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The commodities market is renowned for volatility… Here's why the prices of commodities experience such a rollercoaster ride

by , 16 September 2014

As an investment option, commodities are for investors who're willing to take on risk.

Their prices can bounce around in short periods of time. They can soar as quickly as they can tank.

So why do the prices of commodities move around so much?

Let's take a closer look…


The rollercoaster ride of commodity prices


You don’t have to look far to find examples of extreme price volatility with commodities. This year alone, the price of iron ore is down an astonishing 40%.

And it’s not just commodities from the ground that are subject to this crazy price action. Food commodities can be just as bad.

The commodities market is cyclical. There’s a close link between behaviour of the business cycle and commodity prices.

For the majority of commodities from the ground, this business cycle can take decades to complete. On average, you’re talking 25 to 30 years!

Let’s have a look at iron ore as an example. Look at the chart below…


Chart of iron ore prices


From looking at the above chart, you can see in the last cycle, prices peaked in 1983. It took the market another 20 years to get back to that level!


Why prices of commodities behave the way that they do


When there isn’t enough of a particular commodity coming out the ground to meet overwhelming demand, prices soar.

When prices are high, banks will gladly fund projects to keep production up and fund exploration when profits are so big.

This also attracts exploration companies to the stock market, Bengt Saelensminde in The Right Side explains. And existing commodity companies can easily raise cash from shareholders to find and exploit new sources.

From finding a new source to actual production takes a long time. Buyers know this and it worries them.

They start to buy into available stockpiles as if they can’t get enough raw materials. Their products are at risk. This is great news for producers.

Eventually when the new supplies start to come online, there’s no longer such a squeeze on supply. This leads to demand falling and, in turn, prices. But the production companies have to keep mining. After all, they’ve put so much money into exploration and production.

These production companies need to cover the vast amounts of money they’ve invested in their businesses, regardless of the prices of the commodities they’re mining.

And this is why the prices of commodities are so wildly volatile.

So there you have it, why the prices of commodities experience such a rollercoaster ride.

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The commodities market is renowned for volatility… Here's why the prices of commodities experience such a rollercoaster ride
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