What drives commodity prices? I’ll give you a hint—a lot of variables. But before we talk about how commodity prices are set and what drives those prices, let’s take a moment to make sure we all understand what commodities are.
Commodities can be defined as raw materials or base materials that are of uniform quality. There are four general commodity categories:
Commodities can be classified in two basic categories: hard and soft. Hard commodities have a long shelf life and include items such as gold, copper, iron ore, and oil. Soft commodities, such as rice, wheat, orange juice concentrate, and pork bellies, have a short shelf life and expire.
To be equally traded across the globe, commodities have to be of similar quality, characteristics, and purity—a pork belly in Europe has to be of the same quality as one in the U.S.
The main difference between these commodities and consumer products, such as smartphones, TVs, and cars, is that consumer products vary largely among manufacturers. Commodities are used to make many different items. For example, crude oil is turned into gasoline, iron ore into steel, pork bellies into bacon, and wheat into flour.
Commodities are traded worldwide and regionally at exchanges such as the New York Mercantile Exchange (NYMEX), the Chicago Board of Trade (CBOT), and the London Metal Exchange (LME). Some exchanges handle both soft and hard commodities and others specialize in just one.
So why do prices fluctuate? Commodity prices are driven by worldwide demand. For example, if a region halfway around the world has a severe drought that affects wheat and rice crops, traders know the demand for those commodities will likely go up. They order them at the current price and make money when they sell them at higher prices as the demand becomes greater due to the loss of crops.
This can cause the prices for commodities, including those needed in the U.S. manufacturing economy, to rise and fall. Basically, it comes down to simple supply and demand.
If the U.S. has a strong demand for new cars, the auto industry will buy more steel, which is made from iron ore and other commodities. This can impact the cost of steel you are buying as a manufacturer, even if you are not directly or indirectly working with automotive companies. Their need for more raw materials is raising the price for you as well.
Trade agreements and tariffs, like import or export taxes, can impact commodity prices. Transportation costs can also affect commodity prices. If the oil price goes up, the transportation cost of the raw material for aluminum, which is mainly mined in Africa, Australia, and South America, also increases, which triggers an increase in the cost of aluminum.
As a business owner, what can you do to reduce the impact of pricing changes?
Over the last few years, one thing that has helped stabilize the cost of steel, aluminum, copper, and other materials is recycling, which has reduced reliance on new raw materials and helped minimize large price swings in those commodities. Conservation of energy, such as oil, has also helped. Using alternative energies, like natural gas, wind, and solar has reduced our reliance on oil, putting downward pressure on the cost of oil.
By planning ahead, you can try to avoid seasonal cost fluctuation. Look for suppliers that buy commodities from all over the world, not just regionally. Order and purchase your raw materials when prices are low—lock in your commodities at a lower rate and take delivery at a later time.
Another thing you could consider is getting together with similar businesses, or even competitors, to set up a larger buying group, which gives you more negotiating power when dealing with your suppliers. It also gives your supplier better bargaining power when they shop for those commodities, as they are buying more and have a large picture of the demand.
Implement and use enterprise resource planning (ERP) and material resource planning systems (MRP) to help you manage you material flow. These systems will help you with demand visibility and raw material planning.
To help keep an eye on the global market, use the following sources:
International Monetary Fund (IMF)
The World Bank
Remember, commodity prices are set worldwide, so an issue in one or two countries can impact the prices quickly. Also, currency cost can move the price of commodities.
Don’t drive yourself crazy watching the commodity market. Keep an open eye on the situation and match commodity purchasing to your company’s demand and needs.