Commodity (noun): a raw material or primary agricultural product that can be bought and sold. Also: a useful or valuable thing.
The definition of ‘commodity’ covers a great many things, from natural resources like oil and gas to precious metals, electricity, beef and foreign currency. The subjacent ‘useful or valuable thing’ is a little too broad we’d say, as it could also mean a handkerchief when you’re about to sneeze, so let’s stick to commodities as we generally interpret them in the trade industry; products to be bought and sold. What is striking though is the additional ‘primary agricultural product’. Because it’s easy to think of petroleum, gold or precious metals – but agricultural commodities are something to be desired as well. So much so, the powers that be decided to make it part of the very definition of commodity.
Soft Agricultural Commodities
Indeed, the industry as a whole has over the years experienced boosts in interest due to investors looking to diversify their portfolio of stocks and bonds and looking into soft agricultural commodities, the most versatile category, in the process. Technically ‘soft agricultural commodities’ are products that are grown rather than mined, such as cocoa, coffee and sugar. These soft commodities are unique because farmers can plant and raise new crops year after year. For traders, even the smallest percentage of any soft commodity will lead to a reduction of both volatility and risks.
The top five of soft commodities in terms of annual consumption is made up of cocoa, coffee, grain, sugar and cotton. Agiblocks covers all five and has as much as four of them listed as Specialized Commodities to boot. You can read all about it here. In this article we’d like to focus on the market price of agricultural commodities as well as on mechanisms that influence that price and the various methods used for pricing and valuation.
Market Price: conversation starter number 1
The market price of agricultural commodities, or indeed of any commodity or ‘useful or valuable thing’ is more than likely the number 1 topic of discussion in the industry. What is the market doing? Where are we going? What is the impact of the current pandemic on markets, prices and the value of products? The topic of pricing and risk management is never far away. Neither are graphs charting historic, current and potential future levels of prices, which are used as a central part of much of our activities. Which is remarkable, as we can’t actually control where those graphs will actually take us.
Graphs of markets and (expected) price levels are in a sense not unlike the weather forecast: we can gather as much information as we can, but in the end, we can only accept what the actual outcome is – even if that means hastily seeking shelter from the rain when the weatherman promised you lots of sun for your Sunday picnic. Having said that, there are of course lots of precursors you could have taken into account. Maybe it has been raining for days now? Maybe the low-pressure system forming clouds and eventually precipitation should not really have been a surprise, as the signs were right there. Granted, you are probably not a meteorologist, but the point is: there is a wealth of information out there you can heed if and when you indeed leave the house. The same is true for agricultural markers, are there are lots of price drivers for commodities.
Price drivers of agricultural commodities
What drives the price of agricultural commodities? As with any market, the first rule would be: supply and demand. But that would be oversimplifying the situation, like pointing to a low-pressure system when it has already started raining. Yes, it plays a huge part in establishing prices, but it doesn’t provide a real answer. Because the real question is: what is causing supply and demand? How has the low-pressure system evolved, and how did it get here? As it turns out, lots of price drivers for agricultural prices are well-known – and equally well registered, logged and recorded.
The first example would be, with the risk of confusing you know; the weather. The weather is after all a huge factor in producing commodities that are grown rather than mined, as is the case with all soft commodities. It can cause good crops, bad crops, high yields, low yields, variety in size, quality, quantity – and so on.
A second driver is substitution: the availability (and price!) of alternatives. The presence of substitution possibilities clearly has an impact. When the sugar price is high and a major producer of candy can find a different sweetener just as good as sugar for a lower price, it will have an effect on sugar prices (and sweetener prices). Chances are high he will take that opportunity, causing demand for sugar to drop.
Side note: commodity prices and inflation
Commodities and inflation have a very special relationship. As a general rule, commodities are an indicator of inflation on the horizon. As the price of a commodity rises, so does the price of any product where it is used in the production process. Therefore, commodity prices exhibit measurable economic change before the economy as a whole (inflation) is affected. While commodity prices are not a hundred percent indicator of inflation, they can be a good starting point in hedging against inflation. That is why agricultural goods offer value as a portfolio diversifier that serves as a hedge against inflation.
The same goes for inventory levels, as a third factor in driving market prices for commodities is in-stock availability. Much inventory available will cause increased supply capabilities and impact the price. The list goes on and on, because if you want do some proper fundamental analysis for an(y) agricultural commodity, there are many more factors to consider. Health and taste, for instance – a huge driver in the price of sugar on account of the growing awareness of health-related issues. The same applies to coffee, or chocolate. And what about activities by investors, especially on derivative markets? Protectionism from government? A growing population and increased urbanization?
A full and proper analysis of markets and prices is never easy, and just when you think you have mapped the influence of one (or all) driver(s), something can (and will) happen to throw it all for a loop. Which is why the market price as a conversation starter will always be around – as well as the need for a proper solution to get a grip on and manage the resulting risk. Enter Agiblocks – but you already knew that.
Trading Agricultural Commodities in Agiblocks
At Agiboo, one of the foremost things we have noticed during all our years of developing and perfecting a suitable CTRM solution, is the diversity of how people perceive market price risk and more prominently, the diversity on how they manage it. There is no good or bad way, necessarily – but given that market price risk management has a long history there is still an apparent lack of standardization that shows us how complex it is to standardize and find a real common approach, despite the existence of professional exchanges and their focus on derivatives as the answer.
Are you a trader, buyer or seller in soft and/or agricultural commodities and do you want to know more about commodity trading and our next-generation CTRM solution? The full range of Agiblocks functionality is available within our newly improved demo environment. Familiarize yourself with the tools and features of our powerful and agile software solution and find out how you can improve your daily routine. Find out more about our free demo!
Pricing and valuation
Ok, back to pricing. How do you actually price agricultural commodities? We’ll wrap up our article by covering a few pricing methods that are an integral part of market price development, and obviously of the inner workings of Agiblocks as well, as there is an interesting element that sets the commodity trade apart from an actual market places where goods are bought and sold on the spot.
As we’ve covered, prices of commodities are based on the supply and demand of that particular commodity, no different than is the case for all exchanges. Commodities however are bought and sold at prices while exchange of these products usually takes place on a later date somewhere in the future (yes, this is the unique partner we’ve just mentioned). Therefore, there can be (and usually is) a lot of uncertainty whether the market or spot price will be in line with the pre-determined price of a contract.
Parties agree on a pre-determined price to cover themselves against adverse price movements. They however also risk missing out on positive price movements in the future, due to the obligation to a contract. That’s why a number of different pricing methods have evolved for determining a price upon which both parties can agree;
- Fixed Price
- Floor and Ceiling Price
- Floating Price
- Price based on the Basis
A fixed price is the most basic form for settling a price for a commodity or futures contract. A fixed price is determined at the start of a contract and is in many cases based on the price futures, that have a comparable size and delivery date. This agreed upon price is the price for which the contract will be settled at the delivery date. This fixed price is an insurance for both parties against negative price movements on their position.
Floor and Ceiling Price
Parties can also agree on minimum and maximum price, called floor and ceiling prices. In this situation, when a price would move outside of these boundaries, both parties would share the profit from this price evolution. This way both parties benefit from large price movements. When the price remains within the boundaries, the contract will be settled according the market price upon the time of delivery.
Another pricing method for determining a price for a commodity contract is using a floating price. A floating price can be calculated as an average of a reference price over a set period of time. This method reduces the risks of a temporarily extreme price at the date of delivery. While calculating averages, a sudden increase will only have a small effect on the overall price of the commodity. This type of pricing is especially effective for long-term contracts, because the chance for price fluctuation increases with the increased duration of a contract. The reference price for such a contract is determined at the start of a contract and is in many cases the spot price of a commodity on a leading exchange.
Another way of using a floating price is by agreeing to pay the spot price at the time of delivery or the spot price at a date near the delivery date. Again, it is important the parties agree on the exchange which will be used as reference price. This pricing method is very risky due to the uncertainty of the price in the future. Usually participants will hedge their price risks on an exchange to cover themselves against adverse price movement.
Price Based on the Basis
basis is the difference between the local cash price and futures price. This contract gives the holder the ability to lock-in on a basis, which he thinks will be profitable in the future. The final price for the commodity however will be decided when the holder exercises the contract. When he decides to exercise the contract, the price will be determined by taking the current futures price and reducing this with the agreed upon basis. This results in the final price the buyer will pay for the commodity. Using a basis contract offers certain advantages. In combination with a hedge on a futures market, a basis contract offers a certain level of security about the final price of a commodity. Furthermore, the basis is quite predictable due to seasonal patterns or historical references. Therefore, the risk of high basis fluctuations can be minimized. A basis contract however must always be covered via hedging to reduce the price risk. While the basis is predicted and settled upon in the contract, the actual selling or buying price can fluctuate greatly. A basis contract is only effective in combination with a proper hedge.
Agricultural Commodities and Agiblocks
Commodity trade and risk management (CTRM) solutions are by default complex and rich in functionalities to support all the flexibility that characterizes the industry. Agiblocks CTRM provides a large number of detailed features and functions. In many cases specialized for a certain commodity or commodity group. If you are looking for a particular functionality but cannot find it on the Product Sheet, please get in touch with us to discuss possible solutions.