Commodity Prices

The Fundamental Market Analysis

If forecasting commodity prices were something achievable with complete accuracy and precision, then commodities wouldn't be tradable for a profit, since everyone would know the answer in advance. But with help from a variety of price forecasting techniques, we can at least come up with an educated guess on the direction of commodity prices.

The fundamental market analysis is based on supply and demand information. That is, if you expect increased demand for a product, or a scarcity of supplies for a product, then prices should rise. Conversely, decreased demand or excess supplies should drive prices down.

In principle, fundamental analysis is actually simple. The theory is: you take whatever is left over from last year (carryover), and add it to this year's production (supply), then subtract this year's usage. This should give you a good estimate of available stock levels, from which you can draw price projections.

So, fundamental theory =  
            
   (Carryover + Current Year Production)
           -    Last Year’s Usage

           =   Available Stocks

The reality, however, could be much more complicated. To begin with, carryover may be stored in places where it is extremely difficult to measure. Such as farms in remote parts of the world or uncooperative countries. Also, some carryover stock might have suffered from spoilage, rendering the stock unusable. Additionally, there may be insurmountable transportation problems to move the stock to where it's needed.

Production can be just as troublesome. Weather imponderables will have an unpredictable impact on yields. And demand is very tricky to forecast, to say the least.     

Nevertheless, the fundamental analysis is the most helpful method we have to determine price forecasting and long-term market trends. Much of the fundamental trade centers upon the release of key agricultural and financial reports.

The following are some of the major United States Department of Agriculture (USDA) reports:


         REPORT                                   SCHEDULE
    Grain Stocks                           January and end of March
    Prospective Plantings               End of March
    Crop Production                      Monthly, April through December
    Crop Progress                         Weekly, April through December
    Cattle on Feed                        Monthly

    These reports concentrate on a series of supply and demand factors that may be summarized as follows:
 

The Supply Factors

PLANTING PROJECTIONS: most agricultural markets follow a yearly crop cycle, beginning with plantings and concluding with harvest. At the start of the season, the market assesses the supply outlook by estimating acreage expected to be planted in each crop.

CARRYOVER INVENTORIES: if carryover supplies are considered excessive, prices will be held down.

WEATHER/CROP PROGRESS: throughout the growing season, crop projections begin to focus on crop yields. Weather becomes a major factor. As growing conditions become better or worse, prices adjust accordingly.

INTERNATIONAL COMPETITORS: the progress of major foreign crops are closely monitored to assess the supply outlook on a global scale.

GOVERNMENT PROGRAMS: domestic support programs may increase or decrease the amount of acres planted in various crops. Also, export policies and international trade agreements may impact prices.

FOREIGN GOVERNMENT PROGRAMS: just as the United States, other countries may subsidized their exports, bringing additional supplies into the world market.

 

The Demand Factors

LIVESTOCK REPORTS: livestock inventories may impact prices, since cattle, hogs and chickens consume great amounts of corn and soybean meal. As a result, an increase in the number of cattle on feed, would increase the demand for corn and drive corn prices higher.

CONSUMER PREFERENCES: as consumers' food preferences change, the demand for certain crops will be affected. For example, when studies indicated that oats were beneficial for cutting down cholesterol levels, the demand for oats increased leading to higher oat prices for a time.

CURRENCY MARKETS: as the value of the US dollar fluctuates, the relative cost of US agricultural products in relation to foreign agricultural products will change. For example, a very strong dollar may hurt the demand for US crops.

FOREIGN PURCHASES: major countries, such as China and former Soviet Union, are continuously assessed for their potential import demand.

 

 The Technical Analysis

The technical analysis is another method of forecasting prices. The technical trader is a pure technician that is not concerned – as the fundamentalist may be- with understanding why the market moved the way it did. Instead, he attempts to predict market price direction by detecting patterns of price behavior that have signaled major movements in the past.

Technical traders rely on bar charts to identify price trends, special patterns, trend formations, and areas of support and resistance. Price support occurs when there is sufficient buying of the futures contract to oppose a price decline. On the other hand, where a market rallies time and again only to stall out at a certain price level, is known as a resistance area.

You will find text books of encyclopedic dimensions, discussing the interpretation of bar charts for commodity futures trading. Following, is a brief synopsis of the most common price patterns and trend formations:

DOWNTREND: this is a sequence of lower highs and lower lows. In this case, the trendline is drawn along the top of the prices. Again, the closer to 45 degrees the better. Just like the uptrend, a major downtrend will usually show increased volume and open interest.

TOP: indicates a probable end to an uptrend. A double top is even a stronger indicator that a uptrend has ended.

BOTTOM: indicates the probable end of a downtrend. Again, a double bottom would even be a stronger indicator.

HEAD AND SHOULDERS (TOP): signals a major reversal from an uptrend to a downtrend. It's detected by the formation of a four phase pattern. That is, the formation of a left shoulder, the head, the right shoulder, and the penetration of the neckline.

HEAD AND SHOULDERS (BOTTOM): indicates a major reversal from downtrend to uptrend. It's spotted by the same four phase formation, only inverted.

TRIANGLES: there are three types of triangle patterns – the ascending, the descending and the symmetrical. The ascending triangle indicates a breakout of prices on the upside. The descending points to a breakout on the downside. And the symmetrical triangle signals that a major move out of a consolidation phase will occur, but does not uncover the direction of the move.


Technical traders continuously monitor patterns such as these to discern price movements. For example, a head and shoulders top pattern is taking shape, and the trader recognizes the formation of the left shoulder and the head phase. He may choose to go short in anticipation of a major decline in prices.

Critics of the technical analysis method of trading, suggest that technical analysis is a self-fulfilling prophecy, stemming from the fact that it is so widely accepted by its followers. A technical analysis is built on the premise that history repeats itself, and technical traders expect it to continue. They are conditioned to believe that when a major trendline is broken, it's time to jump off and reverse their position. And with a clock's precision they will all reverse their positions, thereby fulfilling its prophecy. 

Next: Methods of Trading