Demand shocks have been the dominant force behind non-oil commodity price cycles, according to a 145-year empirical analysis. They have been linked to global recessions or recoveries and displayed persistent effects of 10 years or more. The second most import driver has been so-called “inventory shocks”, which have been less long-lived. Supply shocks have not played an important role in driving long-term price deviations of most commodities. They were mostly commodity-specific and transient.

Jacks, David and Martin Stuermer (2016), “What Drives Commodity Price Booms and Busts?”, Federal Reserve Bank of Dallas Research Department Working Paper 1614

The post ties in with the subject of information efficiency, particularly through tracking macroeconomic trends.

The below are excerpts from the paper. Headings and some other cursive text has been added for context and convenience of reading.

Long-term perspective

“This paper is the first in providing evidence on the drivers of real commodity prices in the long-run. To this end…we analyze a new data set of price and production levels for 12 agricultural, metal, and soft commodities… (barley, coffee, copper, corn, cotton, cottonseed, lead, rice, rye, sugar, tin, zinc)…from 1870 to 2013… In marked contrast to this literature which generally uses monthly data over decades, we use annual data over the past 145 years….The individual price series are expressed in US dollars and deflated by the US Consumer Price Index.”

Stylized shocks

“Here, structural vector autoregressive models are used to decompose changes in commodity prices into different types of shocks… The historical decomposition shows the contribution of each shock in driving booms and busts in each real commodity price series over time.”

N.B.: Vector Autoregression (VAR) is a multivariate, linear representation of a vector of observable stochastic time series variables and their lags.  Structural Vector Autoregression (SVAR) makes explicit identifying assumptions in respect to the parameters of a VAR, based on theory and plausibility, such that one can isolate estimates of specific shocks and their effects.

“We…specify three orthogonal shocks to real commodity prices based on long-run restrictions, namely a commodity demand shock, a commodity supply shock, and commodity-specific inventory or other demand shock…The identification scheme is based on the idea that increases in real commodity prices induced by increases in global demand for commodities set in motion two processes: investment in new productive capacity and productivity-enhancing technological innovation.”

“We use these restrictions in the same way to identify three mutually uncorrelated shocks to real commodity prices:

  • Positive commodity demand shocks… representing an unexpected expansion in global GDP …potentially have persistent effects on both global GDP and global production of the respective commodity…induce higher global commodity production, and serve to increase real commodity prices;
  • Positive commodity supply shocks have limited effects on real global GDP, generally induce persistently higher global commodity production, and serve to decrease real commodity prices; and
  • Positive inventory or commodity–specific demand shocks have limited effects on real global GDP, generally induce a muted response in global commodity production, and serve to increase real commodity prices… We assume that price changes due to this inventory or commodity-specific demand shock exhibits transitory but not long-run effects on global production of the respective commodities.”

Empirical findings

“Our results indicate that commodity demand shocks and inventory…shocks rather than commodity supply shocks are the primary drivers of real commodity price booms and busts…[which is consistent with] more recent literature [that] finds that demand shocks are the major source of fluctuations in prices for crude oil.”

“On average, the effects of commodity demand shocks are the most persistent, with effects lingering 10 years or more.”

“Although the proportional contribution of the commodity demand shocks naturally varies across the different commodities, their accumulated effects broadly follow the same pattern with respect to timing across the 12 commodities. Thus, commodity demand shocks affect real commodity prices to different degrees, but they affect the real commodity prices at the same time. These results then suggest that commodity demand shocks have a common source.”

“This interpretation of the accumulated commodity demand shocks is in line with what economic history has to say about fluctuations in global output.

  • Thus, there is a long downturn in prices throughout the 1870s driven by the accumulated effects of negative commodity demand shocks during the first—but somewhat forgotten—great depression.
  • Likewise, the early 1930s bear witness to the accumulated effects of a series of negative commodity demand shocks which sent real prices plummeting and which are clearly attributable to the—second—Great Depression.
  • From 1970, negative commodity demand shocks are evident in the late 1970s, the early 1980s, and the late 1990s, respectively corresponding to the global recessions of 1974 and 1981 and the Asian financial crisis of 1997.
  • These are followed in turn by a series of positive commodity demand shocks emerging from the late 1990s/early 2000s due to unexpectedly strong global growth, driven by the industrialization and urbanization of China.
  • Finally, the lingering effects of the Global Financial Crisis are also clearly visible in the series for the accumulated effects of commodity demand shocks.”

Inventory or commodity-specific demand shocks are an important driver in commodity price booms and busts for most of our agricultural and soft commodities…particularly in the short- to medium-run. For the most part, this type of shock follows idiosyncratic patterns across the examined commodities. Detailed historical accounts for base-metal markets provide evidence that this type of shock can also be attributed more often than not to changes in inventories by cartels, governments, and/or private firms.”

“The accumulated effects of commodity supply shocks do not play an important role in driving deviations in long-run real prices from their underlying trend for most of the commodities under consideration. Generally, this type of shock is idiosyncratic in the timing of its effects and only has a transient effect on real prices. That is, they only drive short-run fluctuations. However, there are two exceptions: commodity supply shocks dominate the formation of sugar prices and it is the second most important driver for tin prices.”

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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds. At present he is head of research and quantitative strategies at Macrosynergy Partners.