How Commodities Are Priced?

Commodity prices play an important role in the global economy as they influence the prices of essential raw materials in the products used in our day-to-day lives, impact businesses, and consumers. 

Commodities can be bought and sold in the commodity exchanges, similar to trading stocks in the stock market. The commodity prices, however, are greatly influenced by the supply and demand of the commodities in question. Any change in the supply or demand of a commodity impacts its prices. On the other hand, financial asset prices are driven by factors such as company earnings, interest rates, and investor sentiment. 

Read along to learn more about the major factors affecting commodity prices and how commodity pricing mechanism works.

How are Commodity Prices Determined?

The Commodity pricing mechanism plays a key role in the global economy as the prices influence everything, starting from the cost of our day-to-day food products to fuel prices. 

Commodity prices are mainly categorised into two types - Spot Price and Futures Price. Let us understand their significance in detail and how they are different.

Understanding Fixed Price and Floating Price in the Commodity Market

Fixed Price: A fixed price in a commodity market refers to a pre-determined price of a commodity for a particular delivery date. This price is fixed regardless of the market condition or spot price of the commodity on the delivery date. 

This pricing method in commodities ensures that negative price movements do not impact either party.

Floating Price: The floating price method in the commodity market refers to a price which is settled as per the pricing movements of the market. This price is calculated as an average of the reference price over a set period. 

This commodity pricing mechanism is mostly effective in long-term contracts as longer duration increases the chance for price fluctuations.

What is Floor and Ceiling Price in Commodity?

The ceiling price refers to the maximum price set for a commodity. The floor price, on the other hand, is the minimum price set for the commodity. In this pricing mechanism, both parties - the buyer and seller - set a ceiling price and floor price for the commodity. When the price of the commodity crosses these set prices, both parties will share the profits/losses from the trade. If the price remains at the set price, both parties will settle the contract according to the market price upon delivery.

Market-Based Pricing in Commodity Market - How it Works?

Market-based pricing strategy in commodity markets is determined by the demand and supply dynamics in the global commodity exchanges. This approach indicates the current market price of the product based on the market conditions which is often influenced by economic, political and environmental factors.

For example, the production and availability of a product largely depends on weather conditions, geopolitical events, natural disasters and even production level. Hence, the demand for a commodity is directly dependent on economic growth, industry need, seasonality and consumer preferences.

Benchmark Pricing

Benchmark pricing is a commodity pricing mechanism where the prices are set based on globally accepted reference prices. This acts as a reference for both buyers and sellers.

For example,

In the oil market, prices of commodities are often benchmarked against the Brent Crude (used in Europe) or WTI Crude (used in the U.S.).

Similarly, in the gold commodity market, the prices are compared to the London Bullion Market Association (LBMA) price.

These benchmarks provide consistency and help businesses manage price risks effectively.

Cost-Plus Pricing

Cost-plus pricing is a common mechanism followed in the commodity market where the final price of a commodity includes the cost of raw materials, processing cost, and a profit margin. This mechanism ensures that there is a stable pricing model for the producers.

For example, 

The price of gasoline is often based on the cost of crude oil refining and distribution.

Role of Speculation and Hedging in Commodity Pricing

The pricing of commodities is influenced by two key factors - speculation and hedging. Hence, understanding these two elements is very important to navigate the commodity market. 

Impact of Speculating in Commodity Pricing 

• Speculating is a strategy of buying and selling commodities to profit from price fluctuation during market volatility. 
• Speculators include traders, institutional investors and hedge funds. However, these speculators are not involved in the production and consumption of these commodities.
• For Example - A speculator expects the price of oil to go up as a result of geopolitical tensions and purchases crude oil futures. When the price goes up, they sell at a profit. If prices unexpectedly go down, they lose money.

Impact of Hedging in Commodity Pricing

• Hedging is a strategy traders use to reduce the risk of price fluctuations in the commodity market. 
• In simple terms, hedging is a futures contract made between two parties to buy or sell a set of commodities at a certain price. 
• Through this contract, the manufacturers can ensure to get the commodities for the production while the seller can ensure to have a buyer for their products.
• For example - Several airline companies hedge against fuel price fluctuations by buying futures contracts on jet fuel. This could guarantee a fixed price, avoiding price volatility.

Major Factors Affecting Commodity Prices

Commodity Prices are largely affected by the fluctuation in supply and demand dynamics, currency, global economic conditions like GDP, inflation and more. Here is a more detailed breakdown of the factors affecting commodity prices:

• Supply and Demand Dynamics

The supply and demand dynamics have a significant role in determining commodity prices. The higher the demand for a commodity, the higher the prices and vice versa.

For example,

If there is a supply shortage for any agricultural product due to weather conditions/natural disasters, the price of that particular product will automatically increase. This is because the demand is higher than the supply. 

Similarly, if there is an abundant supply of any commodity, there will be a decrease in the commodity price.

• Global Economic Conditions

Economic conditions such as Gross Domestic Product (GDP), Inflation and interest rates also affect commodity prices. For example, in a growing economy, the demand for commodities like agricultural products, oils and metals is always high, leading to higher prices. 

Similarly, when an economy is going through inflation, it drastically impacts commodity prices—generally leading to higher prices. This is due to increased production costs, currency depreciation, disruption in the supply chain and higher demand.

• Geopolitical Events and Policies 

At present, most countries are part of the global economy. Although the increase in trade, import, and export have proven beneficial for commodities, events like wars, conflicts, trade restrictions, or political uncertainty have always posed a significant risk.

There are situations in which two countries might go to war, disrupting supply chains, or halting the production of commodities. Similarly, political instability and uncertainty can hurt commodities and lead to higher prices.

The Russia-Ukraine war is a recent example of geopolitical risks in commodity markets. The war between the two countries led to a significant rise in global food and fuel prices in the first half of 2022.

▶️ Read more on Impact of Geopolitics and Natural Disasters on Commodities

• Currency Fluctuations

Commodity prices are also impacted by fluctuations in currency, both globally and locally. Any changes in exchange rates affect the import and export costs, influencing supply and demand. Several global commodities, such as oil and gold, are priced in U.S. dollars. Therefore, a stronger USD makes commodities more expensive for buyers as compared to other currencies. This leads to lower prices. Conversely, a weaker USD makes them cheaper, leading to higher prices.

Currency fluctuations also affect the production costs. A weaker currency means higher importing costs and, hence, higher commodity prices. This can impact global trade, particularly in emerging markets. 

For example, when the USD strengthens, there is a decline in oil prices as oil becomes expensive for other countries and vice versa.

• Weather and Natural Disasters

Weather and natural disasters have a major impact on commodity prices as they largely disrupt the supply and demand dynamics. Agricultural commodities like wheat, corn, coffee, etc, are highly susceptible to extreme weather conditions like drought, flood and frost. 

Similarly, energy commodities (oil, natural gas) and metal commodities (gold, silver, copper) are volatile to natural disasters like earthquakes, hurricanes, floods, storms, etc. These natural disasters can damage the infrastructure, halt production and disrupt the supply chain. This can result in lower production and supply, thus driving higher prices.

Overall, unpredictable weather conditions and natural disasters can contribute to fluctuations in the prices of commodities, thus making the commodity markets more volatile. 

Commodity Pricing Examples in Different Markets

Disclaimer: This content is solely for educational purposes. The securities/investments mentioned above are not recommendations.