Commodity Price Movements in the Short-Run and Long-Run

This is mostly principles of microeconomics material, but I think it's a useful reminder about what to expect in commodity markets when there is a permanent increase in demand.

Here is a typical model of the short-run and long-run response to an outward shift in the demand curve:

The short-run supply curve (SRS) is steeper than the long-run supply curve (LRS), so at first the price rises from P_a to P_b, and this generally happens fairly quickly as shown on the second graph tracing price movements over time (i.e. the time to move from T₁ to T₂ is relatively short).

In the longer run, supply is more elastic because there is more time to respond (building now factories, stepping up production of existing factories, entry of new firms, etc.). But the elasticity of the LRS curve is dependent upon the commodity in question, so two different LRS curves are shown on the graph. For some goods like oil and other natural resources, we would expect the LRS to be fairly steep since new supplies are difficult to bring into production. But for other commodities like agricultural goods it is much easier to expand supply by bringing new land into production, enhancing productivity on existing farms, and so on, so the curve is more elastic.

Thus, the price path that we expect to see over time depends upon the commodity in question. For some goods, like wheat, we expect to see a price movement from a to b to c, i.e. the new long-run price will be near the old long-run price (as shown in the second diagram). However for other goods like oil or copper, we expect that the price path will move from a to b to c', i.e. the new long-run price will be much higher than the old long-run price (not shown on the second diagram, but easy to visualize).

Some notes:

The increase in price in the short-run depends upon the shape of the SRS, the size of the shift in demand, how much of the good is available in storage, etc. So both the size of the initial run-up in price and the the time it takes, i.e. difference between T₂ and T₁, will vary by commodity.

Some commodities may have a fairly flat SRS. And for some goods the peak price effect may be delayed more than others. The point is that there can be big differences in the short-run response across commodities.

Both the size of the fall in price and the time between T₃ and T₂ will vary across commodities as well. The size of the fall in price in the long-run was described above, it depends upon how easily new land (mines, etc.) can be brought into production and the cost of doing so. So as with the short-run response, we would expect to see quite a bit of difference across commodities in both the magnitude of the price change and the time it takes for full adjustment to occur.

I've been telling a story about trend movements in commodity prices that is based upon movements in fundamentals, a story similar to that shown in the diagrams (as opposed to alternatives such as a speculative bubble or price manipulation story). One argument I've been using against any story that relies upon particulars in, say, the oil market to explain commodity price movements is that the prices of all commodities have moved together, we see the common co-movements even in markets where speculation is outlawed or non-existent for some other reason, the inventory changes have not been consistent with a speculation story, etc. For that reason, whatever it is that is driving commodity prices, it must be common to all markets, whatever is driving prices around cannot be something unique to a particular market (unless it can somehow bleed over into other markets, e.g. if oil is an input to the production of other commodities, we would see the prices of these commodities increase after an oil price increase, though a lag in the relationship would be expected, and, notably for the points that below, the price change would differ across commodities according to relative energy intensity in production). One story out there along these lines is a change in the laws regarding speculative investment that would cause an infusion of speculative activity in all markets simultaneously. But  - in addition to the other objections mentioned above - the movements in commodity prices, at least as I've observed from inspection of graphs, do not seem to be tied closely enough to the change in the laws regarding speculation for this story to hold, though I haven't looked at this evidence in detail and I'm open to more evidence on this issue.

But it also strikes me that the movement in commodity prices is too coordinated to be explained by the graph above, i.e. explained solely by fundamentals. If the graph tells the whole story, the timing of the peaks ought to differ by commodity, the magnitude of the price run-up and subsequent fall should vary across commodities, both in magnitude and timing. The price movements should be similar in character, but with noticeable individual differences. I am relying more on the difference in peaks than anything else since I'm not sure enough time has passed to observe the full long-run response, so one thing I'll be watching for, as a test of the fundamentals story, is whether we see the kind of difference in the peaks and the long-run responses that is implied by differences in industry structure. If the largest movements in prices are too coordinated across commodities, if the size of the run-up, the timing of the peaks, and the characteristics of the longer-run responses look very similar across commodities, then  the fundamentals story will be hard to support as the main driver of the large movements in commodity prices we've observed.

Comments

[John V]

(unless it can somehow bleed over into other markets, e.g. if oil is an input to the production of other commodities, we would see their prices increase after an oil price increase, though a lag in the relationship would be expected).

I'm not sure how you prove this "graphically" but I think there's truth to that from simple on the ground observations...which can be misleading but in this case I don't think so.

Higher oil prices are clearly making other commodities more expensive to bring to market. Moreover, steadily higher corn prices had been reaching critical mass. Probably because of ethanol. This in turn has been making other agricultural commodities more expensive because farming preferences dictated by the market. All these factors have made things like cheese more expensive more expensive...and so on.

Not to pick on ethanol but I think it's very production is keeping corn from dropping and hence stifling a steeper drop between your SRS and LRS lines on the graph. A removal of ethanol subsidies would expose the non-profitability of it and corn prices would drop along with other ag prices and then into the "bleed over" items like cheese.

[Roger Chittum]

If coordinated moves among many commodities suggest their prices are not being moved by "fundamentals," that proves that some unknown force(s) other than "fundamentals" can move the price of a commodity, and there would be no reason to believe that "fundamentals" are the most likely force behind, or even relevant to, a particular price move. Sic transit theory.

[Winslow R.]

If the largest movements in prices are too coordinated across commodities, if the size of the run-up, the timing of the peaks, and the characteristics of the longer-run responses look very similar across commodities, then the fundamentals story will be hard to support as the main driver of the large movements in commodity prices we've observed.

Layout an acceptable trend scenario and if the system is being 'gamed' what will keep it from being 'gamed' in an acceptable manner?

It would be better to determine if the system is capable of being gamed in the short/long run. Given the ability to hide the identity of the the traders and unlimited access to monetary resources, is there any doubt that almost any scenario is possible to create?

Who is storing commodities in China? Who is pumping oil in Saudi Arabia? Who has access to unlimited monetary resources?

Is there any doubt a 'bubble' can be created on whim given unlimited monetary resources, example global housing. How much easier are the much smaller commodity markets to game?

I'd like to understand why labor stands by and allows monetary resources to be funneled into everything but labor. When will the labor 'anti-bubble' pop and allow wages to grow?

[DanC]

Now that we see that the largest movements in prices are too coordinated across commodities, can anyone doubt that the derivative markets are now the playground of those who want low commodity prices ahead of the US elections in Nov?

[hari]

The fundamentals in any given commodity market, in terms of international trade, depends invariably on the transparency of its supply/demand/inventory and how spot price is allocated based on fundamentals.

Compared to coffe, tea, sugar and other commodities in which we've international agreements on supply/demand and transparency of statistical evidence...in crude oil we have a cartel which more or less dictates it own terms and conditions of supply with varying degree of realiability and transparency.

Therefore, I'd suggest that unless Opec cartel is finally replaced by an international oil commodity agreement between suppliers and consumers the current lack of transparency will persist and,(may be) in terms of global strategic perspective, oil will become a weapon of state policy with non-Opec countries also getting into the act.

[spencer]

The demand for most commodities, including oil, is largely a function of world economic growth. Moreover, supply is largely a function of prices and firms expectations of world growth or demand. So you get examples like the recent years or the 1970s when the world economy outgrows its supply lines of oil, copper, corn, etc., etc., etc.. The consequences is soaring commodity prices across the board and higher inflation leading to weak world growth or recessions while with a lag the supply of commodities catches up and supply and demand balance at prices higher than before the imbalance emerged but lower than the peak prices.

Whtry to make your analysis more complex?

[spencer]

The demand for most commodities, including oil, is largely a function of world economic growth. Moreover, supply is largely a function of prices and firms expectations of world growth or demand. So you get examples like the recent years or the 1970s when the world economy outgrows its supply lines of oil, copper, corn, etc., etc., etc.. The consequences is soaring commodity prices across the board and higher inflation leading to weak world growth or recessions while with a lag the supply of commodities catches up and supply and demand balance at prices higher than before the imbalance emerged but lower than the peak prices.

Whtry to make your analysis more complex?

[reason]

But it also strikes me that the movement in commodity prices is too coordinated to be explained by the graph above, i.e. explained solely by fundamentals. If the graph tells the whole story, the timing of the peaks ought to differ by commodity, the magnitude of the price run-up and subsequent fall should vary across commodities, both in magnitude and timing. The price movements should be similar in character, but with noticeable individual differences.

I wonder what the graphs actually look like. Anybody have a good link? I think that the recent fall happened when it became obvious that not just the US economy but also the European economy was slowing (i.e. that the hope that export growth would help keep the US recession mild was likely to be dashed), so that demand expectations suddenly took a dive. Why wouldn't the turning point look the same for all markets? But none-the-less, yes if fundamentals are driving this story we would expect substantial differences between different markets. AFAIK that is the case. But I would like to see the raw data.

[Winslow R.]

spencer wrote: "The demand for most commodities, including oil, is largely a function of world economic growth............Why try to make your analysis more complex?"

Hint of anti-intellectualism? So the system doesn't spin out of control as it has in the past?

World economic growth is largely the function of the manipulation in the supply of monopoly sovereign commodities (currencies). Economic growth is not a mysterious 'force' independent of human control.

I know you already understand this.

The autocratic Chinese can peg their currency very precisely but then lack control over growth. The democratic U.S., not so well on currency pegs yet seem pretty good at pegging growth.

Not sure this growth peg vs currency peg is a bug, or a feature of our democratic society. Would tend towards bug with current leadership, a very good reason to think a bit harder.

[me]

"Hint of anti-intellectualism? So the system doesn't spin out of control as it has in the past?"

It could be as simple as the Chinese shutting down the factories and banning cars for the Olympics. Let's see what happens now thet the Olympics are over. Put the tin foil hats away, that increases the demand for tin.

[Winslow R]

"It could be as simple as the Chinese shutting down the factories and banning cars for the Olympics."

Sure, we could call it the Economic Games and hand out Gold, Silver, and Bronze medals to those companies/workers that remain the quietest while their livelihoods are destroyed due to the lack of proper monetary and fiscal controls.

Not sure the national prestige that comes with helping fight global inflation would provide sufficient compensation to those ordered to sacrifice.