As the world economy continues to become increasingly connected, so too does the global commodities markets. One big reason for this is that the financial markets have become much more democratized thanks to new technology. Traders have near-immediate access to commodity futures traded across the globe.
There’s also a flip side to all of this, which can be favorable or unfavorable, depending on the trader. The commodity markets are potentially subject to even greater volatility stemming from economic and geopolitical developments across the globe. As a trader, there’s much more “homework” to do, fundamentally speaking. Here is a look at what major factors drive commodity futures prices; in short, things to look out for.
Economics 101: The Law of Supply and Demand
In the commodities market, you are trading instruments whose underlying products are largely “tangible,” with the exception of stock indexes and other financial instruments. In contrast, equity markets are largely comprised of “paper” products, namely company shares or debt.
Tangible products, as you probably lerarned in Econ 101, are governed by the law of “material” supply and demand. If supply goes down and demand goes up, prices often rise. If supply increases while demand goes down, prices tend to fall. This concept leads small to large price fluctuations, depending on the supply/demand scenario.
Commodities that are traded and produced around the world, are subject to severe price fluctuations when political turmoil and social unrest are thrown into the mix. The best example of this is oil in the Middle East. This region has historically been one where conflict has often occurred, and its effect on oil prices can be sharp. Sanctions imposed on certain countries in or reliant on the Middle East can cause oil prices to rise when there’s a perceived or anticipated threat to the oil supply chain.
Economic prosperity can also affect commodity prices. On the supply side, you can look at Venezuela. They have been a major oil-producing nation but the collapse of their economy, along with governmental sections, has hurt their oil industry leading to less supply. On the demand side, when a country like the U.S. or Western Europe is thriving financially, oil demand will go up. When these economies are on a downslide, so is the demand. The same can be said for any commodity that’s typically traded on an international scale.
A note on US equity indexes and bonds: although we don’t look at the S&P 500, Dow, Nasdaq, or US Treasury bonds as “exported” goods, they virtually function in the same way. Traditionally, countries outside the US have looked to the dollar as a safe haven (whether that’s still the case is debatable). When the US economy is undergoing expansion, investors across the globe may look to acquire US market exposure. Hence, foreign investors may invest in US index futures or bonds depending on their global outlook.
The Weather: Good and Bad
The weather, good or bad, can have a huge effect on commodities. If the weather is great during a growing season and a harvest produces a bounty of crops, that can increase the supply, leading to lower prices. If the weather hurts the harvest or a natural disaster wipes a large chunk of it out or disrupts the supply chain, the supply will be reduced and prices go up. You also see the weather’s effect on energy-related commodities. During hot or cold spells, the demand for energy to power home heating and cooling may increase demand.
Value of the Dollar
Commodities are usually priced and traded in U.S. dollars (USD). This leads to commodity prices fluctuating with the value of the dollar. If the USD rises versus other currencies, the prices of certain commodities could drop and vice versa. This is a smaller factor than some others on the list but still is something to keep in mind when trading commodity futures.
Storage and Shipping Costs
Since commodities are physical products, they often need to get from Point A to Point B to be stored or consumed. If there are issues with shipping due to weather, geopolitical situations, or other supply chain challenges, those factors can affect prices. The cost of storage can do the same, especially if there is oversupply, this can become an issue that drives price movement. The price of oil earlier this year (2020) went so low due to lack of storage and buyers causing crude oil futures to go negative.
The Bottom Line
As you can see, there are many factors that drive commodity prices. Some are predictable and some are unpredictable, but they all come back to the fundamental principle of supply and demand. As a commodity trader, it helps to keep an eye on the economic reports that may affect the instrument you’re trading.
Please be aware that the content of this blog is based upon the opinions and research of GFF Brokers and its staff and should not be treated as trade recommendations. There is a substantial risk of loss in trading futures, options and forex. Past performance is not necessarily indicative of future results.