Commodities

Commodities are classed as “alternative” investments. Unlike “financial” or “traditional” assets such as bonds and equity, commodities are physical assets that produce no cashflows and may incur storage and transportation costs. This makes determining the fair value of commodities difficult. In simple terms, the standard approach to valuing financial assets is to forecast all expected cashflows, be it interest payments or dividends. For each expected cashflow, we apply a “discount rate” based on the risk of the investment and increase the impact of this discount rate as cashflows extend further into the future.

This gives us the current value of the investment. Instead, values of commodities like oil, gold, or wheat are primarily influenced by supply and demand dynamics, including factors like weather, geopolitical events, and production changes. The two prices associated with commodities are the current, or “spot” price, which is the price for immediate delivery of goods, and the futures price, which is the price agreed upon for delivery at a future date. The spot price can be viewed as the discounted selling price of the commodity at some time in the future. Storage costs for commodities often result in forward prices that become higher the longer the time until the commodity is due to be sold. This does not necessarily mean, however, that a commodity’s futures price is always higher than its spot price, because of expectations of future production and demand levels.

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