Commodities accounting concepts
From time to time I have conversations with people about investments and something that comes up is the enormous range of knowledge that people have about investing. What is very seldom talked about are concepts. But yet investing is an abstract endeavour for the most part, so concepts are of critical importance. This post is a still a bit of a work in progress but I've had people ask me to post it so here goes.
A conversation that came up last week basically revolved around how to gain exposure to commodities as a group of investments. The most conceptually simply way to have commodities as an investment is to get delivery of some number of kilograms or tons of some commodity. For a number of reasons, including storage costs, a variety of abstract products exist where you buy a promise that in some way relates to an investment in commodities. In the majority of these investment you aren't actually buying a commodity but rather a derivative product. Behind all the artificial complexity of commodities investment it eventually it all comes back to how can get actual delivery of the actual kilograms/tons/ounces/etc of those commodities. But to come full circle to understand that it is actually really simple in a world where the vast majority of thinking about investing is a combination of oversimplified and downright dishonest is hard. See this video to get more of an understanding of why it's hard to come up with your own thoughts when you are constantly bombarded by a firehose of intellectual garbage.
People's understanding of commodities is typically very poor, but most notably in this space many people just don't ask questions. The lack of intellectual curiosity of most of the investment world is staggering and this prevents people from understanding how it all works. For starters people tend to not ask about the nature of what a commodity is, for example the question "what is a commodity?" is not one that's regularly asked, and you should ask this question. I've met many people who have invested heavily in metals that haven't asked "what is a metal?" or "why are metals valuable?". Perhaps that's a reflection on this absurd cultural trend of believing that one doesn't need to know how something works in order to successfully invest in it. But even in more sophisticated commodities investing circles a question I almost never hear asked is "how does the accounting for commodities investments work?". People dump huge amounts of money into commodities without asking this critical question. Many people lose huge amounts of money because they don't ask questions about the nature of their investments.
People are often both lazy and greedy and invest accordingly. On some level people just say "buyer beware" and make some point along various assumptions about trying to say the free market is great and that people making mistakes is fine in a free market based upon even more assumptions about how markets operate and the contexts in which those markets exist. What they miss is that a free market only has good properties for the world if there's factual information being transmitted. A very large part of what makes free markets useful is that they become a way to discover prices, if all information is garbage that crucial role becomes impossible. People also miss that commodities markets are most certainly not free markets. There's great value to everyone in clearing up some of these misconceptions and this goes far beyond the investors. We live in a complex modern world and if commodities markets fail everyones quality of living will drop. In general many of the assumptions people make in the commodities world are just outright wrong and much of that comes from not questioning the basics of how it all works.
Double entry bookkeeping
These days we take many accounting concepts for granted, but its important for the sake of this topic to revisit some of the concepts we take for granted because there's assumptions behind these practices that are relevant to a few situations.
Over time money became an idea in society that also shaped society. Later people started to create systems to keep track of transactions of money. With the rise of organized agriculture it was important to keep track of things like the sizes of herds and crops. There's some surviving written references to bookkeeping from the Roman Empire times, with households keeping track of their activities.
In 1494 Luca Pacoli while living in Venice published a book summa de arithmetica which had a section that introduced an idea of double entry bookkeeping. Formalizing these ideas, including the idea of the general ledger, greatly contributed to the culture in Venice at the time. Business accounting as we currently know it was likely born from this development and the cultural transmission of those ideas to a wider geographical area. This cultural transmission was crucial because it allowed merchants to trade various items more easily with other groups and allowed them to more easily keep track of if such trade was worthwhile. Being able to more accurately record the activity of a business then allowed for much more sophisticated finance to be conducted. Prior to this it businesses weren't tracking their affairs in consistent ways which among other things made it far harder for financing to occur. What can very easily happen if there's no reference point for value against which different things can be compared is that it can become hard to see what things are most important. From the perspective of an investor it is much harder to invest in a business if you have to spend time first understanding the methodology the business is using to understand its own financial operations. Having common conceptual standards for businesses introduced a level of efficiency that was not seen before.
Introducing some sort of currency as a reference point for value then converting all other values to this currency was a revolutionary step for the way in which people thought about running businesses. This is so common now that its almost entirely taken for granted.
Cryptocurrency craze thinking
There's a phrase I remember hearing during a few of the most recent crypto hype cycles
1 BTC = 1 BTC
On the surface this seems like a tautology, but even in a strict sense this isn't actually true and already shows this statement is worth unpacking.
On a technical level the way cryptocurrencies like bitcoin work is that they have a public ledger which records which wallets own which coins. Every transaction that's ever been made is stored in this ledger. So from the time a bitcoin is mined onwards every single transaction that moves this coin between wallets is recorded in the ledger permanently. While there might be two wallets with the same amount of bitcoins in them the transaction history might be different. This means that bitcoins aren't entirely fungible, as there may be reasons why the history of transactions behind a bitcoin may alter the market price for those bitcoins when purchasing other goods or transferring into another currency. This discrepancy is very real and is the reason why tumblers not only exist but see significant paid usage. A tumbler is essentially a transaction laundering service that will obfuscate the transaction history of bitcoins (or any other public ledger based cryptocurrency). If bitcoin were a true fungible commodity that couldn't be traced people simply would not pay for services like tumblers. Interestingly as the "money" being used in society moves more towards ledger systems we see similar developments in the banking sector. As a general principle the more that ledger systems are used to represent currency the less fungible that currency becomes, but that's a topic for another time.
Now that we have this point about non-fungibility out of the way we can get to the far more important point, which perhaps is the entire reason cryptocurrencies came to exist in the first place. Cryptocurrencies challenge the assumption that all transactions must be valued in a fiat currency. The idea behind the saying is to challenge the assumption that we must price everything in dollars (or whatever the local currency happens to be). This assumption is in direct conflict with the ideas encoded in double entry accounting. Double entry accounting explicitly assumes that all things can, and should, be priced in the local legal tender currency as this forms the basis for those bookkeeping practices. While this assumption is extremely powerful it does introduce some limiting factors in terms of what it allows us to think when we think about business operations. When we are making any value judgement we must always ask "compared to what?". Double entry accounting allows us to have a reference point with which we can compare the value of things by using a currency as the basis point for all business operations. By using the local legal tender currency to represent the value of everything the idea goes that the value of everything a business is doing can be easily and quickly compared with everything else. This is of course a simplifying assumption and is spectacularly wrong in the times it is wrong (the growth of concepts that try to arbitrarily assign dollar values to things that simply can't be measured in dollars is a sign of this, more about that in a future article perhaps). Despite the shortcomings there is great value in this method as a universal reference point for value judgement of what to do is very useful in deciding on the day-to-day operations of businesses. The efficiencies that this concept unlocked created massive value perhaps enough to be a critical factor enabling the enlightenment period in Europe to occur later.
One of my favorite books that challenges these unspoken assumptions about how we conceptualize business is called "The Goal" by Eliyahu M. Goldratt. In this book he introduces the concept of the Theory of Constraints, which is an alternative way of conceptualizing business operations. Introducing new concepts for tracking the operations of a business can make a lot of sense if that improves efficiency. A different way of looking at business accounting makes it far easier to optimize the output of some types of businesses. In particular there are businesses that have chains of processes that take various inputs and produces value added outputs where the value added by each step is not linear however. Most types of manufacturing are like this. The longer the chain of operations thats needed to produce the end good the more the TOC way of viewing business helps for people optimizing the operations of those businesses. The reason traditional accounting isn't a great mental frame for optimizing manufacturing businesses is that its hard, perhaps for philosophical reasons, to accurately price the goods in the intermediate stages as they flow through these business processes.
A practical example might help. Lately I've been doing a lot of 3d printing work. The 3d printing process takes a variety of inputs and creates parts. Eventually these parts get integrated into other products. When I make a design to 3d print there is some value there, however at this stage I usually don't have something that could easily be sold on the open market. When I do the 3d print I then have an unfinished item that might need some post-processing steps. The unfinished item might have some value on the open market to someone who can do that work, but its hard to price because most customers want to pay for the final part that has all the manufacturing work done. This is of course fair enough because many people just want to purchase a part, they don't want to enter into the business of manufacturing for themselves. Now if I want to start optimizing my processes I have to have some way of determining how valuable each task is. One way I could go about doing this is to arbitrarily assign some dollar value to each task and go about my accounting that way. However that value isn't exactly as real as a market based value. Furthermore if I want to optimize my process I might have to assign values that are proportional to the effort being optimized and those values may bear little resemblance to any open market price if I were to try to sell those items at that step of the production. As you can see accounting in dollar terms is trying to force a particular structure onto the analysis and is one that fundamentally is not the most mathematically optimal way to model the situation. This isn't just some academic point, choosing the wrong way to think about optimization will dramatically impact the effectiveness of any attempt to improve processes.
Examples like this are why in recent times more people are revisiting the core assumptions underpinning how they account for value in their business processes. This leap in understanding has directly created new ways of doing business including notably many of the "agile" approaches. Perhaps the system of laws and practices around accounting now have some catching up to do.
What does this have to do with commodities?
In generally accepted accounting practices commodities are typically converted to whatever their "equivalent" dollar value is before being recorded as assets or liabilities on balance sheets. We hear of companies having certain amounts of assets on their books, but we tend to say "this company has X dollars of iron ore on their books" rather than "this company has X tons of iron ore on their books". A large part of the reason for this is that simpler representations of real world business value are, all other things being equal (which importantly they usually are not), are easier to trade on the open market. Conceptual developments like making stocks and bonds be standardized items that could be traded on open markets was a massive development as it made it vastly easier for investors to understand the nature of their investments. We take this for granted these days, but historically this was not so, the structures of ownership of business ventures used to be far more bespoke in the past.
Many people want to get access to various commodities for a variety of reasons. A steel manufacturer for example might whish to purchase iron ore. A battery manufacturer may want to purchase copper along with other commodities used in battery making like lithium, sliver or cobalt. Due to the nature of commodities the source of these input materials, if pure, should not matter. Getting iron ore from Western Australia should be just as usable as as similar grade ore that is mined elsewhere. Commodities are specifically defined as things that are fungible, without this property something cannot be a commodity.
If for example a company is producing high tech products like phones they will need a huge number of inputs. To actually have the ability to profit from manufacturing a phone you need to have all of the requisite commodities available to your company and they need to be delivered to you when you require. In terms of the engineering of the product it doesn't matter where you source your commodity inputs. As you get closer to the final product those commodities have to get closer in proximity to the product before finally being incorporated in the product itself.
As we saw with the great car microchip shortage of 2022 large amounts of very valuable component stock was unavailable to auto manufacturers. This created perhaps the largest bull market ever seen in second hand cars. Cars that were essentially complete but missing crucial electronics components were being stored in manufacturing company parking lots by the thousands waiting for those last few parts. Without everything being installed in a car the value of a car on the open market is greatly diminished. Many jurisdictions probably have explicit prohibitions on selling cars in that unfinished state to customers because of safety concerns. Things like anti-lock braking systems rely on electronics components, and without these components being installed an entire redesign of the breaks would be required for a car to be safe to drive.
While the source of the raw commodity materials may not change the engineering of the product where they are sourced can literally make or break a company. The availability of resources to manufacturing companies has always been a concern to manufacturing managers. As a result of these concerns we started to have contracts emerge that explicitly aimed to provide materials to manufacturers at a later date. Futures contracts started to become a way in which commodities consumers could hedge some of their risks when attempting to acquire their inputs.
As time went on futures contracts became more and more financialized and became increasingly removed from the underlying delivery of the commodities that they tracked. This has gone on to such a degree that some commodity exchanges explicitly discourage the settlement of raw goods by delivery of those commodities.
So if you are buying one of those futures long contracts these days what are you actually buying?
Effectively you are buying an abstract idea. Yes that's right you are buying an idea, not something tangible.
In some sense you are buying a promise to be able to track the price of those commodities, as priced by those futures markets not the spot delivery markets. You can get exposure to the price on the futures market but only so long as you are willing to settle your trades in cash at whatever the current spot cash price is for those commodities.
This might seem like it is the same as just being able to settle a contract by taking delivery of the underlying materials but for a number of very important reasons it is not the same.
Take for example a solar panel manufacturer, they need silicon, silver and copper to make their products. If the exchange defaults on their long contracts because they can't deliver the metal/silicon the manufacturer can get cash but solar panels can't be built with cash. If a cash settlement is forced on a manufacturer they may have cash but they still have to source the materials to actually build their products and hence make a profit from those materials. After all would you buy an incomplete solar panel? Its hard to price the value of a solar panel that's incomplete but it's certainly going to be a small fraction of the value of a completed panel.
If we look at it from a theory of constraints mindset the supply chain decisions become a lot more clear. For example lets say we are trying to optimize a manufacturing chain for solar panels. To make a solar panel we need to have silicon available along with silver and copper for the electronics. Getting large quantities of silicon or silver might not be easy, and the larger the quantity the higher above spot price that may have to be paid. In markets with high demand compared to supply it may not be possible to purchase materials without directly pushing the price of those materials up. If the acquisition of the underlying materials is a main bottleneck the theory of constraints approach would indicate we need to expend more resources on acquiring those commodities so that the overall production chain can have its highest throughput. From this perspective it actually might make sense to pay more than the spot price for commodities if that results in some tangible improvement like faster delivery or lower risk of non-delivery. If everything will come crashing to a halt without a certain input it makes sense to ensure you have that input, nobody wants the equivalent of the car chip shortage for their products. I believe this is part of the dynamics we see on the open market right now. Large electronics manufacturers for example have direct contracts with miners and refiners because they are trying to insure themselves against the downsides of critical materials being unavailable. Because they have such good profit margins on some products they are willing to pay considerably above spot price to reduce the risk that their entire manufacturing process is shut down by a lack of input materials. Apple for example would want to ensure that an iphone that could be sold for over $1000USD isn't stopped because of a lack of $1 of some metal. Doubling the price of that metal to $2 would mean a huge increase in price for that commodity but not a huge decrease in profit margins overall.
Revaluations and unallocated pools
A common way that investors like to get exposure to the price movements of commodities is to by funds that track these commodities.
There's a mental accounting that people use in these situations that can be highly problematic. For example imagine that you are investing in gold in some sort of unallocated pool type of arrangement. You might think along the lines of "I have 1 ounce of gold invested in this pool". But this might not be an accurate mental model of the investment. First of all because it is a pool you only have a claim to a generic ounce of the commodity, there isn't a specific once sitting there with your name on it.
How many of these pools are actually organized is with this traditional western double entry accounting mindset. Which is to say that these schemes are usually settled with dollars and not with the commodities themselves. When people buy in they typically don't go deposit the commodity, they deposit cash. When they "cash out" they get cash and they get that out. Its even in the language itself that we deal with cash, that's how deep this bias runs.
What if the price of a commodity changes suddenly?
The issue we see with these unallocated pools was seen with the crisis that emerged in the Nickle market in 2023. Many people thought that they had claims on tonnage of metal rather than claims of some equivalent cash value. So when the price doubled they thought that they would get twice the amount of cash rather than half the amount of metal. What happened in reality was very messy and showed anyone who was paying attention that most people's mental models of how these markets really work was downright incomplete and in some cases entirely wrong.
Day to day life sets us up with intuitions that end up being deeply flawed when applied in domains like large international markets. When you go to somewhere like a supermarket you can buy more or less items and you won't change the price of those items, they might run out but the first item will cost the same as the last. In many countries there exists laws about signage of prices the reduce the flexibility of the vendor to charge different amounts based on quantity. These sorts of day to day events starts to build an intuition in people about how purchases work. Unfortunately these intuitions are wrong when dealing with large position sizes in international commodities markets. If you make large purchases of commodities relative to the size of the market you will start to put significant pressure on the price to rise. As a result many organizations will try to buy or sell large positions incrementally and they'll do all sorts of things to help their liquidity improve for filling their positions without moving the price adversely. This can, and does, go to extreme levels including paying influencers to lie to the public in order to improve the liquidity for their trades. So as you can see the process is more complex than getting cash and being able to instantly transfer all that cash into commodities at whatever the last spot price was. This gap is actually highly relevant to any sort of exchange traded index that exists to track some underlying commodity.
A great way to help understand this is to put yourself in the position of someone who is running a business that operates an unallocated commodity pool. The aim of this hypothetical business is to allow members of the public to send cash to the business which is then invested into commodities, to do this lets say the business aims to keep a one to one peg with the value of the issued shares and the current spot price of the commodity. Lets say you have investors that have contributed $1 million in assets under management that are assigned to buy a position in the Nickle market. You start to purchase some of this metal onm the open market to start fulfilling those positions. You run into some problems purchasing because a number of warehouses that are supposed to be full of Nickle are just full of bags of rocks. As you are figuring out where to source from other people start to hear the news about the lack of supply and the price now "unexpectedly" doubles in a few days before you have been able to place all the money into positions, what do you do? Your investors bought in at a time when nickle was worth some amount in dollars per ton but now the price is significantly higher in dollars per ton. Your company still has excess dollars on hand but not excess tons of Nickle. Purchasing more Nickle in a market that sees a shortage will put more pressure on the price to go higher. This poses a difficult dilemma, do you buy half the amount of metal that you initially planned or incur even more risk by attempting to wait until the price goes down before purchasing more of the commodity? Or do you do something completely different and just lobby/bribe the exchange to bail you out? In any of these cases the market volatility has made it impossible to reliably maintain the one to one peg between shares denominated in dollars and the price of the underlying asset as it exists on the immediate spot delivery market.
These dynamics point towards a crucial question, if there's a difference in price between the commodity as dictated by the group that has the custody of the commodity and what the general market is pricing that commodity how will that difference in price resolve? With the Nickle crisis it was very messy, the exchange took a somewhat unprecedented step of retrospectively cancelling trades and forcing people to settle their contracts in cash. From the exchanges point of view their entire operations existence was threatened so they took drastic measures. There were huge conflicts of interest at play as well. Make no mistake these commodity markets are not completely free and never will be, to assume otherwise is highly foolish. Because commodities are so important geopolitical factors will always be at play. Those same factors mean that these markets often don't operate as smoothly as the idealized formulas that come from economists would seem to suggest. Many funds that trade in commodities know that its entirely possible for things to not go smoothly and often many of the details are in the prospectuses. But a staggeringly large number of people actually never take the time to read those documents and as a result many people suffer from large misconceptions about the nature of how their investments are being managed by the funds managers and custodians.
The perfect commodity tracking ETF simply cannot exist in the real world. This is much like the idea of a platonic solid, these concepts are easy to understand conceptually but the reality is more complex and messy. And just like a platonic solid people prefer the simple fiction compared to the complex and messy reality. The appeal of simple concepts is strong and people go with these simplifications often without consciously realizing that they have done so. The industry around these investments goes to very little effort to inform people of the complexities and often goes to great lengths to hide them.
Most people invest in commodities explicitly because they think the price will change compared to some currency they are using to invest with. Few people think about how this occurs, is this because the value of the commodity is going up in real terms? Or because the value of the currency is going down? Those two scenarios will make the commodity look more valuable compared to a currency but the situations are very different. How a currency is exchanged into and out of a commodity is very important for this rate and is not a detail that can just be glossed over. Investors should be thinking explicitly about how price changes impact the way in which deliveries happen. When investing in any sort of derivative product the terms of settlement is something everyone should be thinking about. When you buy a commodities tracking ETF you are buying shares that are supposed to be tracking some commodity, you aren't actually buying a commodity. Because we are so conditioned to think in terms of dollars many people just assume that they can settle in cash and also assume that they can settle at a date of their choosing. And for some things like bonds or term deposits that mental model is more accurate because the only way value is measured there is in dollars. Where things are much trickier is if people are measuring value in more than one thing at once as the exchange rate between those values then becomes important, but how this actually is achieved is often not considered. In the case of commodities the exchange rate between some currency and the weight (or volume) of the commodity is determined by people actually exchanging currency for delivery of those commodities at some point in the chain. If no commodities are being exchanged for cash then no exchange rate actually exists and any number given is purely a fiction. Many such fictions exist today and unfortunately many people buy into them entirely.
Insolvency
Lately I've been dealing with a few situations where cashflow has caused companies to go insolvent. Its entirely possible for companies to be profitable and even have great products but yet not have enough cash to be able to continue operations.
When you buy a derivative investment you incur counterparty risk because you are effectively buying an interest in some company out there. What happens to your investment if that company goes under? Almost nobody I talk to asks this question. Because certain commodities investments are supposed to be a hedge against downturns in the business cycle you should be asking what happens to my investments if the businesses that are administrating them go under.
Insolvency is just one example of a situation where the pricing of a commodity related investment can be discontinuous. Discontinuities in pricing are the way in which many people get burnt with commodities investments. These events happen far more often than people realize.
One of the most famous was the Gold Reserve Act of January 1934. A year earlier Executive Order 6102 made it illegal for U.S. citizens to own or trade gold anywhere in the world (with exceptions for some jewelry and collector's coins). This act of legislation changed the statutory price of gold from $20.67USD per troy ounce to $35USD per troy ounce. This wasn't some slow move on the markets but rather a sharp discontinuous change made by fiat. It is worth noting that Gold is now often over $2000 USD per troy ounce, showing the massive change in value between these two over the years.
Many people are concerned that another revaluation like this could happen in a number of important commodities. But they then invest as though they will get paid out on those investments in the case that the large sudden revaluation occurs. Unfortunately looking at history quickly shows that such an assumption is a poor one to make. Often investors get screwed out of their purchasing power by revaluations. This is because revaluations are frequently done with the explicit goal of stealing the purchasing power of one group to transfer it to another. There is often a constant-sum game aspect to these discontinuous price adjustments but many people don't realize the implications. See what happened with the Hunt Brothers in the 1980s for a perfect example.
Strategic stockpiles
Some commodities are so important that running out of them would be a complete disaster. The availability of some commodities are literally matters of national security in the sense that not having them essentially means modern industrialized countries cannot even exist at all. Food groups like rice are a good example. Perhaps the best example is oil, without oil being available modern countries will collapse within weeks, so large is the dependency on this commodity now.
Beyond the national level I think we can expect some groups to start stockpiling commodities they need to ensure that they have availability when they need it. There are some things where even if the costs became prohibitive the demand for them would persist because alternatives don't exist. Economists call such pricing inelastic.
The logic here is different again from the accounting mentioned earlier. In this case the commodities are simply more important than the currency. Currencies have no intrinsic value, and we see this reflected directly here.
In this way of thinking about the value of things you start to count materials by the ton and count parts in terms of their numbers and not their prices. This is the thinking often used in military situations, military objectives are typically not thought of with money as the primary concern. Typically this isn't done often because it introduces inefficiencies as compared with other ways of accounting. But it is nonetheless done in some situations.
As the spot markets increasingly break down due to a large number of factors I suspect many people will be forced to revisit their assumptions about how they will go about valuing things. Unfortunately many people will not change their minds until hardship hits and some won't change their minds even after they lose everything.