The Economics Behind Commodity Markets
Book: Commodities: Markets, Performance, and Strategies
Editors: H. Kent Baker, Greg Filbeck, Jeffrey H. Harris
Publisher: Oxford University Press, 2018
ISBN: 9780190656010
Not One Market, Many Markets
Chapter 2, written by Florian Ielpo, covers the economic fundamentals of commodity markets. And one of the first things it makes clear is that “commodities” is not one big market. It is a collection of very different markets that happen to share the label “raw materials.”
Commodities are usually grouped into four sectors: energy (crude oil, gasoline, heating oil), industrial metals (copper, iron ore), precious metals (gold, silver, palladium), and agricultural products (corn, wheat, pork bellies). Each sector responds to its own unique factors. Weather drives grain prices. Extraction technology shapes oil costs. Risk perception in financial markets influences gold demand.
Despite being so different, these markets do share some common ground. Global economic activity affects all of them to some degree. The 2007-2008 financial crisis showed this clearly. Commodity prices surged in the lead-up to the crisis and then collapsed when the global economy tanked.
The Futures Curve: Backwardation vs. Contango
Most investors do not buy physical commodities. They buy futures contracts. And to understand commodity investing, you need to understand the futures curve.
The futures curve shows the prices of futures contracts at different maturity dates. It can slope upward (contango) or downward (backwardation). This matters because it directly affects your returns.
Backwardation means futures prices are lower than the spot price. When you hold a futures contract and it converges toward the higher spot price, you earn a positive “roll yield.” Think of it as getting paid to hold the position.
Contango is the opposite. Futures prices are higher than spot. As the contract converges toward the lower spot price, you lose money on the roll. It is like paying a fee to maintain your position.
The chapter discusses two big theories about why the curve slopes the way it does.
Keynes and Normal Backwardation
John Maynard Keynes argued that commodity producers naturally want to sell futures to hedge their inventory. They are willing to accept lower futures prices than the current spot because they value the certainty. This creates downward pressure on futures prices, resulting in a naturally backwardated market.
The theory makes intuitive sense, but the data does not always support it. Between 1990 and 2016, some markets (oil, corn) were frequently backwardated, but gold was almost never in backwardation. Copper switched back and forth.
The Theory of Storage
An alternative explanation comes from Kaldor (1939) and Working (1949). They focused on inventories. When you hold physical commodities in storage, you get what is called a “convenience yield,” which is the benefit of having stock on hand to meet unexpected demand. But you also pay storage costs.
The theory predicts that the futures curve slope depends on the balance between convenience yield and storage costs. As inventories grow, the marginal benefit of holding more stock decreases. At some point, the costs outweigh the benefits, and the market moves into contango.
The data supports this theory reasonably well. For oil, copper, and corn, there is a clear inverse relationship between inventory levels and the basis (the difference between spot and futures prices). When inventories go up, the basis tends to go down. Gold is the exception, because gold is not really consumed in the same way. It is mostly held as a store of value.
What Drives Spot Prices?
Beyond the futures curve, the chapter digs into what moves actual commodity prices. Four factors stand out:
1. Technology
This is probably the most important long-term driver. Technology determines production costs, which set a floor for commodity prices. Prices cannot stay below production costs for long because producers go bankrupt and supply shrinks. But prices also cannot stay too far above production costs because high prices attract more production.
A great example is shale oil. Between 2013 and 2017, collapsing oil prices forced U.S. shale producers to dramatically cut costs and improve efficiency. Technology improved because it had to.
2. Supply Shocks
Temporary disruptions to supply can cause big price moves. OPEC restricting oil production in the 1970s sent prices soaring. The increase in U.S. shale oil production between 2015 and 2016 pushed prices down. Supply scarcity tends to increase not just prices but also volatility.
3. Demand
When global GDP growth is higher than usual, demand for commodities rises and prices go up. The research shows an interesting pattern: commodity returns tend to be strongest during late economic expansion and at the start of recessions. When central banks raise interest rates to cool the economy, commodity prices often benefit in the short term.
4. Speculation
Since the mid-2000s, institutional investors have poured money into commodity markets for diversification. The question is whether these “index speculators” are actually pushing prices around. The research is mixed. Some studies (like Singleton, 2013) found that investor flows significantly affected oil prices. Others (like Knittel and Pindyck, 2016) found limited impact. The debate is still open.
The Commodity Risk Premium Puzzle
Do commodities reward investors over the long run? If so, where does that reward come from?
Stocks pay dividends. Bonds pay coupons. Commodities do not pay anything. So if there is a risk premium, it has to come from somewhere else.
Gorton and Rouwenhorst (2006) found that a diversified commodity portfolio between 1959 and 2004 returned about 14 percent annually, with 10 percentage points coming from the positive basis (backwardation) over that period. But when you look commodity by commodity, average returns are mixed. Some win, some lose.
There is also the Prebisch-Singer theory, which predicts that commodity prices should decline over the long term. The logic is that demand for basic goods does not grow much as incomes rise, while technological progress increases supply. This would mean no long-term risk premium for commodities. Testing this theory over four centuries of data shows mixed results. Fewer than half of commodity markets show significant downward price trends.
Commodities and the Economy
The final section of the chapter looks at how commodity prices interact with economic growth. This is mostly explored through oil markets.
The relationship is asymmetric. A 10 percent surge in oil prices can lead to roughly a 1.5 percent decrease in real GDP. But a 10 percent drop in oil prices does not produce an equivalent boost to growth. Oil prices dropped 70 percent during 2014-2015, yet U.S. GDP growth barely exceeded 2 percent.
There is a fascinating debate between economists James Hamilton and Lutz Kilian about this. Hamilton focused on supply disruptions as the main cause of oil shocks. Kilian argued that about 75 percent of historical oil price shocks have actually been demand-driven. Not the demand we usually think of (people wanting more oil), but “precautionary demand” based on fears about future supply shortfalls.
This distinction matters because supply shocks and demand shocks affect the economy differently. A supply shock temporarily lowers GDP. A global demand shock initially boosts GDP (because demand is strong) but eventually leads to recessionary pressures.
My Take
This chapter is dense but important. The key insight for me is that commodity markets are far more complex than they appear. You cannot just look at supply and demand in isolation. You need to understand the futures curve, inventory dynamics, technology trends, and the macro environment.
The debate about speculation is particularly relevant. As more institutional money flows into commodities, the line between “financial asset” and “raw material” gets blurrier. Whether that is good or bad for markets is something researchers are still figuring out.