Understanding Fundamental Theory about Traded Commodities

Traded commodities, such as grain, wheat, soy, oil or gold, operate on the same basic supply and demand principles of all purchased goods. The use of supply and demand laws when analyzing the expected price of a commodity in the future is called the fundamental theory or fundamental analysis of traded commodity prices. The fundamental theory uses three components: the law of demand, the law of supply and the stocks-to-use ratio.

Law of Demand

The law of demand is one of the basic principles of economics. The more a product is in demand, the higher its price will be. For example, if the world has a high demand for corn this year, then its price will go up. This can occur not only when corn is used as a food but also when it is used as a fuel. Corn has seen drastic shifts in demand in recent years because of the development of ethanol from corn. When the demand went up and the prices went up, though, more farmers starting growing corn, which brings the law of supply into play.

Law of Supply

Demand does not exist in a bubble: prices also depend on supply. In the corn example, when more farmers switched to corn as a main crop, the supply went up with the demand. When supply goes up, prices go down. This is called an inverse relationship between supply and price. Demand and price have a direct relationship. Therefore, when both supply and demand are called into play, they begin to balance each other out. If demand is greater than supply, prices increase. If supply is greater than demand, prices decrease. This basic modeling is used to analyze how the prices of commodities futures will change through the stocks-to-use ratio.

Stocks-to-Use Ratio

The stocks-to-use ratio is a relatively simple mathematical formula. Essentially, the total stock of a commodity, or the amount left over from a previous year, is first added to the new amount produced. The total usage during a given year is subtracted from this sum. Then, the remaining number is divided by the total usage and multiplied by 100 in order to represent a stock-to-use ratio. The formula looks like this:

(Beginning Stock + Total Production - Total Use) / Total Use X 100 = Stock-to-Use Ratio

The numerator in this formula can also be called "carryover stock." It shows how much stock will be left for the next year.

Stocks-to-Use Ratio and Price

Analysts have evaluated the historical stocks-to-use ratios on specific commodities to set benchmark levels. For example, a stock-to-use ratio under 20 percent on wheat has led to strong prices in the coming year. This benchmark varies from asset to asset. Once you know the benchmark, you can evaluate the stock-to-use ratio in the current year to see how it measures in. If the ratio were 17 percent for wheat this year, modest growth could be expected. If the ratio were 7 percent, however, large gains may be recognized.

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