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Levers in Commodity Business

Today I played Deep Town. Basically it’s a resource management simulator. Drill down, mine coal. Deeper, you get copper, then amber, aluminum, silver, gold, oil, uranium, and so on. Each of the ore has little value. But if you smelt them to metal bars, the value goes up by two or three times. If you use those smelted materials to craft components, the value goes up even more. Those crafted components can be used to build more sophisticated goods, commodities, materials, machines, etc.
This is basically supply chain optimization. As we go down along the chain, the goods become more valuable, given enough capital, equipment, skilled labor, and time. There are a lot of various goods which require different materials. To earn the maximum amount of money per unit time with the limited capacity of my equipment, I have to optimize. I have to know what to produce, how much to produce, when to produce, and what commodity depends on what raw materials. It’s very interesting.
I wonder how this translates into the real world?
Back in my mock case interview practice, manufacturing is my favorite industry because it is so simple to understand. Input this, output that. Cut cost by doing this. Increase revenue by doing that. The product are usually commodity and traded at spot market.
It would be interesting to know what are factors that affecting commodity based business. I think first would be availability of low cost input materials, be it raw materials or semi-finished goods. Then, access for cheap capital for initial expenditure (usually huge investment), which hopefully can be recouped over time. If own capital is not enough, one can always get funding from issuing equity or seeking loan. Perhaps in the industry, loan is preferable because it has lower cost of fund. Then the interest can be serviced as fixed cost to be paid over time.
This sector is very prone to fluctuations in demand. Oversupply or underdemand will both crush the margin. No ingenuity or innovation can overturn the fate of business owners of this sector because nobody can change the state of the world by themselves. Very different with retail business, tech industry, etc where smartness can get you ahead. In this sector, one bad fortune will crush everybody almost equally.
What happen if you happen to heavily indebted because you were in a commodity rally that made you overconfident on the prospect of future profit, then the market suddenly reversed? The margin will be lower, maybe even negative. But the loan doesn’t care. You still have to pay it. Big players can endure such bear market by their large capital reserve, negotiating with their suppliers, using economies of scale, try to rely on alternative products, etc. But if you are an upstart, you have none of those advantages. It is true that commodity business can present you with handsome profit by the generosity of the market. But your fate are also at the mercy of the market.
Other way to profit from the commodity market other than setting your own business is to gain exposure to that market by investing instruments. Buying and selling the shares of related company, gold, gold futures, oil futures etc. The downside is limited, so is the upside. Because we are only indirectly involved, there are only limited avenue to employ our intelligence in the business other than deciding when to buy and sell those instruments. We are not the management that can influence the day to day operations of the business.
That being said, commodity can be a quick-rich scheme if we know market timing. This is true for both running the business directly or indirectly investing. But market timing itself is tricky. My interim hypothesis for now is that joining the commodity business is riskier than other business. Huge initial investment, unpredictable margin based on market condition, the need of navigating the local business and political environment, and other factors. So commodity business should not be my main arm of business. I should rely more on more resilient business sector. So in case of bearish commodity market, the excess from my main business can save my pressured commodity business arm.
However, going by that logic, it means that sometimes the business need to be subsidized. This is no recipe for a healthy business. So, do we have other method to make sure that the commodity business can survive by itself. How to make my future commodity business more resilient? Can it be:
  • Data-driven decision making: knowing which market that is either over- or undersupply and when to sell intelligently.
  • Flexible operations: Seek for a way that make capital investment in equipment or plant can adapt to changing global commodity regime.While 3D printing is still a long way to go, there should exist a number of unsexy niche innovations on respective commodity to increase production flexibility
  • Hedged portfolio: Having both businesses that benefit from price rise (e.g. selling oil) and businesses that benefit from price fall (e.g. power generators), Similar to hedge funds but instead of long/short on equities, it is “long”/“short” on real sector business.
  • Resilient financial structure: Having no loan will make growth slower, but it will also means less financial obligation to be paid in times of distress.
  • Higher negotiating power along the supply chain: So we would have bargaining position to sell other than pricing reason, e.g. supplying for the government or supplying to a long-time client.
I should learn more about this kind of business.

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