Commodity prices are driven by supply and demand, of course. What drives supply and demand then? And what else impact commodity prices? Weather, climate change, geopolitical events, technology, behavior change, regulation, just to name a few. However, it is important to keep in mind that markets have very quick ways to adjust itself. A shortage can quickly turn into an oversupply.
Inflation and deflation
Inflation and deflation affect prices of almost all goods, including commodities. Take oil for example, oil prices are higher in an inflationary enviroment since dollar is the currency that is used for most trades. If one dollar is less than it was a year ago, then it should buy less oil. Equivalently, prices are higher for the same quantity of oil.
People often thought inflation was caused by higher oil prices. I think that’s not the correct logic. The right logic is that higher oil prices are the result of inflation. Since most products and goods are related to oil prices, their prices will go up as well.
There are also situations that oil prices go up due to supply constraints and subsequently cause higher prices in everything. That’s a different story.
Demand
Stronger or weaker demand can very quickly impact prices.
- Economic strength impact demand.
For example, when the Chinese economy and the housing market was skyrocketing, the demand was strong on many commodities, especially iron ore prices. As the Chinese economy and the housing market slow down, iron ore prices are projected to be lower due to weaker demands.
Another example, as countries came out of Covid lockdowns, the demand for traveling suddenly increased many fold. This puts upper pressure on fuel prices.
- expectation can drive up demand However, besides consumption, expectation of events can as well. When people hear about some possible upcoming crisis (Covid lockdown, supply chain problem, hurricane, inflation), they go out and buy those things they need (or they can sell) and hoard. If many people are buying and hoarding at the same time, prices will be higher, or goods become simply not available.
When there is a strong expectation of inflation, financial institutions and large businesses want to hedge for inflation. They buy commodity futures. Just like the hoarders, their actions drive up demand and subsequently the prices.
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Behavior changes can also impact demand
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Regulation can also impact demand. For example, some states forbid new homes using natural gas as a heating source. So from a local perspective, eventually demand for natural gas will be lower than before the regulation. As another example, many states give tax incentives for electric vehicles, which can lower demand for petro-fueled cars.
Supply
Now we come to supply. Supply and price have inverse relationship. Oversupply leads to lower prices, and vice versa. Precious metals are expensive because the supply is limited.
The same factors that impact demand do impact supply as well. We will just highlight a couple.
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Investments and commodity business cycles impact supply. Like almost all businesses, the best of time is also the worst of time. In the best of time, commodity business is very profitable. So more investments come in to produce more of the commodity. But when economic slows down couples with an oversupply of goods, prices will fall sharply. When prices are low, commodity producers and investors lose money. Many exit the market. Supply drops. This creates a cycle.
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Geopolitical events can affect supply. The Russia-Ukraine war damanged pipes, routes and ports for transporting natural gas, wheat, corn natural gas and other commodity. As a result, supply has dropped. Spikes are 40% to 50% or even higher changes up and down.
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Regulation can definitely change supply. When some commodity when from illegal to legal status, or the opposite, supply dynamics will very quicky change.
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Weather Whenever we have a hurricane coming or other types of severe storm, the energy prices always. For example, during Hrricane Katrina and Rita, and the Texas snow storm, energy prices spiked, but then quickly returned to pre-hurricane level after the bad weather passed.
Commodity and climate change
A closely related perspective is climate change. It is often quoted that the last ten years the world has observed more extreme weather than the decade before: extreme heat, drought, flooding, etc. can all aggrevate the commodity markt.
Commodity positions
Portfolio diversification across the value chain is critial for commodities.
| Sector | Producers | Refiners | Consumers | Hedge Funds and Investors |
|---|---|---|---|---|
| Position | “long” raw material | “short” raw material & “long” product | “short” product | |
| Transaction | sell raw material or sell product forward | Buy product forward | Buy and sell based on perception of market |
A large bank may engage with all sectors of customers, including producers, refiners, consumers and investors. By doing so, the bank will have a diversified portfolio that has off-setting positions, as well as more products for broader customer base.
Question:
- how fast
- what kind of research that goes into your : geopolitical. everything is event based. And look at the fundamental. If you have a shock, can you wheather the shock. Never do going Jan and Feb