Lesson 2: What factors affect the price of commodities?

In yesterday’s lesson you learnt what commodities are and some of their basic characteristics. Today’s lesson looks at the factors that affect commodity prices in more detail.

Over the long term the underlying fundamentals (demand and supply) play a prominent role. These include income and population, the cost of production and technology plus the actions of governments and producer organisations. In the shorter term, commodity prices are affected by amongst other factors, the weather, interest rates and speculation.

Income and population

As economies grow, industrialise and urbanise, they typically consume increasing amounts of commodities – particularly industrial metals like steel, as well as energy.

However, as economies become richer you typically see smaller increases in commodity demand for a corresponding rise in income.

Meanwhile, the type of commodities consumed changes – as economies become wealthier people typically consume more protein based foods, which in turn increases demand for livestock and the crops used to feed them.

Costs and technology

The cost of producing a commodity plays a defining role in determining commodity prices. Commodity production costs include: raw materials, wages, research and development, insurance, licensing fees, taxes and every other cost incurred by real world commodity businesses.

In the longer term technological developments may result in greater yields (deeper mines, more resilient crops, etc.) which reduce the marginal cost of production.

Government policy and producer organisations

Some governments (often those from autocratic countries) subsidise commodity prices, particularly energy and agricultural ones, in the name of providing a benefit to their poorest citizens, e.g. cheaper fuel and food.

Meanwhile, taxes tend to be used by some governments to tax consumption and here they are generally placed on the consumption of energy (particularly transport fuel). One reason governments use to justify taxes on fuel is to account for the associated environmental cost.

Groups of commodity producers may also coordinate output cuts in order to push prices higher. One of the most famous examples is the Organisation of Oil Exporting Countries (OPEC).

Weather

Too much sun, too dry, too wet, too hot or too cold; unless the weather is just right agricultural yields will undoubtedly suffer.

The weather can affect other commodities too. Hurricane force winds in the US Gulf can force offshore oil producers to shut down. Low water levels in Indonesia can make it more difficult for nickel miners to ship the metal to market.

Interest rates and the US dollar

Lower interest rates may result in businesses and consumers borrowing money to fund investment and consumption, which will then indirectly result in an increase in demand for commodities.

Since most globally traded commodities are priced in US dollars, changes in US interest rates are transmitted through to its currency, either appreciating with tighter monetary policy or depreciating if it is loosened, and in doing so demand for commodities is affected.

Speculation

Commodities are an asset class in their own right. Financial innovation has meant that anyone can now take a stake in one or a basket of different commodities. Increasingly pension funds and other investment firms have taken stakes in commodities with the aim of diversifying their returns. Meanwhile, algorithmic trading of commodities has become more important to investment funds looking for a return.

Nevertheless, there are concerns that speculators may be moving prices away from levels that would be justified based on the underlying factors outlined in this lesson.

All of these factors have some form of impact on commodity prices, but their significance is magnified when global stocks of commodities are low. Low stock levels may make a particular commodity market more vulnerable to an unanticipated disruption to supply or a sudden increase in demand.

Thank you for taking the time to read lesson 2 of this course.

In the next lesson you will be taken step by step through the workings of global commodity futures markets, and in particular discover the vital role that speculators play.

Go to lesson 3

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