What Really Drives Commodity Prices? Fundamentals Explained
Book: Commodities: Markets, Performance, and Strategies
Editors: H. Kent Baker, Greg Filbeck, Jeffrey H. Harris
Publisher: Oxford University Press, 2018
ISBN: 9780190656010
Fundamentals vs. Everything Else
Chapter 6, by Michael Haigh, tackles one of the most important questions in commodity investing: what actually moves prices? Is it supply and demand fundamentals, or is it bigger macro forces like the global economy, the U.S. dollar, and financial market sentiment?
The answer is both, but the balance shifts over time. And this chapter provides a rigorous way to measure that balance using principal component analysis (PCA).
The Framework: Splitting Fundamentals from Non-Fundamentals
Haigh uses PCA to decompose commodity price movements into two buckets: fundamentals (supply and demand specific to each commodity) and non-fundamentals (macro economic conditions, dollar movements, and liquidity factors).
The analysis includes 23 different financial variables across volatility indexes, currencies, carry trades, bonds, equities, and credit markets. Three main factors emerge: a macro factor (capturing the relationship between global equities and volatility), a dollar factor (capturing currency movements), and a liquidity factor (capturing interest rate differentials).
The results are then measured as: how much of a commodity’s price movement can be explained by these three non-fundamental factors? Whatever is left over gets attributed to the commodity’s own fundamentals.
Oil: The Most Interesting Case
Brent crude oil shows the most dramatic shifts between fundamental and non-fundamental influences.
In the early 2000s, before commodities became a popular financial asset class, fundamentals explained about 90 percent of oil price movements. The dollar and liquidity factors accounted for the other 10 percent. Oil was a deeply physical market.
Then came September 2008 and the Lehman Brothers bankruptcy. Global growth concerns suddenly dominated oil’s price formation. The macro factor jumped to explaining 55 percent of Brent’s price movements. Fundamentals took a back seat. If you were an oil analyst counting barrels to forecast prices, your job suddenly became much harder because more than half the price action was driven by factors that had nothing to do with oil supply and demand.
The euro crisis in 2011 did the same thing. Fundamentals again dropped while macro concerns dominated, explaining 20 to 60 percent of oil price movements.
By late 2013 and into 2014, Brent appeared to return to a more normal environment with fundamentals largely driving prices again.
Natural Gas: The Polar Opposite
U.S. natural gas is the extreme contrast to oil. It is a contained regional market, dominated by domestic weather patterns rather than geopolitics or global macro. If the eurozone economy weakens in winter, it has essentially zero impact on how much natural gas Americans use for heating.
The PCA results confirm this. Fundamentals explain close to 100 percent of natural gas price movements almost all the time. Even during the 2008 financial crisis, the macro factor only explained 10 to 15 percent. Natural gas is about as “pure fundamental” as a commodity market gets.
Copper: Sensitive to Global Shocks
Copper falls somewhere between oil and natural gas. Before the Lehman crisis, fundamentals dominated, though the dollar had a significant influence. The euro crisis in 2011 heavily impacted copper, similar to what happened with oil. By late 2013 and early 2014, fundamentals returned to the driver’s seat.
China’s equity price collapse in August 2015 briefly reduced the fundamental influence, but overall, copper returns to fundamentals fairly quickly after global disruptions pass. It takes a major global event to knock copper off its fundamental trajectory.
Gold: The Outlier
Gold is a massive outlier among commodities. What would be considered “non-fundamental” for other commodities is actually fundamental for gold. Changes in the U.S. dollar, inflation expectations, and interest rates are not background noise for gold. They are the main drivers.
The PCA profile for gold looks completely different from any other commodity. All three non-fundamental factors (macro, dollar, liquidity) are significant throughout the study period. The dollar factor alone is often the single biggest influence on gold price changes.
This makes gold unique. You cannot analyze it the same way you analyze oil or wheat. Gold competes with interest-bearing assets as a store of value, so monetary policy and currency movements are its fundamentals, not supply and demand in the traditional sense.
Agriculture and Livestock: Mostly Fundamental
Agricultural commodities like wheat are similar to natural gas. They are relatively isolated from broader macro influences. Fundamentals explain more than 90 percent of wheat’s price variance. The only exceptions were during the subprime crisis and the euro crisis, when macro temporarily spiked in importance.
As of December 2016, the numbers tell a clear story. Cotton was 99.10 percent fundamental. Live cattle was 99.42 percent. Coffee was 95.94 percent. Natural gas was 99.61 percent. The average across all 22 commodity markets in the Bloomberg Commodity Index was 87.13 percent fundamental.
Supply vs. Demand: What Drives Oil?
The second half of the chapter gets even more specific. Given that oil is mostly driven by fundamentals, how much comes from supply versus demand?
Haigh uses a separate PCA analysis with over 100 forward-looking asset prices as proxies for oil supply and demand. These include equity prices of exploration companies, oil drillers, oilfield services firms, and currencies of oil-producing countries (proxies for supply), along with equities in utilities, chemicals, airlines, trucking, and retail (proxies for demand).
The logic is simple but clever. When oil prices fall, different companies react differently depending on whether the drop came from oversupply or weak demand. If oil drops because of oversupply, demand-related companies (airlines, trucking) should benefit from lower fuel costs. But if oil drops because demand is weak, those same companies would also suffer.
The analysis maps to historical events remarkably well:
- July 2008: Oil peaked at $147/barrel. Demand concerns explained about 40 percent of price variability.
- September 2008: Lehman bankruptcy. The market focused entirely on demand destruction. Supply had zero bearing on prices, while demand explained 70 percent.
- February 2011: Libyan civil war dropped production from 1.6 million barrels/day to nearly zero. Supply’s explanatory power shot from 0 percent to 50 percent in one month.
- November 2014: OPEC decided not to cut production. The supply factor’s explanatory power roughly doubled.
- Mid-2015: Chinese equity crashes shifted focus to demand weakness.
- January 2016: Iranian sanctions lifted. Supply explained a near-record proportion of oil’s price variance.
As of early March 2016, about 65 percent of oil price variation came from supply and about 6 percent from demand. Supply characteristics explained over 90 percent of the combined fundamental contribution.
Why This Matters for Investors
The practical importance of this analysis is huge. If you are investing in commodities for diversification, you need to know whether your commodity is currently trading on its own fundamentals or getting pushed around by broader financial markets.
When commodities are deeply fundamental (like they were in 2016), they offer genuine diversification benefits. Their price movements are driven by their own supply-demand dynamics, which are largely independent of stock and bond markets.
But during crises, many commodities start moving with equities and other financial assets. The diversification benefit shrinks exactly when you need it most. The 2008 crisis was a painful lesson in this reality.
The chapter also highlights that “financialization” of commodities (the flood of institutional money into commodity markets since the mid-2000s) appears to have, at most, a transitory impact on prices. Supply and demand fundamentals remain the dominant long-term force across most commodity markets.
My Take
This is one of the most practically useful chapters in the book. The PCA framework gives you a real, data-driven way to assess whether a commodity market is trading on fundamentals or being pushed by external forces. That is genuinely useful information for anyone making investment decisions.
The gold finding is especially striking. It confirms what many investors intuitively understand: gold is not really a “commodity” in the same way as oil or copper. It is more of a financial asset that happens to be a physical metal. Treating it the same as other commodities in a portfolio is a mistake.
And the supply-demand decomposition for oil is fascinating. It shows that the popular narrative about oil prices is not always right. When everyone was blaming OPEC and supply gluts for the 2014-2016 oil crash, demand weakness was also playing a role, especially during the Chinese equity declines. The data tells a more nuanced story than the headlines.