Commodity Prices: Supply, Demand and Speculation

For awhile, commodity prices starting to climb again, which some, like me, took as a sign that the economy would soon start growing again. I heard a rumor that editor of the Journal of Environmental Economics and Management predicted oil will hit $100/bbl by the end of the year. But now commodity prices are falling off again.

I think Paul Krugman's tidbit on all this is right on the money: it's been speculation about "green shoots" that now are not materializing as expected. Unlike the much larger boom in commodity prices that culminated in last summer's record peak, the recent more modest rise appears to be due to speculation. This is indicated by the rise in inventories that accompanied the boom. The market was anticipating world demand to rise as the recession bottomed out and growth resumed. So, instead of selling commodities at low prices, commodities were stored, in speculation of higher future prices. But future demand growth is proving more elusive than thought, so prices are falling off again, a lot like long-term interest rates.

Looking more broadly at the pattern commodity prices, something quite astonishing has happened over the last few years. Price fluctuations have become much more a demand-related phenomenon than a supply-related phenomenon.

For energy price fluctuations used to come mainly from oil embargoes, wars, and worry about impending wars or other events creating supply interruptions. Occasionally there was worry about OPEC commitments having real teeth. Thus, there were supply actual shocks or speculation about possible supply shocks that sent prices soaring, with prices falling once the actual or feared shock abated.

For agricultural commodities prices trended down due to remarkable yield growth. Price fluctuations came mainly from surprises in the weather. Prices and inventories would occasionally build up because markets anticipated some kind of supply disruption.

But today it's all about demand. Demand for all kinds of commodities from oil to food grains came from tremendous growth in China and India. Supply growth couldn't keep up. Agricultural commodities got an additional demand boost from ethanol, which also linked agricultural prices more closely to energy prices. Then, when the global economy tanked, so did commodity prices. And today speculation, instead of being about possible supply disruptions, is all about when demand growth will resume.

Killian has a nice technical academic paper on all of this, focusing on oil prices, recently published in the flagship economics journal (AER). Here's an unguarded version. It's also pretty obvious if you just stare at the data long enough. The story looks very similar for agricultural commodities.