Location is everything -- especially with commodity pricing

Commodities are ubiquitous in everyday American life. We drive cars built of aluminum, drink coffee each day and wear clothes made of cotton. But when it comes to pricing, they aren’t all created equally—even within the same commodity market. Location affects commodity prices, and those differences in prices based on location are called “differentials.”

When market fundamentals are balanced, such differentials generally maintain a steady ebb and flow. But they can swing to far extremes when dramatic local or regional events upset the equilibrium. From oil to wheat, or gasoline to metals, no commodity is immune to the impacts that regional dynamics can have on local spot pricing.

Recently, we’ve seen the price of metals impacted by geopolitical actions. The S&P Global Platts Midwest Aluminum Transaction Premium is a differential—that is, the cost difference between aluminum sold in the United States and aluminum sold elsewhere in the world.

Like oil benchmarks, this price reflects what buyers and sellers pay for aluminum in the physical market. The differential reflects regionally specific supply-and-demand conditions in the United States, as well as the regional cost of logistics, such as truck freight rates.

Sanctions and tariffs affect regional aluminum markets.

For much of 2018, the aluminum premium has been swept higher by US government tariff actions and trade sanctions.

Following the March 8 announcement to impose a 10% tariff on aluminum imports, the aluminum premium in the US jumped nearly 12% from the day before. This price increase reflected higher costs due to the tariffs.

In other words, the potential supply of aluminum to the US just got at least 10% more expensive for companies looking to import foreign aluminum to the country—and the US is a big net importer of aluminum, recently importing about 90% of its needs.

Soon after the tariff was imposed on March 23, a second shock to aluminum prices worldwide came on April 6. The world’s second-largest aluminum producer, Russia’s Rusal, was subjected to US sanctions, which drove prices even higher in North America.

The premium remains at a lofty perch because some warehouse material in the US is from Rusal. Effectively, this is “phantom supply,” because uncertainty around Rusal deters many potential users who fear running afoul of the US Treasury sanctions.

Click thumbnail to view full-scale

Similar trends are also apparent in agriculture. China’s announcement of retaliatory actions to the US trade tariffs had an impact on prices, but the more frequent occurrences of weather disruptions to crop conditions and crop quality variances and preferences can alter prices and market views.

If farmers in one region have trouble growing crops, buyers look elsewhere. Starting in mid-May 2018, Asian buyers increasingly turned to Russian milling wheat as the price of Australian Premium White wheat continued to climb—upwards of 15%—because of extended dry weather.

Given dryness across the major Australian wheat belt, growers continued to hold onto existing stocks, in case there is a scarcity of new crop wheat for the 2018-19 harvest year. What’s more, as domestic demand and prices in Australia strengthened, this in turn pushed up prices for milling wheat. The result: Buyers with inelastic demand for Australian wheat are paying a substantial premium.

The dry season in several regions has resulted in rising wheat prices in recent weeks -- contributing to global disparity. Example: According to the International Grains Council, US No. 2 wheat has topped $250/mt FOB, EU (France) grade 1 has hovered around $215/mt FOB, Argentina wheat has reached above $260/mt FOB, and Platts recently assessed Russian wheat at $204.50/mt FOB.

Tariffs and sanctions aside, regional price variations are omnipresent in petroleum and petroleum-related markets.

Crude oil markets also witness a divergence in prices, depending on location. Dated Brent is the global crude oil benchmark that industry estimates indicate accounts for 60% of world production. In the US, the West Texas Intermediate (WTI) benchmark reflects the value of crude delivered into landlocked Cushing, Oklahoma—the delivery point for the NYMEX WTI futures contract.

In late May to early June 2018, the spread between the Brent crude futures contract and the WTI futures contract for August topped $10 per barrel—the widest spread between the two contracts since mid-March 2015. The reason: geopolitical and macroeconomic factors (economic sanctions on Iran and Venezuela, for example) pushed Brent prices higher, while underlying physical constraints in the US central and southwest regions kept WTI prices subdued.

Why the disconnect? The Permian Basin is the epicenter of the US shale boom in New Mexico and West Texas. Growing supply there has led to severe pipeline constraints. As production in the Permian grows and no new pipeline capacity is planned until the second half of 2019, supply bottlenecks will intensify.

Many factors affect supply-and-demand fundamentals, which is reflected in price differentials for commodities.

When a commodity’s price jumps, it’s rarely a mystery as to why. It’s clear that commodity prices respond to changes in regional supply-and-demand fundamentals. Geopolitical fears, regional upheaval, curbs of free trade, weather and regional logistics all affect local supply-and-demand dynamics, which are reflected in differentials.