Fundamental commodity forecasting- A tricky business

Fundamental analysis is the process of collecting supply and demand data to establish whether a market is in deficit, equilibrium or oversupply. Fundamental analysis is an essential exercise when it comes to forecasting price direction in commodity markets. In these markets, production is often local while consumption is ubiquitous. Some supply and demand data is better than others. The quality of the data often depends on the source, however; both supply and demand statistics are far from perfect for a variety of reasons.

The supply side

In general, it is easy to get a handle on commodity supplies, because commodity production depends on geographical conditions. Chile has the largest copper reserves in the world because of its geology. Therefore, the nation is the world's biggest copper producer. The United States has the most fertile soil and appropriate weather conditions for growing corn and soybeans. The U.S. the world's number one producer and exporter of these grains. Cocoa beans must grow in a tropical climate, which makes the Ivory Coast and Ghana important countries for cocoa -- between the two they produce over 60% of the world's cocoa. Nickel reserves in Siberia, Russia makes the nation the world's largest producer. There are so many other examples of countries that dominate commodity production. Therefore, when compiling data on commodity supply, knowledge of production data from major producing nations is an essential ingredient in assessing total output and supplies.

Additionally, the level of stockpiles or inventories held in storage of the commodity already produced will round out the total available supply.

There is a tremendous amount of data available from both government and private sources about supply (and demand) for each commodity. The private source data comes from trade organizations or research companies that serve to support each commodity.

The government data comes from agencies of nations around the world. For example, when it comes to agricultural commodities the United States Department of Agriculture (USDA) issues periodic reports on a variety of issues surrounding the supply, demand and progress of crops in many different agricultural commodity markets. Before the release of USDA reports, analysts estimate the data that agency will release. If a USDA report ultimately deviates from analyst expectations prices will move, sometimes violently. Thus, when these reports become public, they tend to move prices. Another example of supply side data would be the information released by the American Petroleum Institute (API) and the Energy Information Administration (EIA) in energy commodities like crude oil, oil products, coal, natural gas and other energies. The API is a private enterprise while the EIA is a U.S. government agency. Some data, generally the government information, is available free of charge while other data is for sale. Supply side information is available for almost every commodity product.

A problem arises in the cases where commodity production occurs in parts of the world where local governments view the data as a state secret.

Governments like Russia and China carefully guard dissemination of supply side data and information on strategic stockpiles of commodities produced and stored within their borders. Therefore, it becomes harder to assess total available supplies and proven and probable reserves in these countries. In other countries, a higher degree of transparency results in robust data that is readily available for all interested parties to see.

The demand side

Commodity demand is ubiquitous -- consumption of raw materials occurs all over the world. The richest nations on earth with the highest growth rates tend to be the largest consumers of raw material staples. China has been a huge consumer of commodities over recent years due to the high rate of growth of the Chinese economy and population. Therefore, demand for commodities is highly correlated with economic growth, currency values, interest rates and other economic data.

When the world economy is healthy and growing, commodity demand tends to increase, and the converse is true during times of economic weakness.

While supply side data comes from concentrated regions, the widespread nature of consumption allows fundamental analysts to utilize various statistical methods, including hedonics, to estimate demand on a global basis. However, it is not a perfect science, and exogenous events can skew the data dramatically at times.

Term structure tells us a lot about fundamentals

A real-time indicator of commodity fundamentals is term structure or the forward curves in various commodity markets. When a market is tight, a condition of backwardation where deferred prices are lower than nearby price illustrates that current demand is greater than current supply. A market in oversupply will exhibit a condition of contango where deferred prices are higher than nearby price. This highlights that supply is greater than demand. Fundamental analysts monitor underlying supply and demand data to pinpoint and predict times when a market will shift from deficit to oversupply and vice versa. When these shifts occur, prices can move.

Commodity price forecasting is a tricky business. The collection and analysis of supply and demand data have limitations in terms of the quality of the raw data. The underlying price action in any commodity reflects these fundamentals and sometimes term structure is the best indicator of fundamental changes to a market.

Update- Exogenous Factors

While supply and demand are the most important factors in the determination of the path of least resistance for commodity prices, other issues can turn fundamentals quickly. Political events are always a source of concern for commodity traders. The sudden imposition of a tax or tariff on imports or exports by a government can change supply and demand characteristics. Variations in the weather or acts of nature can change the fundamental equation. The appearance of a crop disease or logistical problems surrounding bringing a commodity to market can always modify the price dynamics.

Speculative action in a commodity is always a critical concern for market participants in the world of raw material markets. These exogenous factors together with fundamental supply and demand data result in the price solution for commodity prices. Forecasting the price direction of any raw material market is always a tricky business, but that is what makes commodities trading a challenge.