(Listen to our latest podcast here. It is with Dhruv Bansal of Unchained Capital, and it is proving to be a sleeper hit! In case you just want to read the summary notes, you can find them here).
Commodities are a unique asset class that are not cash yielding (the only return is through price appreciation) and whose value is primarily driven by their real-world consumption demand. Every asset that is consumable and somewhat constrained in supply can be termed as a commodity. Popular examples include livestock, food grains, crude oil, metals etc. The price of a commodity, in most cases, is a function of its real-life utility and its supply demand changes. However, there is a special class of commodities such as gold, silver, whose market value is multiples higher than what can be attributed to their real-world consumption. This special class of commodities are held for investment and price appreciation rather than for consumption.
Stock-to-flow Ratio for a commodity is defined as it’s years of inventory relative to annual supply. While the economic utility of a consumable good is created when it is destroyed or used up, the utility of investment assets lies in their possession and later resale. Industrial commodities therefore have low stock-to-flow ratios, this is to say, inventories usually only cover consumption demand for a few months. If there were no inventories at all, supply would have to correspond exactly to production and demand exactly to consumption. However, if there are inventories, consumption can temporarily exceed production. Since inventories of consumable commodities are as a rule very low, prices will rise quickly in anticipation of a future supply shortage and bring consumption into balance with production. As opposed to this, the price stability that comes with having a huge pile of inventory gives platinum, gold and silver a new monetary aspect. The demand driven by the store-of-value use case for gold, for instance, far outstrips that from actual industrial use cases.