Commodity Price Volatility – A Self-Fulfilling Prophecy

Commodities are notorious for their volatility. I saw this first hand when I was working as an Investment Analyst at Dixon Advisory. I was tasked to investigate whether shares with exposure to the silver price were worth pursuing. Silver is a fantastic example of a ridiculously volatile commodity. The chart below shows you what I mean:

The chart tracks the spot price of silver in 2011, the year I was following the silver price. In that year, the price fluctuated between $25 and $50. When I first starting tracking the commodity, its price spiked 40% in a matter of weeks (March/April), before plummeting even further just a few weeks later. This was definitely a risk proposition for clients to pursue, especially with their retirement savings!

What causes this significant volatility in commodities such as silver? I will use real option theory, a theorem well known to those taking corporate finance this semester, and some simple supply and demand analysis to try to explain the general price volatility of commodities. Most economists focus on the demand-side factors that lead to commodity price volatility – I will argue that the supply side exacerbates this volatility.

Sunk costs and the value of waiting

The (sunk) cost of building a mine, smelter, refinery or any other infrastructure required to extract commodities is significant. Due to these high costs, the decision to invest in these projects to extract supply is a high-risk, complex proposition for managers. The high sunk costs also means the decision to abandon a project can also be very costly. This is based on the assumption that once a mine, smelter or refinery is closed, it cannot be reopened very easily.

Further, as real option theory suggests, the volatility of commodity price means the option to wait and seek more information before investing or disinvesting (abandoning) is very valuable. Any extra time gives managers the ability to better assess the market and make a more informed investment/disinvestment decision.

The combination of high sunk costs and the option value created by volatile prices leads to an inherent risk-aversion on the part of managers. For example, a positive demand shock can increase the price of a commodity, theoretically inducing more investment from companies chasing profit margins.  However, due to the commodity’s historically volatile price, plus the large amount of investment capital required to extract the commodity, managers might be reluctant to invest at first. This is because that profit margin can disappear quickly, and shareholders will not be impressed with sub-par returns. Only if prices remain high for a sustained period will managers respond with investment, reflected in an increase in supply and hence lower price for the commodity.

All these factors create a very slow supply side response in commodity markets – large shifts in demand are met with largely unresponsive supply in the short run. The result? Even more volatility, and the cycle goes on.

So next time you hear a mining magnate complaining about volatile commodity prices, remember that it’s their own risk aversion that is causing much of that volatility.