In general, there are four main factors that affect commodities prices:
- Supply & Demand
- Inventories & Stocks
- Currency
- Inflation
Let's go down the list to best understand their harmony. We'll start in a tiny, isolated town of farmers and families.
Supply and Demand in Commodities
If supply and demand are in perfect balance (assuming no other factors affect the price), commodities prices would go nowhere. Take corn for example. If the demand for corn was exactly one ear each day, and a farmer could grow exactly one ear every day, supply and demand would be in balance and the price would not change.
With no external factors on this transaction, the farmer of the corn could not raise or lower his price because he must sell one ear each day or he loses money. (The cost of growing the corn.) By raising the price, he would drive the purchaser away to another farmer at a lower price. By lowering the price, he would increase demand for his corn. Still, he wouldn't be able to meet that demand; so, buyers would go back to the other farmers and the price would not change.
We're making huge, unreal assumptions about how the real world works because nothing in economics is devoid of external forces; but, you get the idea. If supply and demand are in balance and there are no external factors, prices can't change.
Inventories and Stocks
Let's assume that supply and demand are not in balance. Instead, there's a draught this year and half the farmers can't grow corn. The demand is still strong — the people have to eat. Supply and production are short — half of what it should be. And because nobody stocked up on corn, creating reserves for this very scenario, prices rise to drive demand down.
Ten years later, another draught hits. This time, however, the town was prepared. Half the farmers can't grow corn; but, those farmers had built silos and stocked them for emergencies. Though production has temporarily shut down, the supply is fine for the amount of demand. Inventories begin to fall; but, nobody is worried because the draught is a temporary problem. Prices don't change.
Of course, if production remains offline for too long, inventories will begin to fall to alarming levels. In that case, prices will rise to quell demand and preserve inventories until production can ramp up again.
Currency
We'll now expand our scenario. Rather than having a single, self-sufficient town, we have three countries — Import (the "Eaters"), Export (the "Producers"), and Investment (the "Investors"). All three countries have different currencies.
Sometimes, Investors believe that Export offers the greatest investment opportunities; so, the people of Investment convert their money into Export currency, driving the value of that currency higher. In Export, the Producers don't really notice, except that they have a little more coin in their pocket. Why? Let's explain.
When the people of Investment keep their currency at home, Import and Export are not affected. With supply, demand, and stocks in perfect balance, prices never change. The exchange rate between the two countries is one Import dollar for one Export dollar.
Enter the Investors, putting their money into the country of Export. When that happens, the currency of Export begins to rise against that of Import (and that of Investment). Without getting too technical, it comes down to supply and demand. As more people want Export currency and less people want the other two, the Export currency rises against the other two (or, the other two fall against that of Export).
Now that corn price has to change, not because supply and demand are out of balance, but because the farmer from Export still wants one Export dollar for an ear of corn but the folks in Import can't convert $1 Import into $1 Export because of the currency fluctuation. Instead, the conversion is now at, say, $1.50 Import to $1.00 Export, and for the people of Import, the price of corn (commodities) just went up 50%.
Ouch.
And Then There's Inflation
Now, let's assume that the world is perfect. Supply and demand are in balance, inventories are perfectly managed, and currencies never fluctuate. But, inflation chugs along at 3% a year. How will that affect the price of commodities?
If you said that they'd go up at 3% a year, give yourself a balloon — you now understand how commodities work. The corn farmer has to raise his prices 3% a year because his cost of living — electricity, fertilizer — is going up by 3% a year. People can pay that increase without feeling it because everything (including their incomes) is going up 3% a year.
This Is All Too Macro For Me
I know — Buffett says that investors should ignore the macro stuff. That's all well and good; but, this is one area in which Buffett's actions don't match up precisely with his words. Buffett doesn't ignore the macro stuff or commodities. In fact, he tends to have very strong opinions on both, and takes actions based on those opinions.
Take, for example, his 1997 purchase of silver. World mine production of sliver was 16,500 metric tons. World consumption was 857 million troy ounces. A quick math conversion (32,500 troy ounces = 1 metric ton) tells you that, in 1997, the world was producing 16,500 metric tons while demand for the metal was 25,163 metric tons. Warehouse stocks were being depleted, down about 40% through 1997.
