Are Relative Valuations Important In Commodities Trading?

Frequently in the news media you will hear analysts or reporters talking about the relative value of a commodity, but is that really an important factor in valuing a commodity?

Relative valuations are often use to compare say the price of silver to the price of gold. Over the last 200 years, gold values have averaged 32 times silver values. However, some silver investors point to the fact that gold now trades at 68 times the value of silver. The argument then goes that silver must be undervalued based on price of gold, so we should all buy silver.

The theory of relative valuations is used with other commodities as well. The price of crude oil and natural gas is another popular comparison. Oil generally trades about 6 times higher than natural gas, but currently it trades at 18 times the price of natural gas. Investors who are bullish on natural gas often point to commodity’s relative valuation to oil as proof that the commodity is undervalued.

While over the long-run relative valuations may hold up, but is that sufficient evidence to trade a commodity in the short term?  Furthermore, if your commodities trading strategy is based on the relative relationships of commodity prices, how low does a relative valuation have to be before it becomes attractive?

In the short term, supply and demand dynamics are likely to drive commodity prices much more than their price relative to other commodities. So while you should definitely consider the relative price of an individual commodity, don’t make that the sole reason for investing.