The Calculus Of Trading Or Investing- Commodities Prices Are A Critical Variable For All Asset Classes

Commodities are global assets. They flow around the world from areas of production to consumption. Output is a local affair as minerals, ores, and metals occur in the earth in certain areas where producers can extract and profit from production.

When it comes to agricultural products, fertile soil and water availability create the opportunity to grow crops. Chile is the world’s leading producer of copper, the Middle East is home to more than half the world’s crude oil reserves, and the US produces the largest crops of corn and soybeans while Brazil does the same for Arabica coffee beans and sugarcane. Three nations in West Africa produce almost 70% of the world’s annual supply of cocoa beans which is the primary ingredient in the chocolate confectionery products enjoyed all over the globe each day. While production is local, requirements are ubiquitous. Almost every person on the planet depends on the availability of commodities for food, shelter, and to power their lives.

Raw material markets influence the prices of almost all other asset classes. While individuals are consumers, so are companies that depend on commodities that are critical ingredients when it comes to their cost of goods sold equation. Therefore, commodities prices impact corporate earnings and share prices. Commodities impact revenue flows for many nations from both a commerce and tax perspective. As such, currencies can move based on price volatility in the raw material markets. As commodities prices reflect rising or falling inflationary pressures, they also impact bond yields as inflation is a significant component of interest rates. As you can seem commodities are at the hub of the global economy. Even if an investor or trader never ventures into the volatile asset class, knowledge about price trends and factors affecting the commodities market is a key variable in the calculus of markets.

A volatile asset class- Sentiment is critical but is not the whole enchilada

Many market participants looking for action or price volatility trade or invest in commodities markets because of the wide price variance that offers opportunities for financial rewards. Therefore, technical analysis and overall sentiment often drive prices higher or lower. Herd behavior can move markets to extremes at times based on the speculative behavior of buyers and sellers. Futures markets evolved as hedging tools for producers and consumers around the world. However, producers tend to look to sell when prices are moving higher, and consumers often act as bargain hunters, buying when prices are moving to the downside. Speculators and arbitrageurs grease the wheels the of the futures markets providing liquidity at all price levels, high and low. The advent of unleveraged and leveraged ETF and ETN products over the past decade has only exacerbated the influence of speculative interest in the markets.

I watch four critical technical indicators when it comes to monitoring the activity of market participants in commodities futures markets. The first two, volume and open interest, can shed light on the strength of prices at certain levels. Volume is the total number of futures contracts that change hands each period, while open interest is the total number of long and short positions in a futures market. When volume and open interest increase when prices are rising or falling, it tends to provide technical validation of a trend that has high odds of continuing. However, when the metrics fall when prices are moving higher or low, it often is a signal that a trend is running out of steam and a reversal is in the cards.

Slow stochastics is a price momentum indicator that tells us if a trend is in neutral, oversold, or overbought territory. Sharks tend to die when they stop moving and market trends are similar. When oversold or overbought conditions occur, a market can run out of the volume and open interest necessary to keep it going. Relative strength also provides neutral, overbought, or oversold readings and tells us if a price trend is likely to continue based on past price performance. When it comes to both metrics, timing is everything as short, medium, and longer-term charts can point to differing price trends. There are many other technical metrics that can provide guidance for prices, but all have one thing in common. They rely on past performance to project future price trends. Since many speculators and other market participants employ technical analysis, it often becomes a self-fulfilling prophecy in markets which makes it a critical component when it comes to analyzing price behavior in commodities and all asset classes.

Aside from the technical perspective, many other factors can move raw material prices over time.

Supply and pricing cycles

In the world of commodities, supplies each year will determine if there is enough of a raw material to satisfy global demand. Supplies include inventories and production. Shelf life is a consideration when it comes to supplies. Copper, gold, silver, and many other metals and minerals can sit in warehouses for months, years, decades, and centuries without deterioration. In agricultural markets like grains, coffee, sugar, cocoa, and many others, the commodities often rot or lose potency or nutritional value over time. Therefore, understanding the idiosyncratic nature of a market is a significant factor when it comes to analyzing supplies.

In a pricing cycle for a commodity, the price tends to rise to a level where producers work overtime to capture the increasing margins between output costs and market prices. As prices rise, inventories often build. Conversely, when the market price decline to levels that are at or below production cost, production often grinds to a halt leading to falling stockpiles as prices move to the downside. Analyzing the supply side tends to be a microeconomic discipline.

Demand in an ever-growing world and pricing cycles

The demand side of the fundamental equation in the commodities market is an ever-present and ever-increasing factor thanks to demographic trends. Therefore, demand analysis tends to be more of a macro than microeconomic exercise.

I was born in 1959, which my children constantly remind me was a very long time ago. In that year there were just under 2.9 billion people on the planet earth. By the turn of this century, the population more than doubled to the six billion level. Most recently, more than 7.55 billion people inhabited our world. It is truly amazing to live in an era of exponential population growth. At the same time, technology has allowed for communications and news to travel from one side of the world to the other in the blink of an eye. While the population has grown dramatically, so has wealth and standards of living have increased. Therefore, each day, more people, with more money, are competing for raw materials which are finite at certain price levels. Take crude oil as an example. There is only a finite amount of the energy commodity that producers can extract from the crust of the earth at $40 per barrel. At $50, they can extract more, and at $100, a lot more of the fossil fuel. This phenomenon is not only applicable to the oil market but for most commodities as production tends to rise as a function of the price. Therefore, the base prices of most commodities have been rising as demand increases allowing for the production of commodities at higher output costs. Copper never traded above the $1.62 per pound level before this century. For the past ten years, the price has not been below $1.9355 level.

When it comes to pricing cycles, consumers tend to act as wise economists. They increase buying when prices move to the downside and curtail purchases when prices rise often looking for less expensive substitutes. Consumption and production work side by side to establish a flow of prices that often create significant peaks and troughs in the commodities markets which offer market participants compelling buying or selling opportunities. Human nature tends to drive people to buy rallies as they offer the excitement of profits and to sell dips in a panic which can send prices above the top of fundamental pricing cycles and below the bottoms, for a time.

Weather and acts of God- Mother Nature can cause the most significant moves

While the supply and demand characteristics of commodities markets operate efficiently and reflect classical economic theory, the periodic volatility caused by the weather or unexpected acts of God can throw curveballs at markets. In 2012, a severe drought in the US caused the prices of corn and soybeans to rise to record highs because it created deficits where global demand exceeded supplies. Droughts, floods, earthquakes, tsunamis, extreme heat or cold, crop diseases, and other events can cause sudden and often violent price changes in commodities markets.

While stocks, bonds, currencies, and other assets rarely double, triple, halve or experience the wide price variance seen in raw materials, commodities are always susceptible to extreme price moves which often come out of the blue, as do the events that trigger the volatility. Since commodity prices impact all other asset classes, these periods of high price variance can ripple through other markets like a tsunami when it comes to values.

After four decades in the commodities markets, I have learned that it is always best to expect the unexpected and to never say never about the potential for unprecedented price moves on the up or the downside. In 2011, a shortage in the cotton market took the price of the fiber to $2.29 per pound. The price of cotton had never traded above $1.18 before that year. In May 2018, the price of lumber rose to an all-time peak at $659 per 1,000 board feet. Before 2017, the price never traded above $493.50 per 1,000 board feet, and that high occurred in 1993. In an example of the wild volatility that grips all commodities at times, the price of lumber collapsed to a low at $299.90 by October 2018, just five months after its record high at $659. There are many examples of how Mother Nature and acts of Gold created periods of extreme price variance in commodities prices, and there will be many more of these events in the future.

Politics and policy often distort prices and technology is always changing the fundamental equation

Finally, politics and policy can cause price variance in the world of commodities. The most recent example comes from the ongoing trade dispute between the US and China, the nations with the world’s leading GDPs. With 1.4 billion citizens and years of economic growth, China had become the demand side of the equation when it comes to the raw material markets. Commodities prices tend to rise and fall these days with China’s economy. In 2011, when the Asian nation was still experiencing double-digit economic growth, the price of copper rose to over $4 per pound. However, the slowdown in growth has weighed on many commodities prices over recent years. In 2018, protectionist measures in the form of tariffs by the US on Chinese goods and retaliation by China on US exports to the nation caused the price of soybeans to drop to their lowest level in a decade. The US is the world’s leading producer of the oilseed while China traditionally purchased one-quarter of the annual US crop. The trade dispute, a political event, distorted the price of soybeans causing an oversupply in the US and a shortage in China.

At the same time, many governments view commodity output as a matter of national security which leads to subsidies for producers and tariffs on exports. In the sugar market, subsides in the US, Europe, and other nations lead to two or more price levels for the same commodity. The world price for sugar has been trading at between 12 and 13 cents per pound, but in the US the price is double that level because of subsidies for sugar producers. In another example, the oil shortages of the 1970s in the US led to a policy to encourage energy independence. The ethanol blend in gasoline that comes from US corn was a child of the move to reduce imports from the Middle East as was the growth of US crude oil production that has made the nation the world’s leading producer recently. The genesis of the oil market reflects how politics, policy, and technology all changed the supply and demand of the energy commodity dramatically.

To complicate matters, two of the leading commodities producing nations in the world, China and Russia, consider data on production and consumption a state secret which leaves a stark hole where analysts can only provide guestimates about the state of fundamentals for some commodities market. The US and Europe are far more transparent when it comes to data dissemination.

The policies of governments around the world and political considerations often distort commodities prices away from levels that supply and demand would dictate. Commodities fundamentals are dynamic and since they can impact all assets, traders and investors should monitor these markets as without the knowledge they will be missing critical variables when it comes to the calculus of investing.