Commodities Prices

Gerald Greene asked:


Commodity prices have in many cases reached new record high levels over the past year. In spite of high prices the long term trend is still up and likely will be for a long time to come. Skilled commodity traders are indeed making their fortunes as markets soar.

Commodity prices are volatile because they respond to many unpredictable factors. Weather, labor strikes, inflation, foreign exchange rates, government monetary policies, and well intentioned but flawed government programs, like the US ethanol production program, all have their part to play in the pricing of commodities on open markets.

In an individual commodity trading account, because your position in futures and options is usually highly leveraged, even a small move against your position may result in a large loss, including the loss of your entire initial margin payment and liability for additional losses. Commodity prices are a double-edged sword for the world economy. High commodity prices are a negative for commodity importers, but a positive for commodity exporters.

Many commodity prices are currently at or near all time highs. Producers are retiring debt and replacing worn out equipment but consumers are starting to scream as food shortages and prices beyond what many consumers can readily pay are developing in many countries.

Commodity prices are more volatile than exchange rates and interest rates. Hence commodity price risk represents a more important source of risk to corporations in altering their production costs. Higher prices for raw materials are priced into increases in prices for finished goods. The inflation rate soon responds to increases in commodity prices.

Today commodity prices are high because for one thing China has grown to the point where it is a significant portion of world growth and demand for food and products made from commodities has soared along with China’s high rate of economic growth. Let’s say, as far as commodities are concerned, that China now has roughly the same amount of consumption as the US but that demand is growing more rapidly.

With a large percentage of a population of well over one billion experiencing a general improvement in income and living conditions demand for better food, shelter, and lifestyle is keeping upward pressure on demand for foodstuffs and goods of every sort.

Commodity prices are normally positively correlated with real interest rates, as rate troughs correspond with recession and related weakness in commodity prices. However, this commodity boom cycle is different. Central banks around the world, especially the US Federal Reserve Bank, have tried to support economic growth by keeping interest rates low for long periods of time. The low interest rates have aided “bubbles” to occur in hard assets, especially in commodities.

The central bankers and their policies are a major part of the problem with current high commodity prices. The fall in value of the US Dollar has made this situation worse as many commodities are priced in Dollar terms and a lower Dollar translates into higher commodity prices, no matter what stupid things the US Secretary of the Treasury may say at G-8 meetings.

In the long run commodity prices are less volatile than stock prices. But news shocks, like the current floods in the American Mid West crop producing regions, can strongly drive prices in the short run. Commodity prices are subject to supply and demand factors and sudden shocks to the supply outlook when demand is strong can send prices sharply higher in just a few trading sessions.

The floods in Iowa and other American corn producing states have destroyed up to 20% of the corn crop in key producing regions. Corn futures closed last Friday at record levels well above $7.00 a bushel. 2008 seems to be the year of soaring commodity prices as weather and man made events, like wars in key oil producing regions, create supply shocks in the face of strong demand.

At a minimum you can expect higher inflation rates for this year and next as commodity prices continue to climb. You can also expect great social unrest around the world as even middle class families find it difficult to pay higher prices for food and energy.