How are commodities priced?
There are many factors that affect and move the prices of commodities everyday. Similar to equities, the price of commodities are primarily determined by the intersection of supply and demand. For example, when sanctions were placed on Russia post its invasion of Ukraine, the supply of oil decreased, which caused the price of oil to rise.
Other factors include weather, specifically for agricultural commodities like crops. If the weather affects the supply of a commodity in a certain region, it has a direct impact on the price. Examples of such commodities include corn, soybeans and wheat.
The majority of investments in the commodity market are through futures contracts - derivative instruments where the holders are obligated to buy/sell at a set price at a future date. However, there are ways to determine the price:
Through this method, the price of the commodity at delivery is pre-decided. That means, regardless of the real market value or spot price, both parties are obligated to transact at the fixed price. This ensures both parties are protected against any negative price movements but can also limit the return earned, in the case of a positive price movement. In some cases, parties can agree to a periodic revision of this fixed price.
2. Floor and Ceiling Price
In this method, a maximum price is set (ceiling) and minimum price (floor) for the product. This window provides flexibility to both parties when the time comes to transact. If the market price of the product falls within the window at delivery, then that spot price becomes the price. However, if there is a large price movement, both parties can benefit from higher profits.
3. Floating Price
Through this method, the price of the commodity is determined by monitoring price movements along a period of time and then averaging it to arrive at a price. This is more suitable for longer term contracts, especially in volatile markets. It provides security from sudden fluctuations and essentially evens out the price.