Commodity prices have definitely taken a beating the last 2 years, with oil prices hitting new lows and hoarding financial news headlines.
Commodities are basically raw materials or any agricultural products such as gold, copper, coffee and etc.
The perennial favourite, gold, among commodity investors for the last decade, has taken a huge beating with prices falling from an all-time high of more than US$1,900 an ounce in 2011 to a low of $1,060 in November last year.
Now that oil prices are recovering and gold gaining more than 15% this year, is it time to look into commodity investing again?
Looking at how volatile commodity prices can be, investment in this asset class is not for the faint-hearted. So for those who want to start learning about it, where do you start?
As with all sorts of consumer goods one should perhaps start with looking at the fundamental factors of demand and supply.
One of the main factors that drive commodity prices is definitely demand, and an increase in demand can stem from several reasons:
Depending on the commodity you are looking at, seasonality can drive an increase in consumption. Take for instance, the summer driving season in the U.S. is known to drive up gasoline and diesel oil prices.
Similarly, during the cold winter period, you can expect heating oil prices to go up since most families require heaters to warm up their homes.
As each commodity will have its own factors affecting their demand, it’s best to focus only on one or two so that you can have a better grasp of their fundamentals.
2) Government Policies
Other than consumption during a specific season, a change in government policy can also affect the demand or supply for certain commodities. This can be in the form of import or export taxes, trade incentives or government spending.
Some of these can be less obvious – take for instance the decision by China to increase investment on building power grids.
At first glance, no one can tell that this piece of news is likely to impact copper demand, unless you are a keen investor or is working in the copper supply sector.
In fact, copper, used in the cabling in the power distribution network and electricity infrastructure in China accounts for about 40% of copper consumption in China.
3) Exchange Rates
Most commodities trading in the financial markets are priced in US dollar terms, which means that there is an inverse relationship between the prices of US dollar and commodities.
This is because when the dollar strengthens, commodity prices must move lower to reflect its increased purchasing power.
A cheaper dollar can also affect demand for commodities from buyers outside of the U.S., since their currency will have more purchasing power.
4) Substitute Products
Another way demand for a commodity can be affected is closely-related substitutes.
Imagine commodity A and B as close substitutes. If the price of A goes up for whatever reasons, consumers could turn to B if it’s in more abundance and cheaper.
This list is a very broad introduction to studying the fundamental demand factors for commodities. In Part II, we’ll look at the supply factors affecting commodity prices.