Commodities Markets: Analyzing Price Volatility in Commodities Markets

1. What are commodities and why are they important for the global economy?

Commodities are basic goods that can be bought and sold in standardized units across global markets. They include agricultural products such as wheat, corn, and coffee; metals such as gold, silver, and copper; energy sources such as oil, natural gas, and coal; and other raw materials such as timber, rubber, and cotton. Commodities are essential for the production of goods and services in various sectors of the economy, such as food, clothing, transportation, construction, and manufacturing. They also play a vital role in international trade, as many countries depend on exporting or importing commodities to meet their domestic needs or generate foreign exchange.

The prices of commodities are determined by the forces of supply and demand, which are influenced by various factors such as weather, geopolitics, technology, consumer preferences, and market sentiment. However, unlike other assets such as stocks and bonds, commodities are subject to high levels of price volatility, which means that their prices can change rapidly and unpredictably over short periods of time. This volatility can have significant implications for both producers and consumers of commodities, as well as for investors and speculators who trade in commodity futures and options contracts.

Some of the main causes and consequences of price volatility in commodities markets are:

- Seasonality: Many commodities have seasonal patterns of production and consumption, which create cyclical fluctuations in supply and demand. For example, the harvest season for wheat typically occurs in the northern hemisphere from June to August, which increases the availability and lowers the price of wheat. Conversely, the winter season increases the demand and raises the price of natural gas, as people use more heating. Seasonality can also affect the quality and quantity of commodities, such as the impact of droughts or floods on crop yields.

- Speculation: Speculation is the act of buying or selling commodities with the expectation of profiting from future price movements, rather than based on their intrinsic value or utility. Speculators can use various financial instruments, such as futures and options contracts, to bet on the direction and magnitude of price changes in commodities markets. Speculation can increase price volatility by amplifying the effects of supply and demand shocks, creating bubbles or crashes, and introducing noise and uncertainty into price signals.

- Hedging: Hedging is the act of reducing or eliminating the risk of adverse price movements in commodities by taking an opposite position in a related market or instrument. For example, a farmer who grows corn can hedge against the risk of falling corn prices by selling corn futures contracts, which lock in a predetermined price for a future delivery of corn. Similarly, an airline company can hedge against the risk of rising oil prices by buying oil futures contracts, which secure a fixed price for a future purchase of oil. hedging can reduce price volatility by providing stability and predictability for both producers and consumers of commodities, as well as for investors and speculators who want to limit their exposure to price risk.

- Substitution: Substitution is the act of replacing one commodity with another that has similar or better characteristics, such as quality, functionality, or price. Substitution can occur at both the production and consumption levels, depending on the availability and affordability of alternative commodities. For example, if the price of oil rises, producers may switch to using natural gas or renewable energy sources, while consumers may opt for more fuel-efficient vehicles or public transportation. Substitution can moderate price volatility by reducing the demand for the more expensive commodity and increasing the supply of the cheaper commodity.

2. Supply, demand, geopolitics, weather, and speculation

Commodities are basic goods that can be interchanged with other commodities of the same type. They are often used as inputs in the production of other goods or services. The quality of a given commodity may differ slightly, but it is essentially uniform across producers. Examples of commodities include oil, gold, wheat, coffee, and copper.

The prices of commodities are determined by the interaction of supply and demand in the global market. However, there are many other factors that can influence the volatility of commodity prices, which is the degree of variation in the prices over time. Volatility can have significant implications for both producers and consumers of commodities, as well as for investors and traders who speculate on the price movements. In this section, we will examine some of the major factors that affect commodity prices and their volatility, such as:

1. Supply: The supply of a commodity is the amount of the commodity that is available for sale at a given price. The supply of a commodity can be affected by various factors, such as the production capacity, the cost of production, the availability of inputs, the inventory levels, the environmental regulations, and the geopolitical events. For example, the supply of oil can be influenced by the decisions of the Organization of the Petroleum Exporting Countries (OPEC), which is a cartel of oil-producing countries that can manipulate the output and price of oil. Similarly, the supply of agricultural commodities can be affected by the weather conditions, such as droughts, floods, pests, and diseases, that can damage the crops and reduce the yield.

2. Demand: The demand for a commodity is the amount of the commodity that buyers are willing and able to purchase at a given price. The demand for a commodity can be affected by various factors, such as the income level, the population growth, the consumer preferences, the substitute goods, the complementary goods, and the technological innovations. For example, the demand for oil can be influenced by the economic growth, which increases the consumption of energy and transportation, and by the development of alternative energy sources, such as solar and wind power, which can reduce the reliance on oil. Similarly, the demand for agricultural commodities can be influenced by the dietary habits, the health awareness, and the cultural norms of the consumers, as well as by the biofuel production, which can divert some of the crops from food to fuel.

3. Geopolitics: The geopolitics refers to the political and economic relations among countries and regions that can affect the global trade and security. The geopolitics can have a significant impact on the commodity prices and their volatility, as they can create uncertainty, instability, and conflict in the world. For example, the geopolitics can affect the oil prices by causing disruptions in the supply chain, such as wars, sanctions, strikes, sabotage, and piracy, that can hamper the production and transportation of oil. Similarly, the geopolitics can affect the agricultural prices by creating food shortages, famines, and humanitarian crises, that can increase the demand and reduce the supply of food.

4. Weather: The weather refers to the atmospheric conditions, such as temperature, precipitation, humidity, and wind, that can vary over time and space. The weather can have a direct and indirect effect on the commodity prices and their volatility, as it can influence both the supply and demand of commodities. For example, the weather can affect the oil prices by affecting the demand for heating and cooling, which are major uses of oil and natural gas, and by affecting the supply of renewable energy, such as hydroelectricity, which can compete with oil and natural gas. Similarly, the weather can affect the agricultural prices by affecting the crop production, which depends on the optimal weather conditions for growth and harvest, and by affecting the crop consumption, which can vary with the seasonal preferences and needs of the consumers.

5. Speculation: The speculation refers to the act of buying and selling commodities or their derivatives, such as futures and options, with the intention of profiting from the price fluctuations. The speculation can have a positive and negative effect on the commodity prices and their volatility, as it can provide liquidity, information, and risk management to the market, but it can also create bubbles, crashes, and distortions in the market. For example, the speculation can affect the oil prices by reflecting the expectations and sentiments of the market participants, such as the producers, consumers, investors, and traders, who can anticipate and react to the changes in the supply and demand of oil. Similarly, the speculation can affect the agricultural prices by amplifying the effects of the weather and the geopolitics on the crop production and consumption, as well as by creating arbitrage opportunities and hedging strategies for the market participants.

3. Standard deviation, coefficient of variation, and historical volatility index

One of the most important aspects of commodities markets is understanding how prices fluctuate over time. price volatility is a measure of how much the price of a commodity changes in a given period, relative to its average level. Price volatility can have significant implications for producers, consumers, traders, and policymakers, as it affects the profitability, risk, and uncertainty of the market. There are different ways to measure price volatility, each with its own advantages and limitations. In this section, we will discuss three common methods: standard deviation, coefficient of variation, and historical volatility index.

- Standard deviation is a statistical measure of how much the price of a commodity deviates from its mean (average) value. A higher standard deviation indicates more variability in the price, and thus more volatility. Standard deviation can be calculated for any time period, such as daily, weekly, monthly, or yearly. For example, suppose the daily prices of gold in January 2024 are as follows:

| Date | Price (USD/oz) |

| Jan 1 | 1,850 |

| Jan 2 | 1,860 |

| Jan 3 | 1,870 |

| Jan 4 | 1,880 |

| Jan 5 | 1,890 |

| Jan 6 | 1,900 |

| Jan 7 | 1,910 |

| Jan 8 | 1,920 |

| Jan 9 | 1,930 |

| Jan 10 | 1,940 |

The mean price of gold in this period is 1,895 USD/oz. The standard deviation of the price is 29.15 USD/oz. This means that the price of gold varies by about 29.15 USD/oz around its mean value.

- Coefficient of variation is a normalized measure of price volatility that takes into account the level of the price. It is calculated by dividing the standard deviation by the mean. A higher coefficient of variation indicates more volatility relative to the price level. coefficient of variation can be used to compare the volatility of different commodities or the same commodity over different time periods. For example, using the same data as above, the coefficient of variation of gold in January 2024 is 0.0154 (29.15 / 1,895). This means that the price of gold varies by about 1.54% around its mean value.

- Historical volatility index is a measure of price volatility that is based on the logarithmic returns of the price. Logarithmic returns are calculated by taking the natural logarithm of the ratio of the price at the end of a period to the price at the beginning of the period. Historical volatility index is calculated by taking the standard deviation of the logarithmic returns over a certain number of periods, such as 10, 20, or 30 days. A higher historical volatility index indicates more volatility in the price movements. Historical volatility index can be used to assess the risk and uncertainty of the market, as well as to evaluate the performance of trading strategies. For example, using the same data as above, the 10-day historical volatility index of gold in January 2024 is 0.0079. This means that the price of gold changes by about 0.79% on average per day.

4. Risks and opportunities for producers, consumers, traders, and investors

Price volatility is a measure of how much the price of a commodity changes over time. It reflects the uncertainty and risk in the market, as well as the supply and demand dynamics. Price volatility can have significant impacts on various actors involved in the commodities markets, such as producers, consumers, traders, and investors. Some of these impacts are:

- For producers: price volatility can affect the profitability and sustainability of production activities, as well as the investment decisions and planning of future output. Producers may face challenges in managing their costs, revenues, and cash flows, especially when prices are low or unpredictable. For example, oil producers may have to cut back on exploration and drilling activities when oil prices are too low to cover their costs, or hedge their output using futures and options contracts when prices are volatile. On the other hand, price volatility can also create opportunities for producers to benefit from high or rising prices, or to diversify their product portfolio and market access. For example, agricultural producers may switch to more profitable crops or export to new markets when prices are favorable, or adopt new technologies and practices to improve their productivity and resilience.

- For consumers: Price volatility can affect the affordability and availability of commodities for consumption, as well as the welfare and purchasing power of consumers. Consumers may face challenges in meeting their basic needs, especially when prices are high or fluctuate rapidly. For example, food consumers may have to reduce their food intake or quality, or spend a larger share of their income on food when food prices are high or unstable. On the other hand, price volatility can also create opportunities for consumers to benefit from low or falling prices, or to substitute or diversify their consumption patterns. For example, energy consumers may switch to cheaper or cleaner sources of energy, or invest in energy efficiency and conservation measures when energy prices are low or decline.

- For traders: Price volatility can affect the profitability and riskiness of trading activities, as well as the liquidity and efficiency of the market. Traders may face challenges in managing their inventory, margins, and exposure, especially when prices are erratic or unpredictable. For example, commodity traders may have to incur higher storage and transportation costs, or face lower demand and competition from other traders when prices are volatile. On the other hand, price volatility can also create opportunities for traders to benefit from arbitrage and speculation, or to provide market information and intermediation services. For example, commodity traders may exploit price differences across time, space, and quality, or anticipate and react to price movements and signals when prices are volatile.

- For investors: Price volatility can affect the returns and risks of investing in commodities or commodity-related assets, as well as the diversification and portfolio management strategies. Investors may face challenges in valuing and selecting their investments, especially when prices are uncertain or unpredictable. For example, commodity investors may have to deal with higher volatility and lower correlation of returns, or face higher transaction and information costs when prices are volatile. On the other hand, price volatility can also create opportunities for investors to benefit from capital appreciation and income generation, or to hedge and diversify their exposure to other asset classes. For example, commodity investors may invest in physical or financial commodities, or in commodity-related equities, bonds, or funds when prices are volatile.

5. Examples of price volatility in different commodity markets such as oil, gold, coffee, and soybeans

Price volatility is a measure of how much the price of a commodity changes over time. It reflects the uncertainty and risk associated with the supply and demand of the commodity, as well as the influence of external factors such as geopolitics, weather, and market sentiment. Price volatility can have significant implications for both producers and consumers of commodities, as well as for investors and traders who seek to profit from price movements. In this segment, we will examine some examples of price volatility in different commodity markets, such as oil, gold, coffee, and soybeans, and analyze the causes and consequences of these fluctuations.

- Oil: Oil is one of the most widely traded and consumed commodities in the world, and its price is affected by a variety of factors, such as production levels, inventories, demand, geopolitics, environmental regulations, and technological innovations. Oil prices are often volatile, as they respond to changes in these factors, as well as to speculation and market sentiment. For instance, in 2020, oil prices experienced a historic collapse due to the COVID-19 pandemic, which reduced global demand for oil, and a price war between Saudi Arabia and Russia, which increased global supply of oil. The west Texas intermediate (WTI) crude oil futures contract, a benchmark for US oil prices, plunged below zero for the first time in history on April 20, 2020, meaning that sellers had to pay buyers to take delivery of oil. This was a result of a lack of storage capacity and a mismatch between the contract expiration date and the physical delivery date. Oil prices recovered gradually as the pandemic eased and the OPEC+ group agreed to cut production, but they remained volatile due to the uncertainty of the recovery and the emergence of new variants of the virus. As of March 10, 2021, the wti crude oil futures contract was trading at $64.44 per barrel, up 31% since the start of the year, but still below the pre-pandemic level of $61.18 per barrel on January 2, 2020.

- Gold: Gold is a precious metal that is often considered as a safe-haven asset, a store of value, and a hedge against inflation and currency devaluation. Gold prices are influenced by factors such as supply and demand, interest rates, inflation expectations, geopolitical risks, and market sentiment. Gold prices tend to rise when there is uncertainty, instability, or crisis in the world, as investors seek to protect their wealth and diversify their portfolios. For example, in 2020, gold prices reached a record high of $2,067.15 per ounce on August 6, 2020, as the COVID-19 pandemic, the US-China trade war, the US presidential election, and the Brexit negotiations increased the demand for gold as a safe-haven asset. Gold prices also benefited from the low interest rate environment and the unprecedented monetary and fiscal stimulus measures implemented by central banks and governments around the world, which raised the inflation expectations and weakened the US dollar. However, gold prices declined in the later part of the year, as the development and distribution of COVID-19 vaccines, the US stimulus package, and the Brexit deal improved the economic outlook and the risk appetite of investors. As of March 10, 2021, gold prices were trading at $1,721.80 per ounce, down 9% since the start of the year, but still up 14% since January 2, 2020, when they were at $1,515.10 per ounce.

- Coffee: Coffee is a tropical agricultural commodity that is consumed by millions of people around the world. Coffee prices are determined by the balance between supply and demand, as well as by factors such as weather, pests, diseases, quality, trade policies, and market sentiment. Coffee prices are often volatile, as they reflect the uncertainty and variability of the production and consumption of coffee. For instance, in 2020, coffee prices experienced a roller-coaster ride, as the COVID-19 pandemic disrupted the supply chain and the demand for coffee. The International Coffee Organization (ICO) composite indicator, a benchmark for global coffee prices, fell to a four-year low of 97.16 US cents per pound on April 21, 2020, as the lockdown measures and the closure of foodservice outlets reduced the consumption of coffee, especially in Europe and North America. Coffee prices rebounded in the second half of the year, as the easing of the lockdown measures and the reopening of the foodservice outlets increased the demand for coffee, while the adverse weather conditions and the labor shortages in some of the major producing countries, such as Brazil, Colombia, and Vietnam, affected the supply of coffee. The ICO composite indicator reached a three-year high of 125.35 US cents per pound on December 18, 2020, before falling slightly to 119.55 US cents per pound on January 29, 2021, as the Brazilian real appreciated against the US dollar and the Brazilian crop prospects improved.

- Soybeans: Soybeans are an oilseed crop that is used for food, feed, and biofuel. Soybean prices are influenced by factors such as supply and demand, weather, crop conditions, trade policies, and market sentiment. Soybean prices are often volatile, as they reflect the changes in these factors, as well as the interdependence and competition among the major producing and consuming countries, such as the US, Brazil, China, and Argentina. For example, in 2020, soybean prices surged to a six-year high of $13.42 per bushel on January 13, 2021, as the strong demand from China, the world's largest importer of soybeans, and the tight supply from the US, the world's largest exporter of soybeans, created a bullish market for soybeans. Soybean prices also benefited from the favorable weather conditions and the high oil content in the US crop, as well as from the phase one trade deal between the US and China, which committed China to increase its purchases of US agricultural products, including soybeans. However, soybean prices retreated in the later part of January, as the Brazilian harvest, which is expected to be a record one, started to enter the market, and as the US dollar strengthened against the Brazilian real, making Brazilian soybeans more competitive in the global market. As of March 10, 2021, soybean prices were trading at $14.18 per bushel, up 9% since the start of the year, and up 54% since January 2, 2020, when they were at $9.21 per bushel.

6. Key takeaways and recommendations for readers

In this article, we have examined the factors and dynamics that influence the price volatility of commodities markets, such as supply and demand shocks, market structure, speculation, and geopolitical events. We have also discussed the implications of price volatility for producers, consumers, traders, and policymakers, as well as the strategies and tools that can be used to manage and mitigate the risks associated with volatile commodities prices. Based on our analysis, we would like to offer the following key takeaways and recommendations for readers who are interested in commodities markets:

- Commodities markets are inherently volatile, due to the nature of the underlying assets, the diversity of the participants, and the uncertainty of the future. Price volatility can be beneficial or detrimental, depending on the perspective and position of the stakeholders. Therefore, it is important to understand the sources and effects of price volatility, and to monitor the market trends and indicators regularly.

- Commodities markets are interconnected and interdependent, both within and across different commodity groups, such as energy, metals, and agricultural products. price movements in one commodity can have spillover effects on other commodities, as well as on the broader economy and financial markets. Therefore, it is essential to adopt a holistic and comprehensive approach to analyzing commodities markets, and to consider the linkages and correlations among different commodities and sectors.

- Commodities markets are influenced by multiple and complex factors, some of which are observable and measurable, such as production, consumption, inventories, and trade flows, and some of which are unobservable and unpredictable, such as weather, political events, and market sentiment. Therefore, it is advisable to use a combination of quantitative and qualitative methods to assess the price volatility of commodities markets, and to incorporate both historical and forward-looking perspectives.

- Commodities markets offer opportunities and challenges for different types of players, such as producers, consumers, traders, investors, and regulators. Each player has different objectives, constraints, and preferences, and faces different risks and rewards in the commodities markets. Therefore, it is recommended to identify and evaluate the potential costs and benefits of participating in the commodities markets, and to devise and implement appropriate strategies and policies to achieve the desired outcomes.

- Commodities markets are constantly evolving and innovating, as new technologies, products, and platforms emerge and transform the way commodities are produced, consumed, traded, and financed. Price volatility can be a driver or a result of these innovations, as they create new opportunities and challenges for the commodities markets. Therefore, it is important to keep abreast of the latest developments and trends in the commodities markets, and to adapt and adjust to the changing environment and circumstances.