Over the past six months various newspapers and broadcasters have sought to explain the apparent weakness in commodity prices by trotting out what has happened to one commodity index or another, explaining that commodity prices hit their lowest for x number of years. But what exactly is a commodity index, why should you care anyway and are newspaper reports just picking the one that best fits the story?
In general a commodity price index is a fixed-weight index or (weighted) average of selected commodity prices, which may be based on spot or futures prices. It is designed to be representative of the broad commodity asset class or a specific subset of commodities, such as energy or metals.The value of these indexes fluctuates based on their underlying commodities and can be traded by investors on an exchange.
Just take the four indices shown in the chart. Each of them have been used to describe how commodity prices have developed. While the RICI and CRB indices have finished broadly flat over the past twelve months, the S&P GS Commodity index is down almost 15% while the Bloomberg index is somewhere in between.
All of them measure different things (commodities), in very different ways and for different purposes.
The CRB index includes 19 commodities and has been adjusted 10 times since 1957 to reflect changes in market structure and activity. The Goldman Sachs index currently contains 24 commodities is weighted based on the average quantity produced of each commodity over the past five years and is much more weighted towards energy than the other indices. The Bloomberg commodity index meanwhile adjusts regularly based on price movements, requiring that no single commodity can comprise more than 15% or less than 2%. Finally, the RICI index is probably the broadest based of the indices including 38 commodity futures contracts from 13 international exchanges. Unlike many of the other indices the index has altered little since it was established and perhaps gives a more consistent measure over time.
If that wasn’t enough, don’t forget currency movements. All of the four commodity indices highlighted are prices in US dollars. Since most currencies tend to be priced in dollars, movements in your home currency versus the dollar can significantly affect the relative movement in commodity prices that you face.
These commodity indices are designed to enable investors easier access to a range of commodity markets at low cost. But do they actually reflect the commodities that your industry or your country actually use? There’s also The Economist, the IMF, the World Bank and plenty of others.
All of which makes it very difficult to say exactly what commodities are doing…but it won’t stop headline writers and investors trying.