What drives commodity prices- speculation or fundamentals?

Published on 26 Dec, 2019

Commodity prices are affected by various factors. While demand and supply dynamics could be the underlying cause of fluctuations, at times, other forces too create ripples in the market, such as speculation by traders, and changes in government policies. What is, therefore, the main cause of price fluctuation historically and has it changed?

Commodity prices can be extremely volatile at times and to understand the phenomenon, it is important to have an insight on factors substantially impacting them. While demand and supply dynamics do play a role, they cannot be considered the sole cause.

Is speculation responsible for driving commodity prices?
During the past decade, prices of commodities have moved more or less in tandem with each other. Before the financial crisis of 2008, commodity prices rallied and increased significantly; this was followed by a sharp decline across categories due to recession. At the start of 2009, commodity prices again started to escalate at a rapid rate. The synchronization in commodity price movements across types can sometimes be ascribed to the price bubbles created by excessive speculation in the commodities market. Prior to the recession of 2008, even the US parliament noted that the increase in energy prices was not a byproduct of demand and supply dynamics alone. Speculation in commodity futures markets starts when commodity traders enter into contracts to buy or sell a specific quantity of commodity at a certain price on an identified date in future. The future price of a commodity is estimated based on the trader’s understanding of demand-supply dynamics at that point of time. Another argument in the favor of speculation is that just prior to the recession, inflow of funds in the commodities market increased. According to a report published by Barclay’s, investment in commodities market by index funds increased to approximately USD200bn toward the end of 2007 from USD90bn in 2006. The huge influx may have created a price bubble. Speculation among traders regarding the US’s expansionary policies can also create price bubbles.

Monthly price change in commodity indices

Source: Index Mundi

Another theory supporting this suggests that the US’s monetary policies have an effect on commodity speculation which, in turn, drives prices. For example, if interest rates in the US are high, traders lean toward treasury bills which naturally brings down the real price of commodities. Conversely, when interest rates are low, speculators gravitate toward commodities, driving prices north. This happened prior to the recession when interest rates in the US were low. Traders are quick to anticipate the next move of the US Fed with regard to interest rates. Therefore, speculation in commodities market following a hike or cut in rates plays a role in determining the direction commodity prices go.

Commodity Price Index in response to the US Discount Rate

Source: fred.stlouisfed.org, index mundi

The arguments in favor of speculation driving commodity prices notwithstanding, the theory remains debatable. Various prestigious organizations downplay the role of speculation, citing it as vague. The IMF states, “Despite recent financial innovation in commodity markets, such as indexing, which has allowed investors to benefit from rising commodity prices without having to maintain physical inventory holdings, there is little discernable evidence that the buildup of related financial positions [in commodity markets] has systematically driven either prices for individual commodities or price formation more broadly.”

Demand-supply dynamics key driver of commodity prices
Demand and supply are postulated as the main determinants of commodity prices. For many soft commodities, demand and supply largely depend on the country’s seasonal and the economic conditions. Any change in seasonal pattern can lead to depletion of stock, causing food prices to shoot up. Prices of soft commodities, such as wheat, are inversely proportional to the stock-to-use ratio, i.e., prices decline when the stock-to-use ratio rises. The graph below depicts this.

Wheat prices w.r.t stock-to-use ratio

Source: FAO (Food and Agriculture Organization), index mundi

During 2014–18, the stock-to-use ratio increased; concurrently wheat prices declined. Therefore, we can reasonably argue that demand-supply dynamics regulated the movement of wheat prices.

Among energy commodities, the price of crude oil is mainly governed by the global demand and supply scenario. Over 2000–08, oil prices rose swiftly and reached USD150/bbl, led by strong demand from fast growing economies such as China and India. However, after the recession, demand for oil started to decline. Beginning 2014, prices of crude oil went on a downward spiral on weak demand from China, India and Brazil amid decelerating growth. Another reason for the decline in crude prices in 2014 was increase in supply led by extraction of oil from shale deposits in the US.

Recently, oil prices dropped 8% QoQ in 3Q19, averaging USD60/barrel. The oil prices registered this decline despite an attack on Saudi Aramco on September 14th 2019. This strike almost halved the production capacity of the oil giant and reduced the global supply by approximately 6% (Source: World Bank) and caused a temporary rise in oil prices. However, oil prices corrected rapidly to the pre-attack level as Saudi Arabia restored production. Slump in oil demand also steadied prices.

World Oil Balance vs. Crude Oil Prices

Source: EIA

The graph above shows the relationship between crude oil prices and world oil balance (difference between the production and consumption of oil globally). It is clear that as world oil balance tipped toward the negative territory (i.e., consumption exceeded production), oil prices rose sharply.

Other fundamental factors affecting commodity prices

  • Inflation – As inflation rises, the cost of living of commodity producers and distributers increases, prompting them to adjust commodity prices in line with the inflation in order to maintain the equilibrium. The US economy has been struggling with low inflation rates. For the period ended October 2019, it stood at 1.8%, below the Fed’s target of 2.0%. This implies commodity prices may decline in the short term.
  • Political uncertainties – The political environment has an effect on commodities used for investment purposes, for example, gold and silver. The price of gold, considered a safe haven, usually shoots amid geopolitical uncertainties. Gold rose 14.3% YTD until November 2019 on tensions surrounding US–China trade talks and the possibility of a recession. Gold prices are expected to rise further as political uncertainty increases.
  • FX rate – Most commodities are priced in US dollars and its depreciation makes commodities costlier as now more dollars would be required to purchase a unit of specific commodity. US Fed rate hikes have a positive impact on the US dollar. By far, there have been three rate cuts in the US this year due to which the dollar has weakened vis-à-vis other currencies. However, the Fed has hinted at a curb on further rate cuts in 2019-20 which may stabilize the dollar. The graph below highlights the movement of commodity prices vis-à-vis the dollar index, which is generally in the opposite direction.

Dollar Index vs. Commodity Food Price Index

Source: Index Mundi, Cap IQ

Nearly all commodity prices declined in Q3 2019 as global trade weakened due to growing tensions between the US and China. Consequently, the price outlook for non-fuel commodities for 2020 has been revised downward. According to the World Bank’s Commodities Market Outlook, published in October 2019, fuel prices would remain at around USD58 per barrel in 2020, mainly due to subdued demand globally.

Even though the role of speculation in driving commodity prices remains debatable we can safely conclude that it does create temporary bubbles in the commodity prices. Likewise, going by historical evidences and examples, we can comfortably conclude that in the long term, commodity prices are largely impacted by fundamental factors rather than speculation.