Commodity Modeling and Pricing: Methods for Analyzing Resource Market Behavior

PART Two

Inventory Dynamics and Price Behavior

Inventories are the key to understanding the dynamic behavior of the economy. One of my teachers once said that without the possibility of keeping an inventory, the economy is like a fish market before the invention of refrigeration. Markets must clear at the end of every day, and what cannot be sold is given or thrown away. Day-to-day price and quantity changes may be more volatile, since market participants cannot rely on inventories to satisfy demand that exceeds production or to smooth production, that is, keep production going in the short run, and produce to inventory, in the knowledge that the time will soon come when demand exceed production. Thus, inventory allows a steadier rate of production, as long as the cost of carrying an inventory does not outweigh the benefits of not having to adjust production.

However, with the accumulation of inventory, the maximum difference between the high of the market and the low of the market is much greater, because without inventory, there is no stock accumulated over time, only what is produced on any given day. This becomes important in a downturn. Nobody worries a great deal about carrying a little extra inventory when demand pressures cause rising prices that increase the value of inventories. However, the same is not true in a market downturn. At first, when most firms still carry sizable inventories, none of them will be eager to cut prices and thereby lower the book value of their ...