Q&A - What are commodities and how are their prices determined?

A commodity is a product for which there is demand and which is supplied without any clear difference in product quality or standard.

An important feature of a commodity is that its price is determined as a function of its market as a whole – by the interaction of market demand and market supply.

Examples of commodities include:

• Oil
• Copper
• Wheat
• Sugar
• Coffee and tea
• Tobacco
• Cocoa

Commodities are widely traded on specialist commodity markets.

- The suppliers to those commodity markets are the farmers and other producers who grow, harvest or extract the commodity.
- The demand for commodities comes from the manufacturers, wholesalers and other businesses that want to use the commodity in their production processes.

Commodity markets are generally seen as very efficient. The markets quickly respond to changes in supply and demand to find an equilibrium price and quantity. That is how price is determined – by the interaction of demand and supply.

Commodities are good examples to use as a way to consider the factors that affect the level of demand in a market.

Take the example of oil. Oil is one of the most heavily traded commodities in the world. Fluctuating prices have important effects for oil producers/exporters and the many countries and businesses that depend on oil as a key raw material.

What factors affect the demand for oil?

Economic growth
There is a strong link between the demand for oil and the rate of global economic growth because oil is an essential input into many industries. When an economy is expanding, the demand for oil rises. The best recent example of this is the growth of the Chinese economy which led to a surge in demand for crude oil from China.
Similarly, a downturn in economic activity (such as that experienced during 2009) results in lower demand for oil.

Prices of substitutes
Demand for oil is affected by the relative prices of oil substitutes (e.g. the market price of alternatives such as gas or bio-fuels). If, in the longer term, reliable and relatively cheaper substitutes for oil can be developed, then we might expect to see a reduction demand away from oil towards the emerging substitutes.

Changes in climate
It is often said that if the winter in North America is fierce, then the global oil price rises as the USA and Canadian economies raise their demand for oil to fuel household heating systems and workplaces

Market speculation
There is always a speculative demand for oil (i.e. investors hoping for a rise in prices on world markets).