Markets are largely guided by uncontrolled forces – the so-called invisible hand – and nowhere is this more readily apart than in the commodities trade, where fluctuations in supply and demand leave prices in a constant state of flux.
This volatility creates opportunities for traders but also risks so it’s important to keep a close eye on the ever-shifting fundamentals that drive it.
How do supply and demand affect commodity prices?
The basics of supply and demand are pretty easy to understand: if demand grows faster than supply, prices will rise as buyers are willing to pay more to get their hands on a relatively scarce product or commodity. If supply outstrips demand prices are likely to fall as sellers try to attract more buyers.
These fundamentals affect everything in the economy but for traders they are especially important when it comes to commodity markets.
The price of individual commodities like crude oil, corn and wheat fluctuate during the year in response to a range of seasonal factors like harvest times and weather patterns. It’s important to understand at the outset, however, that the commodities market is a complex place and seasonal factors are only one of many things that impact prices.
Consumables
Consumable commodities like corn, soybeans and wheat are among the most volatile commodities because of significant swings in supply. An unusually cold winter in the US, for instance, could have a significant impact on wheat production, which would force prices up. Meanwhile, a strong growing season could lead to an oversupply and bring prices down. Traders who focus on these commodities pay close attention to weather patterns and production reports.
Another thing to remember is that price movements can also affect the future supply of a commodity. For instance, if corn prices rise for an extended period, more farmers will switch from other crops to take advantage of the situation. As more producers do this, supply will rise and prices will start to fall. If the price falls enough, farmers will start to switch away from corn.
Oil
Demand for crude oil rises at certain times of the year, such as the northern hemisphere winter, when more heating oil is needed, and the summer, when demand for gasoline is at its highest. As with consumables, some of the best opportunities for traders comes from uncharacteristic seasonal behaviour – for instance, after seeing a forecast for an unexpectedly warm winter in the US, a trader may decide to short crude oil in the expectation that lower demand will lead to a glut in supply and push prices lower.
On the supply side, any reduction in production, whether as part of a decision from OPEC nations or due to external events like the September 2019 attack on Saudi Arabian oil refineries can lead to significant price rises.
Metals
Since metals like iron ore and copper are mined all year round, they are less impacted by supply issue on a short-term basis, unless there is a major disruption like a large mine closure. However, fluctuations in supply will still have a longer-term impact.
In the near term, however, prices tend to move according to changes in demand. Iron ore traders, for instance, will closely watch Chinese ports data to understand whether demand is softening or weakening.
Two concepts every commodities trader needs to know: contango and backwardation
Traders looking to profit from changes in supply and demand dynamics in commodities markets need to form a hypothesis about where futures and spot prices are headed. Part of this involves looking at what economists call the futures curve: how current spot prices compare to futures contracts for delivery in say three, six and 12 months. Plotting these onto a graph will create a line that curves either up or down and its direction can tell you a lot about how the market views the commodity.
If the spot price of wheat is currently below its future price, the market is currently in what is known as contango. Using this information, a trader could conclude there is currently a supply glut and that spot prices are likely to rise over time. Alternatively, they may conclude that futures prices are likely to fall to meet the spot price and decide to go short on wheat.
The reverse situation to contango is backwardation. This occurs when futures prices are below the current spot price, indicating that either futures prices are likely to rise or spot prices are likely to fall. In this situation the commodity trader might decide to go long on wheat futures in the expectation of price rises.
What commodity traders need to know
While trading and investing in any asset always involves some level of risk, there are few markets more complicated and volatile than commodities. For that reason, it is normally the domain of experienced investors, those with a deep knowledge of an individual commodity and those with a strong appetite for risk.
Whatever the case, it is crucial that traders develop a detailed and nuanced understanding of the dynamics driving the price of a commodity and reach an informed view of how they might change in the future.