One of our jobs as investors is to have a sense of the fundamental drivers of input prices: agricultural goods, battery materials, energy production, labour costs, semiconductor chips, even bitcoin.
The price discovery process of these goods and services is of interest to us. It is this process that impacts the profitability of the firms which we are trying to value.
What then determines prices? Economics has an identity that states that supply always equals demand. But how does that work in practice? Suppliers can’t know the exact quantity and timing of consumers’ demand for their produce.
In a market-based economy, price is the mechanism that ensures that the identity holds. Producers and consumers respond to changing prices, thereby avoiding structural shortages or surpluses.
In a command economy, the price is what the authorities say it is. In the absence of flexible prices, demand, and supply struggle to adjust. Fixed prices lead to surpluses and shortages, and hardship for producers and consumers.
Adam Smith’s invisible hand is a better arbiter of the processes that match demand and supply. Unelected regulators – only caring about the political imperative – fare much worse.
Demand, or supply?
Analysing demand is often the starting point for most analysts. But demand for most goods and services, in total, is pretty stable. A good statistic to estimate demand is GDP. If one graphs the progression of GDP over time, the line is pretty stable. Different geographies have different growth rates but, over time, the lines all move upward and to the right.
Anyone seeing this stable demand would guess that prices would be stable, too. Producers could forecast long-term demand, and – apart from the odd unpredictable event, like a pandemic – they would make sure they had enough capacity.
But prices of commodities are quite volatile. Recently electricity prices in Europe increased by a factor of six. Last year, Ammonia prices – a major input into fertilisers – jumped by 600% in the space of a few months. Oil, one the most important input costs, has varied between $100 and minus $40 a barrel over the past decade. Over the same period, iron ore, a major input into steel, has varied between $40 a ton and $220 a ton – a difference of over five times.
And the list goes on.
Why are these prices so volatile when demand is so stable? As I’ve shown, producers should be able to model demand and adjust their activities accordingly. But, in the real world, supply chains take lots of time and capital to build out. As a result, changes in supply tend to be lumpy.
So, it is these lumpy supply-side reactions that are the dominant cause of volatile prices.
Get on your bike
Let’s take a simple one-unit example. If you wanted to build a steel bicycle, you would need to design it and specify the components. Then you would need to source and order them. Finally, you would put everything together and – hey presto! – there’s your new bike. It wouldn’t take longer than two months, from concept to final product. And cheap too if you are using commoditised components.
Now, let’s introduce a wrinkle. Assume the steel supply chain is running at full capacity. Now, to build your bike, you have one of two choices. Wait for the steel supply chain to expand or offer to pay more for existing steel than someone else.
For the steel supply chain to expand, you need to wait for new mines, new mills, and new steel plants. This could take quite a few years. But you want your bike now, so you decide to invoke option two, and pay more. Voila – prices adjust to make demand meet supply.
If one scales this up from one unit to many, it is easy to see how the price of steel and iron ore could go crazy. Most manufacturers of bicycles, cars, etc would not want to wait for the next mine build-out. They would pay up and try to pass on that cost to the end-user.
Only a small disruption…
Under normal conditions, such supply disruptions would not happen. Increased capacity constraints cause gradually higher prices. New mines and plant become viable. Demand is stable and forecastable, and the expansion of the supply chain happens in time.
In this way, markets are efficient, allocating resources in response to price signals. As they say, the best cure for high prices is high prices.
But when supply interruption make capital for expansion completely unavailable, price distortions take place. For example, misplaced ESG considerations are preventing expansion in sectors of the energy industry. This is expanding into other commodity markets, too.
But, when prices are high enough, supply will come on stream regardless. And supply responses take time to put in place. From the decision to increase output of a commodity it can take up to 10 years to reach production. Of course, when everyone reacts to high prices, we are likely to experience a glut in the future. This is unlikely to happen soon, given the long lead times.
The bottom line: focus on supply dynamics when building a set of expectations around future commodity prices. It only takes a small supply disruption to catalyse large price increases.