What is a Commodity?
When we talk about natural resources, a commodity is a product where one unit is the same as any other.
For example, there is no difference between one barrel of oil and another no matter where it comes from in the world. These types of resources are also referred to as fungible.
For example, because all oil is the same, no company can charge more for their oil than then the general market price. This explains why most commodities have a central global trading hub that sets the price of the commodity. Resource companies effectively have no control over the price they charge for their product and as a result have no control over their revenues. The only thing they can control is their costs.
How is the Price of a Commodity Set?
The price of a commodity is set by the average cost to supply the last unit demanded by the market.
The Cost Curve Explained
Let’s take an example. Say oil demand is 100 barrels a day and there are three suppliers, Companies A, B, and C.
- Company A supplies 50 barrels for $5 per barrel.
- Company B supplies 40 barrels for $10 per barrel.
- Company C supplies the final 10 barrels the market needs for a cost of $20 per barrel.
In this scenario, the global price of oil will trade at $20 per barrel.
The reason is if the global price is below $20 per barrel company C’s costs to drill are higher than the price it receives for its oil and it will eventually go bankrupt, depriving the market of those last 10 barrels it needs. So the market as a whole needs to offer to pay $20 per barrel to make sure it can buy all of the oil it needs.
As you can see, Company A, with the lowest cost of production will be the most profitable company because it received the market price like everyone else, but has much lower costs than competitors. This is the reason you always want to invest in the company with the lowest cost of production. They will have the best profit margin and throw off the most cash flow over time.
Commodity Price vs. Industry Production Costs
The chart above provides a real-world example where we can see that the price of iron ore (in red) generally trades at the production cost of the producer with the highest costs (in black). The only time the commodity price goes higher or lower than the black line is when there is either an oversupply or a shortage.
A shortage causes the commodity price to increase above the highest cash cost to incentivize new companies to enter the market and supply the extra units the market needs.
An oversupply causes the commodity price to fall below the highest cash costs until some producers go out of business and their lost volumes lead to declining production until supply meets demand once again. Commodity prices recover to equal the highest cash production cost in the industry.
Explaining Depletion from an Oil Perspective
Companies that pull natural resources out of the ground have to deal with one big factor called depletion. There are only so many barrels of oil and gas in the ground so, as a company produces oil from a well, less and less oil comes out of the well over time until it is eventually empty.
Companies must always spend money to drill a new well to make up for the declining production of older wells. This is a massive cost and explains why resource companies look so profitable on a gross margin basis before you account for the capital they must continually reinvest into the business.
Depletion will play an important role when we talk about the difference between a company’s cash, or bare minimum costs, and their total costs, but that breakdown will have to wait for the next article.
