Why Is Oil and Other Commodities Traded on the Market Instead of Pricing Being Set by Companies?
Tuesday, October 28th, 2008 at
2:13 pm
rmsmith2299 asked:
Why is oil and other commodities traded on the market instead of pricing being set by companies?
Why is oil and other commodities traded on the market instead of pricing being set by companies?
Filed under: Commodity Trading
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Because they are commodities. There is no real difference between one company’s product and another’s.
Oil is oil. Gold is gold. Wheat is wheat. Orange juice is orange juice. The products are essentially identical, so the price differences will be negligible.
Also, the commodities market is based on what the price of a commodity will be in the future.
A very simplistic view of commodities trading: people are betting on what the price of a commodity will be in the future.
trading makes it more liquid. because there are many buyers and sellers, it more resembles perfect competition than other market structures. it prevents any single company from setting the price, which is a good thing. also, since the price is constantly fluctuating, price changes are daily and more gradual instead of having one major price change every week or so. also, for certain commodities, such as farm products, having a market makes it much easier because farmers don’t have to pay search costs to find buyers.
Because companies don’t own most of the oil in the world so they must buy crude to process it into gasoline and distribute it. Their large profits are due to the fact that they price what they do own. at world market prices.
I think it started with farmers. My finance professor explained it to me, but I don’t remember all the details. I think it started when a farmer tried to sell their crops before they harvested them so they could pay for some needed equipment, repairs, or debt. So the farmer lowers the price slightly below market value and then when they do harvest it the buyer of the commodity can hold it till the make a profit or until they cut their losses. I could be wrong, cause it has been a while since I was explained this. The other commodities were probably added just because people wanted to make money. Because they have had experience with farm commodities.
Think of commodities in these terms. Nobody has a monopoly on a commodity. Anybody with a shovel, a plow, a drill, can obtain a commodity for free (in theory, ignoring production costs).
Now that you have this commodity, you want to sell it to earn some cash. If you just set an arbitrary price, whomever is looking at your Asking Price will decide if they want to pay that amount. If they can get that same commodity from somebody else cheaper, you’ll never make a sale. As such, you have to lower your price. And the reverse is true. If you ask too low of a price, you’ll be swamped with requests for that commodity. But then will you be able to fill those orders and net a profit?
All a “Market” does it pair up buyers of commodities and sellers of commodities. And its in that market where the supply/demand of buyers and sellers discover a price point that values the commodity in question.
So yes, companies can set a price for their commodity. Question is, will anybody pay it?