Mean reverting price in commodities market


Commodities and its purpose:

Commodities can be used for two purposes such as investment purpose and consumption purpose. Example of Investment purpose commodities are metals such as gold, silver etc. Example of Consumption purpose commodities are Agriculture commodities, electricity, natural gas etc. 

Cost involved in storing a commodity:

– one needs money to buy a commodity. When borrowing money to buy a commodity involves borrowing cost which is called as interest rate. 

– Transporting and Storing the commodity involved storage cost. Example: transporting and storing natural gas is difficult and therefore the cost is high. 

– Borrowing the asset to short it involves Lease rate. Lease rate is the cost involved in borrowing the asset. 

Benefits involved in storing a commodity:

Storing a commodity allows the user to use it anytime when it is needed. For example, if a gold producer doesn’t have enough gold to make jewels and sell it to the end user. And one day suddenly the demand increases and the producer does not have the gold ready in hand. And since the demand has increased, the price would have also increased, therefore the producer would also find it costly to buy it. Instead if he had enough stock when the price was low, it could have benefited him. This is called convenience yield which means the convenience/benefit of storing an asset. 

Prices of commodities:

Among all the types of commodity, storage cost and transportation cost of natural gas is high. And it is also seasonal. Electricity is used more when the climate is hot due to additional usage of air conditioners. And the cost also depends on the production facilities in each region. Therefore, the cost is also dependent on which region it is produced. 

prices of commodities are mostly mean reverting:

The prices of commodities are usually volatile as discussed before but the prices always pulled towards a mean price. 

When price of commodity is high –> production becomes attractive –> supply tends to increase –> users search for less expensive product –> then the price of the commodity tends to reduce

Similarly when price of commodity is low –> production becomes unattractive–> supply tends to decrease —>the usage/demand will increase due to low cost–> price will increase

Therefore the prices always pull back to the central value for commodities. 

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