There's a number of steps between metal being in the ground in a raw ore form to being able to purchase for your business. There's a whole lot of ways in which raw materials exist in the ground, from various types of ores and purities to various locations. A quick look on mindat.org shows that there's an enormous number of variations on how ores are found in the ground. This is in stark contrast to refined and processed metals, these are effectively interchangeable and thus are commodities as explained in the previous post

There's a variety of ways in which metals are bought and sold. This creates a number of different markets in different parts of the world where the exchange of metals for other goods takes place.

To understand the fundamentals for how these markets work in this article I'm going to have a look at some sources that create supply of metals and some sources that demand those metals.

Trades happen when a supplier finds someone who has a demand for the good. Modern markets obscure this fact, with many people having mental models of buying and selling based on their day to day experiences of low-volume purchases where the small volume of trade doesn't impact the prices. This doesn't happen at an industrial or a national level, which has a number of very important economic and political consequences.

The demand side

There's an enormous number of products with metals in them. Every day we deal with products containing metals. However much less often do people deal with purchasing metals directly.

This leads to one of the interesting things about the metals market, there's an absolutely enormous demand for products that contain metal. But there's far fewer buyers and sellers of metals in their raw forms.

Example: Industrial demand

For example lets say you are in the business of creating hex nuts for use in industry. To do this at scale you need a number of things in place, a consistent supply chain, available labor, available electricity and a factory that is set up in a way to make the items.

Doing all of this in an efficient way is extremely difficult, but the average person has no exposure to any of those difficulties. The fact that the average person can use an abstract idea like currency to purchase these specialized items without needing to know the details of how those items was created is the cornerstone of the value that a system of currency for exchange enables.

When I say that these things are extremely difficult to make at scale I mean it. There's whole areas of study where you could easily spend a lifetime without exhausting the topics that deal with manufacturing. If you don't believe me go watch some manufacturing process videos online, you'll see a large number of very fine tuned steps has to come together to make modern industrial products at scale. I'm a big fan of the works of Eliyahu M. Goldratt, an expert in manufacturing process design and efficiency, who wrote books that had a huge impact on the manufacturing industry. In particular he wrote a book called "The goal" that I'd highly recommend reading if you want to understand more about the complexities in process management for manufacturing. Coming back to the Hex nut example I'd recommend having a look at this video of a metalwork factory that makes hex nuts. There's a surprisingly large number of intricacies involved in making these items.

Part of what makes manufacturing hard is figuring out all the technical details that goes into making things. The engineering aspects of making, even simple things, at scale has a surprisingly large depth to it. There's a huge depth of experience needed to make a even simple things to a high standard with consistent quality and predictable build times.

The other part of what makes manufacturing hard is the economics of making things. The business aspects of making things profitably also has a huge depth of knowledge behind it.

Manufacturing complex items requires both having the specialized engineering skills required to make the item AND the business knowledge to enable such an item to be made in the context of an operating business. Goldratt's work on the Theory of Constraints provides a very practical set of concepts to help you understand how to maximize throughput from a manufacturing process and the concepts required to do the business accounting to keep track of that.

When you start manufacturing complex items you need to get a rather large number of components, and those components can in turn rely on complex supply chains. Not only do you need to purchase those items you then need to set up logistics arrangements such that the items you purchased arrive at your locations at the right times. Procurement of raw items is an area where both the engineering and business aspects overlap.

The supply side

There's a number of ways in which supply of metals can make it to the market.

Example: New mining projects

I have known many people who have been involved in the engineering of mining and other large scale infrastructure projects over my career.

These projects are highly costly and take a large time to get built.

Part of what makes modern mining projects difficult is that you need to both have the engineering skills and business skills to make them worthwhile. In a modern era with a lot of automation that is powered by complex equipment and processes this is no easy task.

To create a new mine requires first doing the geological surveys to find out if there's anything at that particular site that is worth going to the effort to dig up.

Example: recycling

When the cost of getting metal out of the ground and refining it gets higher people start paying much more attention to refining the waste products that exist above ground.

For example with early photography a large amount of silver was used. The first commercial process for commercial photography the Daguerreotypeappeared in 1839. This process involved plating a large sheet of copper with silver then treating it with a number of chemicals to get the chemical properties required to take a photograph. This was expensive and the high expense led it to be almost completely superseded by the 1860s by the Collodion process. This in turn was replaced by the gelatin silver process. George Eastman developed a machine to coat glass plates in 1879 and founded the Eastman Film and Dry Plate Company in 1881. This company eventually became Eastman Kodak. The way it all works is that silver halides are light sensitive, when these are exposed to light chemical processes are started. This of course is handy when you have lenses set up such that the light that hits the photographic material corresponds to the projected image you are wishing to capture. If you are curious about these processes there's a set of videos about it over on Kahn academy.

It's hard to express just how big a market traditional film photography was, for decades if someone mentioned Eastman Kodak it was likely to be about how it was one of the largest companies in the world. A stark difference from today where mentions of the company come up either as nostalgia or are in stock market "meme" posts like this.

In the past when processing the negatives some of the silver containing chemicals were just poured down the sink! When the costs of silver rose there was a very strong economic incentive created to not waste this. So techniques were developed to recover the silver from those processing chemicals.

These days we don't take many photographs with photographic film. The huge proliferation of "smart"phones means that the overwhelming number of photographs taken today are done with electronic cameras.

These electronic cameras are built with a number of raw elements, and considering the enormous number of such devices manufactured these days, there's a large number of raw materials consumed. This means that much like what happened with early photography there's a large number of waste products being created that contain valuable materials. In the future there's likely to be an increasingly large demand for recycling electronics waste. When it becomes more expensive to purchase materials from the mining supply chain more people will be economically incentivised to figure out ways to recycle this waste. This is of course provided that there is a free market operating in this space, an assumption that one would have to be very careful to make given just how politicized recycling has become.

How demand is matched with supply

In any market for a transaction to take place a buyer and a seller have to agree on a price. In our day to day lives we often buy such small quantities of items that we take this sort of process for granted. Large scale industry however cannot take this for granted.

There's a huge number of companies that want to use metals, and there's a large number of companies that mine metals.

The process of a company procuring metals that they need can occur in a number of ways. In some senses conceptually the simplest way for a company to acquire metals is for a company to mines its own metals. This involves the fewest counterparties and requires the least number of contracts to be created. The reason this isn't popular is because mining is a difficult endeavor and it requires a lot of specialized skills and equipment. Put simply most businesses aren't in the business of mining because that's just not central to their business and hence they lack those skills. The next step along the way is to directly make a contract with a mining business, in such a contract you would promise to buy a certain amount and the mining company would produce a certain amount. There would be a number of different clauses you would have to negotiate to make such a contract successful.

One particular friction for buying any commodity in bulk ahead of time is that the prices of mining and then processing that commodity into a useable form for industry can change over time. Mining operations tend to be very sensitive to the cost of energy since energy is so critical to mining. Digging things up out of the ground takes a lot of energy. Some mine sites are electrified but many are not. This means a lot of diesel fuel tends to be used, and the price of such fuel fluctuates. If you were to successfully negotiate a contract with a mining company all parties would have to be aware of the risks created by fluctuating fuel prices and would have to deal with these accordingly. Specifically miners tend to want to know that there will be enough demand for a commodity at a given price before they commit to the expensive step of creating a mine. This is why mining companies pay such attention to prospecting and feasibility studies.

All of these fluctuations has led to producers wishing to hedge their costs against this uncertainty. These desires to hedge risks led to the creation of a number of financial instruments. One particular financial innovation deeply changed the commodities world, which was the invention of the futures market.

The futures market for metals

Complex modern economies are only possible because people who need raw materials are able to acquire them without needing to know everything about the production of those materials.

While there was a stretch in the business world where "vertical integration" was a big trend it still remains the case that businesses do well by specializing in the things that they are good at and letting other companies/organizations do the things they are not so good at.

We see a good example of this with much of modern manufacturing. Someone who wants to build something complex is able to do so much more easily if they are able to get their raw materials from a market where they can exchange currency for those raw materials.

There's a number of steps between a raw material being produced and the end user purchasing those materials. This creates a significant risk for both the producer and the consumer of those materials. What happens if the price changes significantly between the start of mining and the time those materials are sold? What if the manufacturer wants to build a new factory and needs some materials in the future but the price could fluctuate?

Initially the futures market came into existence to smooth over these seasonal issues.

I've wrote some articles before about the futures markets.

The "spot" market

Even if most of the volume of metals bought and sold are done on various futures markets there's still often a need for companies to purchase metals for immediate delivery.

What some quantity of metal costs right now is the spot price.

For a number of reasons a lot of people have been sold on the idea that the front month contract for futures is this spot price. Part of the reason for this is that in terms of industry demand if you can ensure delivery of the physical commodities from the futures market that's a way to supply you with what you need. Of course the participants in the futures market have a rather large incentive to not correct people on this misunderstanding.

If you are a large company the next active delivery month on the futures market might be sufficient for you to get everything you need. However if you need something quicker than this you'll have to source it from somewhere else. The price you pay to get the commodity now is the spot price and this can differ rather significantly from the futures market contract price.

For example if you are a business that needs to use oil as part of a process you'll have to buy it before you can use it. Storing many oil products is a pain in the ass so most companies do not want to store more than they have to. This means you'll have to buy things from time to time on the spot market, this will always cost you money. When we have things like the oil futures market going into negative prices this doesn't mean the spot price went negative. In fact it is a historical episode that clearly shows the spot price is different from the futures price, even if the futures price has an impact on the sport price. During this time I remember petrol prices dropped, but they never went negative. Companies never offered negative pricing to their customers. If you are curious what negative pricing looks like you might want to have a look at the article I wrote about what negative prices look like

Part of what makes the spot market for metals so interesting is that different metals are easier to store than others. There's also enormous differences in how much above ground stockpiling exists relative to yearly traded volume. For example gold has a huge amount of stockpiled inventory around the world in various vaults in investment grade bars (this does not account for more day to day things like jewelry). For industrial uses the spot market tends to be highly driven by the specific availability of large pure bars of metal in stockpiles. Jewelry for example contains precious metals but often in alloys and in very non standardized weights and sizes. If I need to get a metal for some industrial process, I'm likely going to either want pure metals or the exact alloys I need for whatever things I'm producing. For example lets say I want to make some sort of electronics items at scale, I'll want to get industrial sized bars of Copper and Silver and likely a large number of other components as needed to make the items I'm wanting to make. For this purpose it's inconvenient for me to get any of those metals in alloys that I don't want, so I'll pay a premium to ensure that someone has already refined it.

In the sliver market this industrial demand bars are typically 1000 troy oz and at a minimum purity of 99.9%. This size and purity combination are convenient to trade as they are a standardized size that is acceptable for many of the major markets¹. These bars are rather huge and because they are for industrial use the weights of these aren't always exact and can be off by a small percentage in either direction. The availability of these 1000 oz bars is crucial to the spot market, even though investment grade bars are a small percentage of the overall amount of silver out there.

The Relationship Between Spot Prices and Futures Prices

Differences between the spot price and the futures contract prices can be large. In the trading world there's terms that have been created to describe this gap.

Integral to the idea of a futures contract is that there's a certain amount of a commodity promised and a certain date for when that is to be made available. As the time of the futures contract gets closer to the present day the futures price should start to converge on the spot price. In a free market this should happen because opportunities arise to arbitrage differences.

"Contango" is a term that refers a situation when futures prices fall to meet the lower spot price. "Backwardation" is a term that refers to a situation where futures prices rise to meet the higher spot price.