What affects Commodity Prices?

This article is an advanced economic article on factors influencing commodity prices and is aimed at an audience with a basic knowledge of Economics. This document will namely be of significant benefit to investors in the mining sector and traders of commodities.

Firstly it is paramount to define the common definition of ‘commodities’. A commodity can be defined as ‘a good or service that is produced for exchange and sold in a market with the intention of generating a profit for the seller’.

For this document we shall focus on ‘Primary Commodities’ such as Oil, Gold, Copper, Cocoa, wheat and Coal.

The factors influencing commodity prices will focus on historic data as with most analysis we use past data to predict the future.  Firstly we will explore the historic costs of transportation of commodities as this still influences their market price.

Declining Transport Costs:

Transport costs have been a key factor on commodity prices.

Prior to the mid-nineteenth century, freight rates on long hauls were high except for goods with very high unit prices. Consequently global commodity trade was in very small volume.

Trade consisted of mainly highly valued luxuries such as Coffee, Cocoa, spice and semi-precious metals imported mainly to Europe.

In the later half of the nineteenth century the application of steam power to transport revolutionized the economics of moving goods on land as well as oceans.

A large group of raw materials produced at increasing distances from the coast in overseas territories became economically accessible to the worlds industrial centres as horse and camel as primary method of transportation was replaced with metal steamships and wooden sailing vessels.

One point to make is that little trade will typically take place when the transport charges account for a dominant share of delivered price. Trade will be encouraged as transportation share declines.

The economic impact of the new bulk transport technology was very substantial especially for the mining industries. The freight rate as a proportion of total price for US coal in Western Europe was reduced from more than 30% to less than 15% in the thirty-year period.

The successive technological revolutions have gradually reduced the transport costs of bulk commodities by a total of almost 90% between 1870s and 1990s. This in turn has increased the number of globally traded primary commodities from selected high-priced luxuries before 1850, to encompass virtually all products with perceptible values by 2005.

Coffee and Cocoa was a product only available for the wealthy, however with lower transport costs have allowed lower costs of these commodities and consequently created the commodities more affordable and higher volume is now traded.

It is interesting to note that the primary share of GDP (Gross Domestic Product) shrinks as economies develop, it is essential to keep in mind that commodities are indispensable and that no society however economically advanced can survive without their assured supply.

Excepting expensive luxury goods like coffee and precious metals, commodities were simply too expensive to transport across boarders and oceans. The secular fall in transport costs has greatly increased international trade in commodities, making it possible to move production to locations which offer the lowest cost opportunities.

Supply and demand are key influences on commodity prices, however, some commodities are more influenced by one more than the other.

In general price instability of agricultural commodities is  more often caused by supply side disturbances, while that of minerals – strikes and cartels notwithstanding – is more related to variations on the demand side.

The major substitutes for individual products are likely to be found within the same group. This is probably more evident in the fuels group.

An important implication is that prices within each group will have a tendency to move on tandem. For instance, if the price of petroleum rises, the prices of coal and natural gas will tend to rise in sympathy, but there is little presumption that such changes will have a direct influence on the price of say – copper or wheat.

Commodities can also be sorted in to those which are easily stored and those that cannot. Refrigeration and preservation have rendered all commodities storable within some extent. The hard to store commodities are found in the perishable agricultural groups.

The commodities with many close substitutes will have high price elasticities of demand. If the price increases, demand is redirected in favour of the substitutes.

This is true for instance, of bananas or lamb, the demand for which is easily shifted towards other fruits or meats should the price of one in the group become more expensive.

Commodities with important uses and without convenient substitutes will eventually have very low price elasticities of demand. When the use of commodity is in some way indispensable, demand will not be much affected by a change in price.

When the use of a commodity is in some way indispensable, demand will not be much affected by a change in price. Platinum and chromium are prime examples of indispensable materials with few substitutes in many uses and with very low elasticities of demand.

For a somewhat different reason coffee, too has a low price elasticity of demand. Though one can lead a very comfortable life without it, a large part of humanity has become addicted to this beverage and as a result coffee is not very sensitive to price.

Random statistics reveal the US is the world’s largest exporter of cotton and wheat and second only of Brazil in the tobacco market.

Metal demand generally stagnated after 1990 as virtually all economic growth in the mature economies occurred in sectors like services and information technology with very small metal needs.

Food commodities (such as meats, wheat etc) are likely to experience lesser variations in demand over the business cycle than other commodity groups.

Exempting foods of a luxury character like coffee, chocolate or beef, one can also expect that food has a lesser income elasticity of demand and hence a lower trend in demand growth in an expanding economy where consumers tend to spend decreasing shares of their income on basic necessities.

More complex price determination processes are involved when production results in the output of more than one commodity. This is frequently the case in the exploitation of poly-metallic ore bodies (copper and nickel, lead and zinc, gold and copper) but also in agriculture where hides are produced along with beef, wool and mutton.

Where one commodity dominates the revenue, it will tend to be produced on its own merit, irrespective of the price of the by-product. Silver is predominately supplied as a by-product in non-ferrous metals production and its price tends to be depressed by excessive availability when the demand and price for the base metals is blooming.

Palladium presents a similar case, for it is a by-product in South African platinum production and in Russian production of nickel. Palladium price is an important indicator watched by professional traders in forecasting the rest of the precious metals price movements.

Examining Commodity prices further but also the business aspect of Mining companies:

After a price decline  production should contract – however it is common that production will persevere at levels resulting in losses since variable or out of pocket costs exceed market price. (This has been a common trait amongst Coal Mining companies). A number of reasons can explain this counter-intuitive behaviour.

One important explanation is that closure and subsequent reopening involve cost. If the price depression is deemed to be short, it may be more economical to suffer temporary losses from continued operations than to incur the costs resulting from closure.

Distinction should be made between variable costs which are part of the short-run supply schedule and fixed costs which are not.

The cost of labour, is typically assumed to vary with the level of operations but in a very short term perspective, the firm may not be able to sack workers so this cost category becomes fixed. The greater the proportion of costs classed in the fixed category, the lesser will be the variable costs and the lower will be the supply schedule making it economical to continue operations at depressed prices.

Goals other than profit maximisation (e.g maintenance of employment) could motivate continued operations even when price does not fully cover operating costs. A prime example would be managers short run urge to secure their own jobs.

Examining commodity prices and their inter-relationship with other commodities in similar categories.

High price and profit levels tend to push up costs and increase organisational slack. Obversely, low prices and profits induce pressures to reduce costs. This has clear application to industries such as miners who produce raw materials.

A high commodity price relaxes the cost discipline, so costs will tend to rise. The survival threats imposed by a low price work wonders on the producers cost performance.

The price elasticity of demand for raw materials is usually quite low, given that the cost of such materials usually constitutes a small proportion of the finished product price. The price of bread and car batteries will be only marginally affected by a doubling of the wheat and lead prices. So the demand for these raw materials-absorbing products will remain relatively unchanged.

Say there are three downstream stages in the production chain beyond the raw material supplier and that the desired inventories at each stage equal one-half of one period’s sales. A 5% increase in the finished product demand will then result in an almost 17% increase in the demand for the raw material, due to the cascade of inventory adjustment at each production stage to the higher finished product demand. This will result in a much larger price adjustment for the raw material than for the finished product. The same applies in reverse when the finished product demand declines.

Fluctuations in supply contribute to price instability. Weather is an important cause of supply variations in agricultural crops, even though geographical diversification of production in recent decades has reduced the importance of this factor.

Mineral supply can be caused to shrink due to strikes or technical accidents but such failures would have to be widespread to significantly dent the global total.

With the exception of annual crops, it takes an extended period of time to change the supply capacity and in the meantime even small variations in demand will result in sharp changes in price.