Fundamental analysis is a means of examining commodities in an attempt to predict the future path of least resistance for prices. The basis for fundamental analysis is supply and demand.
When looking at prices of a commodity, the concept of supply and demand amounts to a simple equation. However, things get more complicated when you try to forecast prices for the future.
Commodities trade in cycles. Sometimes the supplies of a given commodity like oil or gold will be tight and this will push the prices higher. Other times, there is just too much of a commodity and prices fall. Fundamental analysis and traders like to look at commodities that are trading at multi-year highs or lows. Eventually, the picture tends to change leading to a profitable trading opportunity.
Price movements in commodities using fundamental analysis can be broken down into simple formulas:
- Demand > Supply = Higher Prices
- Supply > Demand = Lower Prices
- Commodities trade in cycles and the ratio of supply and demand has a direct impact on prices.
- If demand is greater than supply, this means higher prices.
- If supply is greater than demand, prices will drop.
- Most professional commodity traders use fundamental analysis to get the big picture and then use technical analysis to time their entries and exits.
Supply of Commodities
The supply of a commodity is the amount that is carried over from the previous year(s) of production (stockpiles) and the amount that is being produced during the current year. For example, the current supplies of soybeans include the crops in the ground and the amount that is left from the past crop years. Typically, the more that is carried over from the previous season, the lower the prices tend to move.
Many factors impact the supply of commodities like weather, the total amount of acres planted, production strikes, crop diseases, and technology. The main thing to remember when using fundamental analysis is that high prices for commodities will lead to an increase in production. Everyone wants to make a profit, so, it is more profitable to produce a given commodity when prices are higher. As you might expect, demand will typically drop as prices move higher. If demand falls enough it will put downward pressure on the price.
Demand for Commodities
Demand for commodities is the amount that is consumed at a given price level. The rule of thumb is that demand will increase when the price of a commodity moves lower. Conversely, demand will decrease as the price of a commodity moves higher. There is an old saying among commodity traders that low prices cure low prices. It means that more of a commodity will be consumed at lower prices, which lowers the supply and thus prices will eventually increase.
Just think about how you would drive more and use more gasoline at $1.50 per gallon than you would at $3 per gallon. Fundamental analysis of commodities is simple economics. Consumption patterns change as the prices of commodities move higher and lower.
Using Fundamental Analysis to Predict Future Prices
Prices will fluctuate in the short term, so it is not easy to make fundamental forecasts of commodities prices for short-term trades. It is even more difficult for new commodity traders to do this. We recommend that new traders, and even experienced traders, use a long-term strategy when using fundamental analysis to forecast commodity prices. You should look for trends that are developing that will cause a shift in supply and demand factors.
To begin your fundamental research of commodities, there are numerous reports that are compiled by government sources – USDA, Department of Energy and the Futures Exchanges. Many of the larger commodity brokers also publish fundamental research for their clients.
It may seem like a daunting task to find all the current data and compare it to previous years to understand how prices reacted under those conditions. The goal is to forecast the supply and demand scenario for the future. It is almost impossible to do that, as you would be competing against experts who have much more data and experience, not to mention resources.
Look for Trends
What you want to do is look for trends in production and consumption and trade with that bias. For example, if the supplies of corn are at a five-year high and we just planted a record amount of acres of corn for this season, it is likely that corn futures will trade with a downward bias. You would be likely want to trade from the short side.
At some point, the price of corn will move to a level that is too low, and demand will increase. Alternatively, there may be weather problems during the growing season that will lower the production of corn. In these cases, you have to be flexible and realize that prices will not go down forever.
The longer-term trends in commodities are easier to spot with fundamental analysis, but we prefer to use technical analysis to capture shorter-term movements in commodities prices. Most professional commodity traders like to know what the big picture is with commodities using fundamental analysis and then they use technical analysis to time their entries and exits. That is the essence of a Techno-Fundamental approach to the commodities markets.