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Commodity Price Volatility – A Self-Fulfilling Prophecy


Dean Pagonis

By

October 17th, 2012


The supply-side argument for the price volatility in commodities such as silver.


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.

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

  • Monika

    Whilst I agree that there is certainly a ‘waiting for the downturn’ mentality in the mining industry – supply side response is slow not only because of caution but more significantly technical feasibility which limits the ability to respond to demand. Going from greenfields exploration to production takes more than ten years typically with four years (optimistically) just to go from ‘discovery’ to financial feasibility study. Exploiting the resource is also very time consuming as every orebody is different (as unique as a finger print) and will need customised extraction and processing. This is even the case for a brownfields (existing mine expansion) where once again exploration, expansion and processing capacity (orebody will vary throughout) not to mention red tape such as environmental approvals all take massive amounts of time. Producers like Rio and BHBP are more cautious than they need to be in exploiting their assets, but in a practical technical sense capacity to respond quickly to the spot price by increasing production is highly constrained.

  • http://www.linkedin.com/pub/dean-pagonis/1b/117/319 Dean Pagonis

    Hi Monika – thank you for your comment.

    You are definitely right – there are a myriad of reasons why there is slow supply side adjustments in the resources sector. All of the points you have raised are valid, and are clearly missing in my analysis.

    My article was focussed purely on managerial decisions, and how option price theory can explain delays in investment. This was framed in a way to appeal to finance students, to illustrate how the theories they are learning in their degree can be applied in an economic context.

  • Monika

    Hi Dean,

    I think a discussion of why different kinds of firms will delay certain types of investment decisions is very important. In the mining industry I have seen this mindset evident in managerial decisions with regard to in investment in R&D or one of the big issues in our time – emissions adaptation.

    For production decisions however I do not think it goes to explaining price volatility (except indirectly insofar as risk aversion in R&D stymies step change technology development).

    There are always cowboys ready to build a mine and the mining magnates are price takers.

    It is the interaction between theory and practice, the back and forth, and the importance of always being ready to absorb information from other disciplines that I love about economics though…the challenge and excitement of a finance role is always trying to nuance this information I think. This is what I enjoyed in an investment relations role for a phosphate miner and why I am back at uni studying economics now!

    • http://www.linkedin.com/pub/dean-pagonis/1b/117/319 Dean Pagonis

      Definitely – and that is firm/manager specific, and will change depending on their circumstances/personal experience.

      I do think price volatility and real option theory does help to explain supply side responses but whether they are the most important in the host of reasons that you have raised is debatable.

  • Monika

    I will definitely reflect on how these decisions are made in a way I didn’t before…

  • Henry Lin

    great article dean, i’d imagine the amount of silver price hedging going on at existing miners would be substantial.

    do long term supply contracts where prices are fixed for say 5 years exist in the silver industry?

    • Henry Lin

      that is between suppliers and businesses that consume the commodity silver? or do they purely rely on the silver spot price for each transaction?

  • http://www.linkedin.com/pub/dean-pagonis/1b/117/319 Dean Pagonis

    Hi Henry, thanks for your comment.

    A really great question on longer-term contracting and how that fits into the equation. Firstly, don’t rely purely on the commodity spot price for buying/selling, futures and forward markets exist. This analysis would also include those that enter longer-term supply contracts, as they would face the same conundrum: do we hedge now and lock in the spot/forward price prevailing today, or do we delay and see if we can get a better deal. If they exercise the option to set their price today, they are foregoing the option to delay and make this decision in the future.

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