# Prices and cycles: How a commodity price is made Source page: https://www.materialinsights.org/learn/commodities/prices-and-cycles/p1/ [Understanding Commodities](https://www.materialinsights.org/learn/commodities/) / [Module 5: Prices and cycles](https://www.materialinsights.org/learn/commodities/prices-and-cycles/) Part 1 of 5 ## How a commodity price is made Every price on a tile came from some mechanism: a trading ring in London, a phone survey by a price reporter, months of haggling between a miner and a steel mill. The mechanism decides how fast the price moves, who can see it, and whether anyone actually paid it. Start with the economics beneath them all, then the institutions. ### 1.1 The price is set at the margin, by the last unit of supply that is needed In a competitive market the price at any moment sits where short-run supply meets demand. In the short run capacity is fixed, so the supply curve is just the variable costs of existing mines, wells and farms ranked from cheapest to dearest. Analysts call this the cash-cost curve. With spare capacity the curve is flat and extra demand barely moves the price. Near full capacity it turns steep and then vertical, and small shifts in demand produce large price jumps. The long run is different. Given time, capacity can be built, so the long-run supply curve shows the full cost, capital included, of the marginal new project. Radetzki and Wårell stress that nobody ever trades at this long-run price; it is the level the market price is pulled towards. Above it, investment floods in and eventually drags the price down. Below it, investment dries up and prices recover. Tilton and Guzmán add a useful division of labour: short-run swings are mostly about demand, long-run trends mostly about supply costs. The real cost curve is blurry. Closure and restart are expensive, so a mine may run at a loss through a slump it expects to be short, and state firms may chase jobs rather than profit. Above all, prices feed back into costs. High prices breed slack and pull high-cost producers in; low prices force cost cutting and closures. Humphreys shows copper's curve rising and steepening between 2004 and 2007 as wages, equipment, energy, royalties and producer currencies all rose with the copper price. Common misreading #### Cash cost is not a floor It is tempting to think prices cannot stay below operating costs. Humphreys describes the 1980s and 1990s, when falling prices kept pushing costs down rather than meeting a floor. Because closure is expensive, the costs a producer can actually avoid by shutting are often below its operating costs, so loss-making output continued. Yergin's sharper example: on the eve of the 1986 oil price collapse, the cash cost at the North Sea's Ninian field was about $6 a barrel, so there was no reason to stop pumping at any price above that. - Radetzki & Wårell (2021), A Handbook of Primary Commodities · pdf pp. 102-109 - Tilton & Guzmán (2016), Mineral Economics and Policy · pdf pp. 112-117 - Humphreys (2015), The Remaking of the Mining Industry · pdf pp. 33-34, 108-110 - Yergin (1991), The Prize · pdf pp. 1288-1289 ### 1.2 Exchanges discover the price, and most physical trade borrows it An exchange gathers many buyers and sellers of a standard grade, with a clearing house standing between every pair of trades. Its central function is price discovery. Humphreys describes the London Metal Exchange setting its official prices for aluminium, copper, lead, nickel, tin and zinc in short open-outcry sessions called rings; those prices then serve as references for metal and ore traded worldwide. LME turnover runs at roughly 40 times annual metal production (Humphreys), yet little metal changes hands there: Radetzki and Wårell report that in 2018 LME physical deliveries were about 2.2% of world aluminium output, 3% of copper and 3.6% of nickel. Not every commodity can support a futures market. Radetzki and Wårell's conditions: many buyers and sellers, hedgers willing to use it, enough instability to make hedging worthwhile, easy grading, and storability so spot and futures are linked. Tea fails on grading; niobium, with what Tilton and Guzmán count as two significant producers, on concentration. Once an exchange price is established it tends to absorb rivals. Aluminium joined the LME in 1979 and within a decade its quote had displaced the Alcan producer price. Platinum pricing moved to NYMEX in 1956. After crude oil futures opened on NYMEX in 1983 and in London in 1988, OPEC stopped posting official prices and tried to defend a price band by adjusting supply instead. Exchange prices react to every piece of news, so they are more volatile than other prices. Radetzki and Wårell call this a feature: a smoothed price can hide an imbalance until it breaks. - Humphreys (2015), The Remaking of the Mining Industry · pdf pp. 101-102 - Radetzki & Wårell (2021), A Handbook of Primary Commodities · pdf pp. 117-118, 121, 143, 147-148, 153-156 - Tilton & Guzmán (2016), Mineral Economics and Policy · pdf pp. 95-97, 102 ### 1.3 Where no exchange works, prices are announced, negotiated or assessed Most international commodity trade, Radetzki and Wårell judge, runs on bilateral contracts. Where an exchange price exists the contract simply references it. Copper concentrate, for example, is priced off the LME copper price less treatment and refining charges negotiated with the smelter. Without an exchange price, each pair must agree a price, slowly and privately. In manganese and, for decades, iron ore, one large supplier and one large buyer settled first and everyone else adopted that settlement as the benchmark, adjusting for grade. Producer pricing is the second arrangement. A few sellers announce a take-it-or-leave-it price, as De Beers long did for rough diamonds and Amax did for molybdenum. Tilton and Guzmán list diamonds, platinum group metals, potash and borates as still largely sold this way. Producer prices change slowly, so in booms sellers ration and in slumps they offer quiet rebates; a series of producer prices misstates what was paid. The third is the assessed price. Where prices are negotiated privately, trade journals and price reporters such as Metal Bulletin, Platts and Industrial Minerals survey traders in confidence and publish a reference price or range. Tilton and Guzmán note this for many minor metals, ferroalloys and lithium carbonate; since 2010 seaborne iron ore has been priced this way too. The last is the transfer price inside an integrated firm, which can be whatever the tax position favours; bauxite is the clearest case. Where private arrangements dominate, small sellers with poor information tend to get worse terms. Case #### Iron ore abandons the annual benchmark, 2010 For decades seaborne iron ore was priced in annual talks, the first settlement becoming the benchmark. As Chinese demand outran supply in 2005-2008, small Indian and Chinese mines sold spot cargoes far above contract; spot rose from 15% of seaborne trade in 2001 to almost 40% in 2008. When the crisis pushed spot below contract, some mills walked away. The benchmark had given steelmakers a free option. After a politicised 2009 round and the detention of four Rio Tinto staff in Shanghai, it was dead by 2010, replaced by pricing on published 62% Fe assessments delivered to China (Humphreys). - Radetzki & Wårell (2021), A Handbook of Primary Commodities · pdf pp. 119-123 - Tilton & Guzmán (2016), Mineral Economics and Policy · pdf pp. 96-98 - Humphreys (2015), The Remaking of the Mining Industry · pdf pp. 121-126 ### See it in the table [Oil Crude oil](https://www.materialinsights.org/energy/crude_oil/)[K Potash](https://www.materialinsights.org/commodities/potash/)[Cu Copper](https://www.materialinsights.org/commodities/copper/)[Al Aluminium](https://www.materialinsights.org/commodities/aluminum/)[Zn Zinc](https://www.materialinsights.org/commodities/zinc/)[Ni Nickel](https://www.materialinsights.org/commodities/nickel/)[Fe Iron ore](https://www.materialinsights.org/commodities/iron_ore/)[Mn Manganese](https://www.materialinsights.org/commodities/manganese/)[Mo Molybdenum](https://www.materialinsights.org/commodities/molybdenum/)[Nb Niobium](https://www.materialinsights.org/commodities/niobium/)[Pt Platinum](https://www.materialinsights.org/commodities/platinum/)[Dm Diamonds](https://www.materialinsights.org/commodities/diamond/)[Li Lithium](https://www.materialinsights.org/commodities/lithium/)[Tea Tea](https://www.materialinsights.org/commodities/tea/) ### Check your understanding According to Radetzki and Wårell, what is the long-run equilibrium price of a commodity? Actual prices are set only in the short run. The long-run price is where investment would neither expand nor shrink, so deviations from it trigger the investment responses that pull prices back. Why did the major iron ore producers give up on annual benchmark pricing around 2010? Humphreys describes the benchmark as a free option for steel mills: they paid contract prices when those were lower and bought spot when spot was lower. That, plus politicised talks and a corruption case, ended the system. [← Module contents](https://www.materialinsights.org/learn/commodities/prices-and-cycles/)[Mark read · Part 2: Why commodity prices swing so hard →](https://www.materialinsights.org/learn/commodities/prices-and-cycles/p2/) ## Other sections - [Module overview](https://www.materialinsights.org/learn/commodities/prices-and-cycles/index.md) - [Why commodity prices swing so hard](https://www.materialinsights.org/learn/commodities/prices-and-cycles/p2/index.md) - [Storage, convenience yield and the forward curve](https://www.materialinsights.org/learn/commodities/prices-and-cycles/p3/index.md) - [Real prices and the long-run trend](https://www.materialinsights.org/learn/commodities/prices-and-cycles/p4/index.md) - [Booms, super-cycles, money and the dollar](https://www.materialinsights.org/learn/commodities/prices-and-cycles/p5/index.md) - [Key terms, quiz and sources](https://www.materialinsights.org/learn/commodities/prices-and-cycles/review/index.md)