What Drives Commodity Prices?

Like everything that can be bought or sold, commodities are driven by supply and demand of the commodity itself, it’s fundamentals in other words. Unlike stocks, which are driven by investor supply and demand and are only influenced indirectly and to varying degrees by fundamentals, commodity prices represent the actual market that the commodities are in.

With investment vehicles like stocks, the value of a stock is directly related to investor behavior. The trading price of stocks is exactly the clearing point between buyers and sellers of the stock, where the amount asked for the stock and the amount bid come together.

What Drives Commodity Prices?People bid and ask with future contracts based upon the delivery of a commodity at some point in time, so what makes the pricing of commodities so different?  With stocks or most other securities, the security itself is all there really is, and people essentially buy and sell it based upon what they see the future market of the stock will be, how supply and demand of the security in the future will affect price.

With a commodity though, these contracts are set up to convert to the actual delivery of a commodity, and while a lot of contracts just get rolled over, the price when they do is going to depend fundamentally on the spot price for the commodity.

This is the part some people miss when they claim that speculation drives up the cost of commodities, and in turn, the price of goods. Futures contracts are derivatives of actual assets, and the price of the asset isn’t going to ultimately change as a result of futures trading.

Can Speculation Really Drive Up The Ultimate Cost of Commodities?

Let’s say you had a lot of money and wanted to influence the price of oil we’ll say. So you buy up a huge number of contracts for oil, and of course you will pay a premium for this, and while you are buying these you’re going to drive the price up.

The value of the contracts though depends on the ultimate value of a barrel of oil at the expiration date, and while you may have managed to drive up the cost of an oil futures contract while you were buying all these contracts, the market will reach equilibrium again to where the contracts achieve market value.

Trading in futures is a zero-sum game so in the end, by your paying too much for these contracts, you will have to settle up for the difference between what it costs to buy the oil and the inflated price you contracted for. Those who you bought the contracts from made money from this deal, you lost money, and the price of oil remains unaffected.

This works the same way if you sell contracts, and the extra pseudo supply that your large orders represent is going to depress the price of the contracts for a time, but ultimately the value of them is going to be based on the actual value of them at expiry, and you’re going to be holding the bag again.

This is what happens in the aggregate, people place bets on the future price of a commodity, and they win or lose money based upon how good or bad these bets are. You aren’t going to move the actual price of the commodity this way though because that is based upon other factors, the supply and demand of the commodity itself in the marketplace.

Does This Turn Suppliers and End Users of Commodities into Traders?

While the actual price on the spot market for a commodity is not affected by trading in commodity futures, the prices of the futures contracts are affected.

Hedgers do get involved in the commodities market during the life of a contract, looking to lock in a certain price to buy or sell a commodity. Since investor supply and demand affects this, this does exert an influence on the futures market, where hedgers may pay more or less than they would if there were no traders in the market, those with no intention of ever supplying or taking possession of the commodity.

What needs to be realized is that futures contracts consist of placing bets, regardless of whether it’s a hedge or a speculation.
Let’s say you own a farm and have a certain amount of corn that will be ready at a certain time. So, you sell some contracts to deliver it according to the terms. Let’s say the price last year was $3 a bushel and you want to get that again this year.

If the actual price of corn at the time of your harvest is less than $3, you win, and you profit by the amount it is under this. If it is higher than $3, you lose, by the amount it is over. So, this is just as much of a bet, just as much of a speculation, as it would be if a trader bought or sold those contracts in expectation of making money off of the trade.

The real difference here is that the hedger would be using this as insurance against getting too little for the sale of his goods, or by paying too much for it, and depending on the price, the profit will compensate them when the price is not to their liking. In exchange for this, they give up excess profit that may be obtained if they did nothing.

As you can see though, the futures market with commodities or with anything else is nothing more than side bets about the future price of a commodity. The value of these bets are dependent, and in the end entirely dependent, upon the value of the commodity on the spot market at the time the contract is up, which is what makes it a derivative.

Along the way, the pricing of these bets will depend upon not only the betting action but fundamental factors that influence the commodity prices, as well as the spot market for the commodities themselves. The betting action can cause certain deviations in the futures market but ultimately this will all be equalized according to the actual value of the goods contracted for.

The Demand Side of Commodities

There are a lot of things that effect commodity prices themselves. While a futures contract is live, the supply and demand for the security will obviously affect it somewhat, but these prices to tend to be grounded in the expected future value of the commodities because that’s what these bets are concerned with, completely.

Ultimately, this comes down to essential supply and demand. The commodity market is more inelastic than most goods, due to the nature of the goods involved. People still need to eat, drive their cars, and so on. If the price of oil goes up or down, this will affect how much people drive to a certain extent, but the inelastic part refers to a lesser effect that price has on demand.

If a certain good that was not seen as necessary or if there were a substitute for it, a brand of something with several competitors in the market for instance, saw a big rise in price, people would just buy something else instead. In our example, with oil, people will still drive a lot and just pay more, as we’ve seen when fuel prices have risen.

Demand for commodities therefore does play a role in the pricing of them but a lesser role than supply. If the price of oil goes down, people aren’t going to drive a whole lot more, for instance. If the price of wheat or corn goes up or down, people aren’t going to eat a whole lot more or a whole lot less cereal and bread.

Even so, economic factors do play a role in the demand of commodities in the aggregate. If there are more cars out there, from people being better off and being able to afford cars, then more fuel will be sold.

This is why aggregate economic data does play a role in commodity prices over time, although this does not tend to affect the time frame that futures contracts are traded in very much.

Commodity Prices are More About Supply

When demand is inelastic, the supply side of the market is going to be even more influential, and this is the case indeed with commodities. This is the case with some commodities more than others. Coffee for instance is relatively inelastic, where something like orange juice would be less so. People would be less likely to substitute coffee drinking than they would be to substitute orange juice drinking, with another fruit juice for instance, if the price of orange juice rose too much.

The gold market is a perfect example of how supply drives price more with commodities, as the price of gold is very much influenced by its lack of supply. Since supply is so low, price is so high, and gold going up in value has little influence on the demand for it. People buy it anyway, at whatever price it is at, and its rising in price may actually tempt people even more.

This is the reason why people look to the weather when it comes to agricultural commodities, and poor weather or good weather can really affect the supply of these commodities and also affect their prices in turn.

Geopolitical concerns can also affect the supply of commodities, for instance the Arab oil embargo of the 1970’s really drove prices up by reducing the supply of oil to the United States substantially. People lined up to buy gas since they still needed to drive, and of course the price went way up as a result.

This is why people look to changes in supply so much when they look to project changes in commodity prices.

Changes in demand matter as well, but over a longer period of time. As the population increases, and GDP goes up, more goods will be demanded, but events that change supply tend to occur much faster and have even more impact upon the short-term prices that futures contracts are concerned with.

All of this is built into the prices of commodity futures though, although some traders do look to fundamentals in looking to choose what to trade. As is the case with all securities trading though, the market itself will tell all the story you need to in order to trade it properly.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

Contact Ken: ken@marketreview.com

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