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What Makes Commodity Prices Rise?

What Makes Commodity Prices Rise?

It’s not rocket science, so we don’t need to talk about things like thrust, energy, force, gravity, etc. Instead, we’ll limit ourselves to three factors that drive commodity prices higher:

  1. Increased Demand
  2. Decreased Supply
  3. Inflation

Increased Demand

There are thousands of new millionaires being added in India, United Arab Emirates, Saudi Arabia, Singapore, and Russia (not to mention the U.S., Europe and the rest of the world) every year. There are also millions of people joining the middle class around the world every year. With this rising affluence comes an increase in purchasing power and a greater demand for commodities; i.e., the essentials that make life possible and/or more comfortable.

Just to give a few examples: 1. Gold is in demand as money and jewelry, which are in greater demand as more people increase their wealth. 2. Crude oil and gasoline are in greater demand as more people buy automobiles. 3. Rice, wheat, soybeans, corn, meats, coffee, sugar, and cocoa are in greater demand as people want to improve their diets and taste the sweeter things in life.

Decreased Supply

For years, commodity prices were relatively low (prior to 2000); however, as countries around the world adopt more market-based economies, the demand for commodities is growing. The added demand increases prices, thus calling out more supply (giving people a greater incentive to produce commodities). Unfortunately, it often takes years to increase the supply of some commodities. Commodities that must be taken out of the ground (oil and metals) have the longest lead times. In the short run, the supply isn’t keeping up with the added demand. Some people view this more as an increase in demand rather than a decrease in supply, but you could say the supply is going down relative to the demand. The effect is the same as a shortage of commodities (relative to demand) and the bottom line is that prices are going up.

Inflation

During the first stage of inflation, commodity price increases are caused by an expansion of the money supply and credit. During the second stage, people begin to anticipate future declines in their currency’s purchasing power, and the currency’s price (relative to commodities) begins to drop faster than the supply expansion would suggest. As existing money buys less, more money is needed to buy the same quantity of commodities. More money is then printed (and easier credit is extended) to meet the ever-expanding anticipatory “need”/demand for it, reducing the currency’s price and pushing commodity prices higher still.

Conclusion

As more countries move toward market economies, billions of people join the marketplace for commodities. This unprecedented demand for commodities is creating shortages while the markets’ rationing tool (price) is doing its job by supplying goods to consumers who are willing and able to pay the (higher) market price. Until the supply of commodities can catch up with the added demand, prices will rise.

In a world of fiat currencies beset with the notion of inflationomics, governments around the world are trying to stimulate their economies relative to the rest of the world. Those who depreciate their currencies more (through currency and credit expansion) are rewarded with greater exports (in the short run), but pay the price for their profligacy with higher commodity prices. Because the world uses the U.S. dollar as a reserve currency, U.S. dollar-holders share the pain of dollar-denominated commodity price rises when the U.S. Federal Reserve (Fed) inflates the U.S. currency and/or expands credit. This occurs every time the U.S. economy has a crisis (which is happening more frequently these days).

The convergence of increased demand, short supplies, and world-wide inflation is bringing the world record commodity prices. Exactly how high prices will go is open to conjecture. Perhaps, in that sense, rocket science results are easier to predict!


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