Commodity: What factors affect commodity prices Why are commodities so important

A commodity is a basic good or primary good that one can group under standard headings before they are then traded. Commodities are mostly used as part of the production of finished goods and services and fall into categories such as oils, minerals and agricultural produce. Each commodity is interchangeable, which is why any attempts to set up a gemstone commodity market have failed since each gemstone is different from the other. Most of us don’t spend much time thinking about commodities, but they touch nearly every aspect of our lives. Almost everything we use, work with, watch, eat, or wear was made with a commodity or used a commodity in its mining, refining, manufacturing, or transporting. Without commodities, modern civilization wouldn’t exist. 

Types of Commodities:

There are different types of commodities which are as follows:

1. Agriculture

Agriculture commodities are those such as coffee, corn and an important source of food for livestock and human, sugar, soybean whose oil is used for making crackers, breads and cake one of the most important food crop in the world.

2. Energy

Energy commodities include crude oil used in transportation activities and production of plastics, natural gas used for electricity generation, and gasoline, which powers light-duty trucks and cars.

3. Metals

Metals come in gold, used in making jewelry, silver, also used for jewelry and having many industrial uses as well, and copper, the most widely used form of electrical wiring.

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What are commodity prices?

Commodity prices are the market values of the many raw materials of our world. Touching our everyday life, commodities include oil, natural gas, gold, silver, cattle, wheat, corn, and lumber. As well as the nearly 90 other assets that trade on commodity exchanges. Commodities can be priced on weight, or by standard unit. Prices are determined by the open market supply and demand.

What is commodity inflation?

Commodity prices rose dramatically in recent years until mid-2008. Oil prices reached record highs in mid-2008, rising to $145 per barrel, 470% higher than at the start of 2000. This increase has been due to the combination of increasing global demand, in particular from strong growth in emerging economies, supply disruptions and downward revisions in expectations of future oil supply. Food prices have increased substantially, partly as rising per capita incomes raised food consumption in emerging economies at the same time that there were temporary supply disruptions. Between the start of 2000 and mid-2008, food prices rose by 150% according to the Commodity Research Bureau’s spot index of foodstuffs.

Why Are Commodity Prices Important?

Commodities traded on the world market ranges from raw materials to intermediate or semi processed goods; or simply goods that are used to manufacture other goods. The prices of these commodities are set in the world market by market forces; buyers and sellers or demand and supply. The most commonly traded commodities include crude oil, gold, copper, wheat, cotton, silver, natural gas, sugar, coffee, and corn. the important role commodities play in our daily activities, analysts, policy makers and businesses keep a close watch on their price movements which can be very volatile, moving up or down, often quite sharply, over short periods. Often the sharp changes in commodity prices are due to two major factors: (i) changes in the supply and demand and (ii) expectations of future supply and demand. Expectations are especially important in the short term as on some days the prices of commodities like gold and oil can vary sharply even though the underlying supply and demand for the commodity has not really changed.

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What Factors affect the commodity prices?

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

Income and Population:

As economies grow, industrialize and urbanize, 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 richer people typically consume more protein-based foods, which in turn increases demand for livestock and the crops used to feed them.

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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, crops, etc.) which reduce the marginal cost of production.

Government and policy and producer organization:

Some governments promote 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. One of the most famous examples is the Organization of Oil Exporting Countries (OPEC).

Interest rates and U.S dollars:

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.

Why Commodities prices moves up and down?

Understanding how and why commodities prices fluctuate can determine your success in trading these instruments. Without this knowledge, you may be fighting a losing battle.

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Commodity market prices:

Commodity prices can be volatile, and there may appear to be no reason to their movements. Commodity pricing can be unpredictable even for the most experienced traders. However, as a rule, their price movements are a function of supply and demand. When the market shows a lower supply, prices tend to rise. Conversely: higher supplies generally result in lower prices. Corn futures are a prime example of this phenomenon. In early 2006, corn futures were trading at around $2 per bushel, which represented the low end of the price range for the 20 years prior. This was mainly caused by soaring crude oil prices, which rapidly increased the demand for ethanol which happens to be produced from corn. Demand was likewise increasing from rapidly growing countries like China. Consequently, prices were low for corn, whose supply then tightened. And as the new crop was planted, there would be no room for a poor crop. This tense climate made traders think twice before selling, which spiked corn prices from $2 per bushel to over $4 per bushel, within about a year.

Update:

There are three chief reasons why commodity prices move higher or lower. The first is the fundamental state of a commodity market. If current inventories exceed demand, the oversupply tends to drive prices lower. But if the demand is greater than supplies, the inventory deficit tends to push prices higher. Secondly, commodity prices fluctuate due to the technical condition of the market. Price charts often drive the behavior of investors, traders, and other market participants. Since everyone studies the same data, a herd mentality of massive group buying or selling consequently influence prices. 

Finally, commodity prices are sensitive to changes in the global macroeconomic and geopolitical landscape. With all of these influential factors, predicting commodity price movements is difficult. But seasoned commodity professionals who analyze past market behaviors may have a opportunity on predicting future price moves.

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How can inflation fall, whilst prices are rising?

Firstly, a fall in the inflation rate, means prices are still rising. Just at a slower rate. Inflation measures the average cost of living. Therefore, it is possible for some goods to be increasing in price by a greater amount than the average price level.

A common example, is petrol prices rising at 10%, when the headline inflation rate is 4%. If we stripped away petrol from the inflation index, we would get an underlying inflation rate of 3%. Rising oil prices were a major factor in causing the UK inflation of 5% in 2008. At the present moment, the fall in oil prices are causing the headline inflation rate to be lower than it would be otherwise. Headline inflation is running at 1% in many European countries, but without the downward pressure from oil, headline inflation may be closer to 2%.

Food prices:

Food prices often change at a greater rate than overall inflation. Food prices tend to be more volatile because they are determined by factors, such as the weather. Also, with inelastic supply and demand, this makes prices more volatile. If there is a bad return in one year, we may see food prices rise quite sharply due to this particular factor. However, at the same time, the underlying core inflation rate could be falling, e.g. due to lower economic growth and a decline in excess demand.

Core inflation

Core inflation is a useful concept because it gives a better guide to the underlying inflationary pressures in the economy and ignores these more short-term temporary factors like energy and food. However, the headline inflation rate can be influenced by these short-term, temporary factors. If we have a rise in raw material prices, such as petrol and food, this could lead to higher inflation expectations. Workers may demand higher wages to be able to afford the higher prices; this rise in wages could therefore make these short-term cost push factors more permanent. But recent history suggests that the cost-push inflation didn’t lead to permanently higher inflation, like some economists / Central Bankers feared.

Different inflation rates

Another issue to be aware of is that different groups of society may be affected by rising food prices in different ways. The average consumer may spend 15% of their income on food, and so be relatively unaffected if food prices rise. However, people on very low incomes (in developing economies) may spend up to 50% of their disposable income on food. Therefore, if there is food inflation, it affects their cost of living quite significantly. In this case, low income groups have a higher inflation rate that those on high incomes.

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