4 Tips for Evaluating the Prices of Commodities

Analysts and traders use a variety of complicated formulas to evaluate the price of commodities. For most commodities, however, a fundamental understanding of the laws of supply and demand is all that is needed to properly consider price today and in the future. If you are looking to grow an income rather than to powerfully transform your wealth, the fundamental theory of commodities prices can help you simply secure long-term growth.

#1 Evaluate Supply

The first thing you have to do is evaluate the supply of a given commodity in the marketplace. You can do this by watching reports of that commodity as they appear in business journals or online. For example, you can follow a blog that tracks the production of soy over a given year. You can read reports from commodities trading analysts who are discussing how weather may impact the supply of soy in the same year. These items, reasonably considered, should give you an idea of whether supply will be up or down from the previous year. If supply goes up, price may go down, because the two have an inverse relationship.

#2 Consider Demand

Supply does not exist on its own when it comes time to set prices. It works in conjunction with demand, which has a direct relationship with price. So, in the soy example, the price of soy will only drop if the increase in supply outpaces the increase in demand. For example, if there were 3 pounds of soy beans produced last year and 3 pounds were purchased, the supply and demand were matched, and the price was right. Next year, the supply will be increased to 4 pounds, but a new purchaser will also step in and want the additional pound of soy beans. The price will still be consistent because the two factors grew equal to each other.

#3 Understand the Stocks to Use Ratio

In the real world, you are not dealing with a few pounds of soy beans. In fact, billions of pounds are grown each year, so determining the demand and supply can be harder to understand. You can use factors presented in the market to show you how the price may change, though, in a relatively simple formula. The formula is the stocks to use ratio:

Beginning Stock (amount left over from last year)+ Total Production (amount produced this year) - Total Use (amount consumed this year) / Total Use

#4 Use Benchmark Analysis

The answer to the equation above is a percentage or ratio called the stocks to use ratio. It basically tells you how much overproduction there was of a given commodity last year. If it was largely overproduced, the stock's price can go down. You can tell whether there was too much production based on a benchmark ratio. For example, investors believe any less than 10% stocks to use on soy beans indicates prices could be very high in the coming year. Working with these factors and considering elements like unexpected changes in supply or demand, you can estimate the value of a commodity. Of course, there are items of unpredictability with any commodity investment, but these measures have been used for decades.