What is Commodity Valuation?

If you’ve ever looked at the price of a commodity, you must have wondered how the price of a commodity is determined. There are numerous factors that impact the price of a commodity. The process of finding a fair and accurate price of a commodity is known as commodity valuation. In this article, we will understand what is commodity valuation and the various methods of valuing a commodity.

What does Commodity Valuation Mean?

Commodities and commodity trading play a significant role for businesses, farmers, manufacturers, and traders. The commodity market facilitates the trade of commodities and also supports price discovery.

The process of finding the fair market value of a commodity based on fundamental factors is known as commodity valuation. Demand, supply, and macroeconomic conditions play a significant role in commodity valuation. The process follows classic economic principles by identifying the intersection of the demand and supply curves to determine the value of the commodity.

Demand and supply for a commodity are affected by various factors such as production, weather, government policies, supply chains, and geopolitical events. These factors can have a direct impact on the price of the commodity.

Why Commodity Valuation Matters?

Now that we have taken a look at what commodity valuation is, let’s understand why commodity valuation matters.

The commodity market sees participation from various market participants. These include businesses, corporations, farmers, and traders. The valuation of a commodity is highly important because it aids in price discovery and provides transparency. When a commodity’s value is known, it helps investors make informed investment decisions.

Since the law of demand and supply is the primary force in commodity valuation, traders often track demand and supply chain data, inventory levels, and consumption trends to forecast potential price movements of the commodity.

As a result, commodity valuation is crucial for traders as it can help in determining if the commodity is temporarily mispriced due to external factos.

Pricing Mechanisms of Commodity Transactions

There are four commonly used pricing structures that help with commodity pricing - 

Fixed Price

Under the fixed price method, the buyer and seller agrees on a price in advance. This method locks in both the price and the delivery date, ignoring the actual market price of the commodity upon delivery. Although this protects the parties from adverse price movements, it may cause lead to missing out on the gains from positive price movements.

Floor and Ceiling Price

The floor and ceiling pricing is where a third party, such as the exchange or regulatory body, sets the floor (minimum) and ceiling (maximum) price of a commodity. This method is beneficial since it offers flexibility to buyers and sellers while absorbing price swings.

Variable Price

The variable price method determines the price based on the real-time demand and supply of a commodity. Since the demand and supply are not constant, the variable price of a commodity also changes frequently.

Floating Price

The floating price is often seen in trading contracts with a longer expiry date. Here, the  the price of a commodity is determined by averaging out the price movements over the period of time. Floating price mechanisms are more commonly seen in cases where the commodities are highly volatile such as the Brent crude oil.

Key Factors Affecting Commodity Valuation

Demand and Supply

The most fundamental factor impacting commodity valuation is its demand and supply. At the point where the demand and supply curve intersects, the commodity’s value is discovered. When the demand is higher and supply is lower, it drives the price of the commodity up. Similarly, a lower demand and higher supply can push prices lower.

Cost of Production

The price of the commodity also depends on the cost required for production. When a commodity requires more money to be produced or procured, the price of the commodity increases. Meanwhile, if a commodity can be produced for a lower cost, it can result in lower commodity prices.

Weather Events

Weather events such as droughts, floods, or wildfires can impact the production of commodities. Lower production can negatively impact supply and drive up the commodity prices.

Geopolitical Events

Geopolitics plays a major role in the valuation of commodities. Wars, trade barriers, and taxation can disrupt global supply chains.

Economic Conditions

Global and domestic economic metrics GDP, inflation and currency fluctuations can impact demand and disrupt supply of commodities. 

Commodity Valuation in India

Commodities in India are traded on major commodity exchanges like the Multi Commodity Exchange (MCX) or National Commodities & Derivatives Exchange (NCDEX).

Like other  markets, demand and supply plays the biggest role in determining commodity prices For example, let us assume that the price of gold is ₹95,000 per 10 grams. Now due to inflation fears, the demand for gold exceeds. This lead to gold prices to surging to ₹1,00,000.
On the other hand, if the supply had exceeded the demand, the price of gold would have declined.