WHAT AFFECTS
COMMODITY PRICES?

Commodities are hugely popular with traders and investors, but commodities themselves can be influenced by a range of different factors. Discover what affects commodity prices and how demand can influence returns on commodity investments.

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Commodity prices are influenced by a range of factors, some of which can impact the sector as a whole, while others might only influence a particular market.

Commodities, such as oil, natural gas, metals and agricultural goods, are assigned a universal monetary value and traded between producers, distributors, manufacturers and consumers. 

What is supply and demand?

Supply and demand are two of the most fundamental concepts in economics. When supply is high and demand is low, prices tend to fall. Conversely, when demand is high and supply is low, prices tend to rise. 

This dynamic is what ultimately drives commodity prices up or down. 

For example, if the supply of oil suddenly drops due to conflict in an oil-producing nation but demand remains the same, there will be upward pressure on oil prices. On the other hand, if a technological advancement makes extracting oil cheaper, supply could increase and put downward pressure on prices. 

How does demand impact commodity prices?

Demand is one of the most important factors influencing commodity prices. When demand for a commodity increases, prices tend to rise as consumers are willing to pay more to obtain a scarcer resource. 

An increase in demand can occur for a variety of reasons. This might include population growth, new uses for the commodity or changing consumer preferences.

For example, rapid economic growth in countries such as China and India has led to greater demand for certain commodities, namely oil and metals. As these economies thrive, the population is more likely to purchase goods such as cars, electronics and appliances, thus boosting demand for the raw materials used to manufacture them.

On the other hand, when demand falls, prices usually decline. This might occur due to an economic recession that reduces consumer spending and industrial activity, for example.

Improvements in technological efficiency that reduce the need for material inputs can also lessen demand over time. When demand weakens, commodity producers make less and typically tap into their stored supplies, putting downward pressure on prices.

What happens if commodity prices fall?

A fall in commodity prices can have wide-ranging effects on the global economy.  Lower prices reduce profits for commodity producers and exporters, potentially slowing economic growth and investment in countries that rely heavily on commodity exports. 

Falling prices can also influence investor sentiment and currency exchange rates, with the currencies of commodity-exporting nations often weakening when prices fall. This may prompt central banks to implement measures to support economic growth, while prolonged low prices may also constrain new production and future supply.

However, commodity-importing countries may also benefit from lower input costs and inflationary pressure.  

For consumers, falling commodity prices mean lower costs for the goods and services that rely on the production of commodities, such as food, fuel and electricity. This, in turn, boosts the purchasing power of consumers. 

What happens to commodity prices in a recession?

Recessions lead to reduced economic activity and lower demand for raw materials and industrial commodities such as oil, copper and steel. With lower demand, prices fall. Recessions can also lead to a stronger US dollar as investors seek safe-haven assets. 

Ultimately, a recession creates uncertainty about future growth prospects. This can make commodities a less attractive investment compared to slightly less risky assets such as Treasury bonds. 

Overall, a recession tends to push commodity prices down across the board, although the magnitude of the decline depends on the depth and length of the recession. However, some commodities, such as precious metals, may see prices rise during recessions due to their perceived safety.

What do changes in commodity prices mean for investors?

Fluctuations in commodity prices can have a significant impact on an investment portfolio. As commodity prices rise, stocks of companies that produce, or rely heavily, on those commodities will often follow the trend. 

For example, when oil prices are high, energy companies will typically see their share prices climb. This can create opportunities for investors, although rising commodity prices also drive up costs for many businesses that rely on those raw materials. Manufacturers that depend on copper or iron ore can face declining profits when those commodity prices are high. This will put downward pressure on their stock. 

Monitoring overall commodity price trends and volatility represents a crucial aspect of understanding the macroeconomic conditions that influence investments. Being aware of these dynamics allows investors to make better-informed decisions and adjust their portfolios accordingly.

How to hedge commodity investments

Hedging is an important risk management strategy for commodity investors. There are several ways to hedge commodity positions to protect against adverse price movements.

Some investors try to lower the risk-return of a portfolio by taking an offsetting position in a related commodity futures contract. For example, an investor with a long position in crude oil could short sell an oil futures contract to lock in gains or limit losses if oil prices were to decline. 

Using futures allows investors to hedge without liquidating the physical commodity position.

Commodity options can also help to hedge commodity investments. Buying a put option gives holders the right to sell the commodity at a set price, limiting downside risk. Meanwhile, call options can lock in profits if prices rise. 

Commodity ETFs are an efficient way to hedge a broad commodities portfolio. For example, shorting a broad energy ETF can offset long positions in oil and gas stocks. ETFs provide exposure to multiple commodities in a single liquid, low-cost instrument.

Diversification across commodity sectors also reduces concentration risk. Blending agriculture, metals, energy and livestock commodities lowers correlation and volatility compared to portfolios that focus only on one sector. Rebalancing periodically maintains target allocations.

Final thoughts 

Commodity prices depend on supply factors such as production costs and geopolitics, and demand factors such as economic growth and new technologies. Prices can be complex and volatile, and while supply disruptions may be temporary, broader trends could reshape demand. 

Investors need to understand the fundamentals, taking into consideration how commodities can diversify portfolios through imperfect correlation with stocks and bonds. Ultimately, grasping supply and demand dynamics allows better-informed investment decisions.

Visit the eToro Academy to learn more about commodities and other asset classes.

Quiz

FAQs

What are the lowest risk commodities for investors to diversify with?

Some of the lowest risk commodities include gold and base metals. Gold and other precious metals have historically demonstrated low correlation with the US dollar and are often used as a hedge against inflation, whereas base metals are common metals that are relatively inexpensive and typically have a steady supply.

The key for investors is to allocate only a small portion of their portfolio to these commodities for diversification purposes. Conservative commodity positions can help to mitigate overall portfolio risk.

How does OPEC+ impact oil prices?

As a large supplier of oil, OPEC+ policies can directly impact global oil prices. Cutting oil production tends to raise prices, while increasing output can lower prices. OPEC production quotas and agreements coordinate supply among member nations.

Which commodities are the most expensive?

Some of the most valuable commodities by price per unit include saffron, white truffles, rare earth metals, platinum and palladium. Some of the more common high-priced commodities include crude oil, cobalt and rhodium.