Generally speaking, there are two different types of commodities in the world – those that are seasonally produced and those that are continually produced.
The differences between the two have major impacts on the way that you analyze the supply and demand to determine fair value. Likewise, the metrics used to to discuss the fair value of seasonal and continuous production commodities are significantly different.
Seasonally Produced Commodities
As the name suggests, seasonally produced commodities are those that are produced seasonally and not on a consistent basis. These commodities are most commonly agricultural products such as grains and oilseeds. These crops are planted in the spring, allowed to grow during the summer, and harvested in the fall. Once the crop has been harvested the local supply is relatively fixed for a certain period of time – usually until the next crop is harvested.
A great example of this is US corn. In the US, corn is typically planted in the April to May timeframe, grown all summer, and harvested around in the fall September/October. Once the corn is harvested in the fall, the market will have a fairly good idea of what the supply will be for the next 12 months and the market will trade around those levels as demand changes.
These seasonal ebbs and flows in supply create a scenario where the price of the commodity both exhibits strong seasonal price trends and is highly dependent on the level of supply remaining before the next crop year, or ending stocks.
Seasonal Price Trends
Seasonally produced commodities tend to exhibit strong seasonal price trends that are caused by the reduction in supply as you move through time from one harvest to another. Logically, this makes perfect sense because around harvest time supply will be at its highest and prices will be at their lowest. As you move through time towards the next harvest the supply gets smaller and smaller causing prices to increase.
Seasonally produced commodities are also highly dependent on their ending stocks. Ending stocks are the amount of supply, or stocks, left over from one crop that can be carried into the next crop. Higher levels of ending stocks represent a scenario where supplies are more ample and prices will tend to be weaker. Likewise, lower levels of ending stocks represent a scenario where suppliers are tighter and prices tend to be more firm.
From an analyst perspective, most people will look at ending stocks in terms of the stocks to use ratio, or S/U. The stocks to use ratio is simply the amount of ending stocks divided by the total use for that year. The result is a percentage that tells you what amount of total use will be carried from one year to the next. The interpretation is very similar to ending stocks in the sense that a large number represents ample stocks and a tighter number represents tighter stocks, but it is a bit more telling. Since the S/U ratio also incorporates the total use, it equalizes the stocks for varying levels of demand. For example:
If corn ending stocks are at 1 billion bushels, it may seem as though supplies are ample, but what if we accounted for total use being at 15 billion bushels? That would mean that the S/U ratio is at 6% (1B/15B =.067), or that we are only carrying in 6% of last year’s crop to the new crop year which paints a much tighter supply scenario.
Continuous Flow Commodities
Continuous flow commodities are those that are continuously produced throughout the year. Examples of continuous flow commodities are crude oil, soybean meal, milk, cattle, natural gas, etc. They are produced year round and are not bound by periods of growing and harvest seasons.
A great example of a continuous flow commodity is crude oil. Once a well has been drilled and tapped that well will produce oil continuously for the usable life of the well. It also means that since there are no longer growing periods to account for, or periods where decisions were made and cannot be changed, wells can be turned on and off relatively easily.
The ability to produce a commodity year round and turn the supply on and off relatively easily creates a scenario where ending stocks don’t matter as much and the seasonal trends are driven by demand more than supply. So, instead of looking for ending stocks as a guide to pricing, analysts will look more towards the short term imbalances between supply and demand.
Supply and Demand Imbalances
As I mentioned above, the price of continuous flow commodities relies heavily on short term imbalances between the supply and demand. This creates a scenario where continuous flow commodities tend to be much shorter sighted, and also more volatile, than seasonally produced commodities. For example, of the top 10 most volatile commodities, only 3 are seasonally produced – and the top 6 is entirely made up of continuous flow commodities.
To analyze continuous flow commodities, analysts look for periods where supply is greater than demand, or where demand is greater than supply. Generally speaking, the shorter timeframe data you can get to do this, the better.
Periods where supply is greater than demand are also called surplus periods and usually end in a decrease in price and a subsequent reduction in supply due to the market adjusting to that price change. The reduction in supply is typically caused by an increase, or a build, in storage or a reduction in capacity (plant slowdowns, well-head capping, etc.).
Likewise, periods where demand is greater than supply are called deficit periods and usually end in prices increasing and a subsequent increase in supply due to the market adjusting to the price change. The increase in supply is typically caused by a reduction, or a draw, on storage or an increase in capacity (plants running overtime, new wells being brought online, etc.)