Inventories as an Asset: The Volatility of Copper Prices

Abstract

The spot price of copper metal is known to be extremely volatile. From 1958 to 1980, the mean monthly average price was $0.49 per pound (in constant 1967 dollars), while the standard deviation of month-to-month changes in the real price was $0.06. Claims to copper inventories are traded on the London Metal Exchange (LME), a competitive world asset market. This paper empirically investigates the dynamics of copper spot prices on the LME, focusing on the rate of return to holding copper metal and on the implications of inventory stockouts for this rate of return. We make one major departure from the standard economic theory of exhaustible resources.2 Instead of assuming constant short-run marginal cost (SRMC), we incorporate rising SRMC of extraction into the model.3 This technological assumption provides an economic motive for production smoothing by holding inventories. Equilibrium inventory holdings ameliorates rising SRMC by moving extraction to low SRMC time periods. We show that this amelioration is imperfect because of inventory stockouts. When stockouts can occur, the spot price of a resource reflects transient shocks to its scarcity value as well as permanent shifts. More specifically, the economic motive for inventory holding affects the equilibrium price dynamics of exhaustible resources in two ways. First, as long as positive inventories are being held, their holders should earn the competitive rate of return. Thus, the price of extracted resource should rise at the rate of interest in expected value. This result differs from most recent theoretical studies of exhaustible resources, which conclude that price minus marginal extraction cost should rise at the rate of