What Drives Commodity Prices — Supply, Demand, and Cycles

Supply and demand.

This sounds obvious to the point of being unhelpful. But the reason supply and demand analysis in commodity markets is so powerful, and why it produces such clear and repeatable trading opportunities, is that the supply and demand dynamics of physical commodities are fundamentally different from those of financial assets.

When a technology stock becomes popular, the company can issue more shares. When demand for government bonds increases, the government can issue more bonds. The supply of financial assets can, within limits, expand to meet demand.

You cannot issue more oil. You cannot create more copper. You cannot grow more wheat than the land and water will support. Physical supply constraints are real and they take time to change. This creates the commodity price cycles, periods of shortage and high prices followed by periods of surplus and low prices, that have defined commodity markets throughout history and that create the most reliable medium-term trading opportunities available.

Supercycles are driven by the long lag between demand signals and supply responses.

Here is how a commodity supercycle typically develops. A period of strong global economic growth, driven perhaps by the industrialisation of a major emerging economy like China in the 2000s, creates surging demand for raw materials. At first, supply cannot keep up because building a new mine, drilling new oil wells, or developing new agricultural land takes years. Prices rise strongly.

High prices eventually attract massive investment in new supply. But this new supply takes years to arrive. By the time it does, the initial demand surge may have already peaked. Prices collapse under the weight of the new supply.

The Chinese industrialisation supercycle of the 2000s is the most dramatic recent example. China''s transformation from an agricultural economy to the world''s manufacturing hub drove decade-long surges in the prices of oil, copper, iron ore, coal, and virtually every other industrial commodity. When that surge eventually peaked around 2011 to 2012, commodity prices entered a prolonged bear market that lasted until 2016.

Some analysts believe we are in the early stages of a new commodity supercycle driven by the energy transition, the global shift toward renewable energy requiring massive amounts of copper, lithium, cobalt, nickel, and other metals for solar panels, wind turbines, electric vehicles, and battery storage.

Commodity inventories, the stockpiles of raw materials held in warehouses, storage facilities, and strategic reserves, are the buffer between production and consumption. When inventories are high, markets are well supplied. Prices are capped because buyers know they can always access material from storage. When inventories are low, the market is tight. Buyers scramble for material, prices rise.

Watching inventory levels and the direction they are trending is one of the most powerful short-term signals available for commodity traders.

For oil, the EIA weekly inventory data gives a real-time picture of US crude oil stockpiles. For copper and other metals, the London Metal Exchange publishes daily inventory data. For agricultural commodities, the USDA''s monthly supply and demand estimates provide the most comprehensive inventory picture.

When inventories are drawing down faster than expected, being consumed at a rate that exceeds production, it signals that the market is tightening. Prices tend to rise. When inventories are building faster than expected, production exceeding consumption, it signals that the market is loosening. Prices tend to fall.

When the dollar strengthens, commodities become more expensive for buyers using other currencies. A European buyer purchasing oil in dollars has to spend more euros to buy the same barrel. Demand tends to fall at the margin. Prices come under pressure.

When the dollar weakens, commodities become cheaper for buyers using other currencies. Demand at the margin tends to rise. Prices tend to find support.

This relationship, the inverse correlation between the US dollar and commodity prices broadly, is one of the most exploitable in commodity markets. It does not work perfectly all the time, and commodity-specific supply and demand factors will always dominate when they are extreme. But as a baseline directional indicator, a weakening dollar is generally supportive for commodities and a strengthening dollar is generally a headwind.

For traders who also trade forex, this creates natural analytical connections. A view on the Federal Reserve''s rate path simultaneously informs both a currency view on the dollar and a directional view on the commodity complex. These connections, understood and applied systematically, make the whole market picture more coherent and more tradeable.