expensive in 2016.

There are many other examples of inter-commodity spreads that can help us to understand the current value of a raw material by using a history of price relationships. An example of how a producer of commodities might employ an inter-commodity spread to determine output is the inter-commodity spread between corn and soybeans. Over past few decades, the average level of the corn-soybean ratio - the number of bushels of corn value in each bushel of soybean value - has been around the 2.4:1 level. The ratio means that over time on average, there are 2.4 bushels of corn in each bushel of soybeans. When the ratio moves above the 2.4:1 level, soybeans become expensive compared to corn or the corn becomes cheap compared to the beans.

Under the average level, the opposite is the case on a historical basis. A farmer who has the choice of planting corn or beans on their acreage each year may use the relative prices of two commodities to determine which crop to plant. Above 2.4:1 a farmer is more likely to plant the expensive beans and below that level corn become a more attractive crop to plant from an economic perspective.

When it comes to consumers, inter-commodity spreads will often determine choices. The long-term average of the price relationship between lean hog and live cattle futures is around the 1.4:1 level or 1.4 pounds of pork value in each pound of beef value. When the measure is above 1.4:1 beef is more expensive than pork on a historical basis and when it is below, pork is more expensive. Consumers tend to make wise economic choices. When steak is cheaper than pork chops, a shopper is more likely to purchase steak and when pork is cheaper, it is likely to show up on the dinner table for the majority of shoppers.

As you can see, there is a big difference when it comes to the price of a commodity and the value of that raw material product. The inter-commodity spread is a tool that can help commodity traders and investors in identifying if a product is cheap or expensive.