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Commodities prices are affected by four main factors: • Supply and demand • Inventories and stocks • Foreign exchange rates • Inflation Supply and demand of commodities Supply and demand is a simple concept - if supply of a commodity is lower than demand, prices rise, and if demand for a commodity is lower than supply, prices fall. However, as the price of commodities are usually set in futures markets, the price is not impacted by today's supply and demand, but the expected supply and demand at a future date. A commodity futures contract is an agreement to buy a certain amount of a commodity at a set price at a predetermined date. As the price commodities fluctuate, this protects the buyer from possible rises in commodity prices, however he also takes the risk that the commodity price could drop and he would be paying more than the market rate. Similarly, the seller is protected from possible commodity price drops and knows his profits in advance, but he takes on the risk that the commodity price could go up and he will lose potential profits. The seller and the buyer of the commodity are both hedgers - both looking for security against possible price fluctuations. However, the majority of commodity trading is done by speculators, who usually guess the price direction and profit on the change in price, never intending to purchase the product. Fewer than 3% of transactions result in the buyer of the contract taking ownership of the commodity being traded. Factors that affect supply and demand include global economic and political events. In the case of oil, as most of the Organization of the Petroleum Exporting Countries (OPEC) members are from the Middle East and Africa, when there is political instability and war in these areas the price of oil tends to rise due to the expected fall in supply. In July 2008 oil prices reached over USD136 a barrel following concerns about the wars in Iraq and Afghanistan. We can also see this in evidence in the case of cocoa - when the president-elect of the Ivory Coast announced an export ban in January 2011, the price of cocoa hit a one-year high.
However, it is not only political events that cause prices to rise. Natural disasters can cause an imbalance of present supply and demand, such as Cyclone Yasi in Australia in February, which wiped out Queensland's banana crop and later caused banana prices to rise to over $12 a kilo. Stockpiles of commodities If we continue using the example of Australia's bananas, commodity prices can be affected by the amount people have stockpiled. As bananas spoil quickly, people don't store them, which results in the demand for bananas remaining strong despite the cyclone. However, if the commodity was a product like grain or coffee, which can be stored for longer periods of time, there would be emergency stocks which would maintain supply, keeping prices steady over difficult periods. That being said, if production stops for a longer period, stocks will fall to dangerous levels, causing prices to rise to lower demand. Foreign exchange rates and commodities If a commodity is traded internationally with a number of different importers, exporters and investors, foreign exchange rates can impact the commodity price. If an exporter is doing very well, this may cause investors to invest in the local currency, pushing the value of the exporter's currency up. This means that the money that the exporter receives from exporting a commodity can buy more in terms of imports, as its currency now has a higher value in comparison to the currency of the country from which they are buying goods. On the other hand, this makes the commodity they are exporting more expensive for those who want to import it, as the importers need to convert their money into the currency of the exporting country to make the purchase. As the exporter's currency continues to rise, it becomes more difficult for the importers to buy the commodity. This will cause the importers to lower their demand, meaning that if the exporters continue producing the same amount they will have an over-supply. Either the commodity price will have to drop, or the level of supply will have to drop to get supply and demand back in balance. Inflation and commodities Let's assume that supply and demand are in balance, stockpiles are well-managed and the foreign exchange rate remains static. But inflation continues rising at 2% per annum. This means that the price of commodities will also have to increase by 2% a year. The banana farmer has to raise his prices by 2% a year because his cost of living is rising by 2% a year. But customers can afford to pay this because not only are their costs of living rising by 2% a year, but their incomes are also rising. Closing thoughts
Although a number of different factors influence commodity prices, most of them somehow impact supply and demand, so this is the main factor to evaluate when determining market sentiment and deciding whether to enter or exit the market.
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