Ever wonder why gas prices change every day? One day, gas may cost $3.09 per gallon. A few months later, that price could be $3.70. Ever wonder why jewelry may become more expensive over time? The reality is that these price fluctuations are driven by changes in the price of commodities, such as crude oil, silver, gold, and other raw materials. These commodities, though not as widely known or understood as stocks or bonds, are an important backbone for the economy, and a significant driver of global economic outlook.
What is a commodity?
Commodities are their own asset class. This asset class consists of various basic resources: generally, agricultural resources and natural resources. These resources are effectively the same, regardless of how they were collected, and who collected them. The crude oil drilled by Company A is the same as that drilled by Company B. The grain harvested by Farmer A is the same as that harvested by Farmer B. The gold pieces found by Individual A are the same as those found by Individual B when melted down. Products such as clothes, for example, could not be considered commodities. Each piece of clothing is different, created with different materials and methods. However, the clothes are created with commodities, such as cotton, for example.
Commodities are broken into four categories: metals, energy, livestock and meat, and agricultural. Examples of commodities are gold, natural gas, meat, and even orange juice.
What affects commodity prices?
The price of commodities, just like the price of any other good, is determined by supply and demand. Suppose a hurricane hits Florida, and orange producers lose their crops. The supply of oranges decreases, and the price goes up. This will be reflected in the Orange Juice May 19 futures contract price. Suppose weather across the United States looks better than forecasted. Demand for natural gas to heat homes will decrease, and the price goes down. This will be reflected in the Natural Gas May 19 futures contract price.
Commodities are mostly exchanged in the futures market (two examples of which I linked above), where buyers and sellers of commodities come to buy and sell the futures contracts that determine the price of commodities. The futures market will be more extensively covered in a future lesson, but you can read more about it here.
How do commodity prices affect the market?
The prices of commodities are largely correlated with much of the stock market. For example, Exxon Mobil, a producer of oil and gas, would likely see an appreciation in its share price if the price of crude oil increases. Since Exxon is a major producer of crude oil, the higher price would spill over into the stock market. The opposite occurs for a company such as Delta Airlines. With an increase in the price of crude oil, Delta Airlines would likely suffer. Gasoline, a key part of flying airplanes, would become more expensive, lowering the profit margins of Delta.
If you analyze commodity prices for a while, you will see how changes in the prices of commodities can affect entire industries and sectors in the stock market. The stock prices of producers of commodities typically change the most as a result of changing commodity prices.
What do commodity prices tell us about the market outlook?
Suppose that gold prices decrease. This may be a bullish signal. Demand for gold has potentially decreased, thus decreasing the price of gold, as more money has been parked in the stock market with the expectation of a higher return from those alternative investments, rather than from gold. Higher gold prices often signal the opposite. Demand for gold has increased, pushing the price up, as investors are worried about a bearish market. Thus, investors seek a safe return in the form of gold.
Suppose that industrial commodities such as steel and copper begin to fall. This may be a bearish signal. Assuming other aspects of a bearish market, such as high unemployment and lower inflation, become clear, the fall of industrial commodity prices may confirm lower demand by manufacturers for such resources, greater inventories, and lower sales, which subsequently leads to a recession.
As with all market indicators, commodity prices cannot be the only metric used to gauge future market outlook. Just because the price of gold increased does not mean the markets are entering into a bearish phase. There are other factors to consider. Perhaps gold miners find less gold. This will make it more scarce and push up the price. This does not indicate that the markets are dangerous or bearish. However, applying knowledge of commodity prices and price movements relative to certain global events can enhance your understanding of the financial markets. It can allow you to branch out from stocks into different asset classes as well.
Commodities are a truly necessary and important part of the financial system. The price fluctuations and trends of various commodities have substantial effects on other aspects of the global economy, and can help predict certain economic trends. However, commodities should not be the only indicator used to gauge the economy. Rather, they can be used in conjunction with other information to more accurately gauge the future of the financial markets.