Do Supply and Demand Fundamentals Explain Price Movements of Agricultural Commodities?
Economics principles dictate that prices are determined by the principles of supply and demand. However, does this theory align with the market dynamics in practice? To what degree do supply and demand fundamentals truly drive the prices of agricultural commodities, and what factors contribute to short-term price volatility? We talked to Scott Irwin, Laurence J. Norton Chair of Agricultural Marketing University of Illinois, and Doug Christie, agribusiness executive and author of Agricultural Commodities Focus, for a deep dive on supply and demand fundamentals, volatility, policy changes, and other factors that move the agricultural commodities market.
The transcript below has been abridged and edited for improved clarity. For the full version of the interview, please refer to our video podcast.
Hedder: To what extent do supply and demand fundamentals explain the price movements in the agricultural commodities markets right now?
Irwin: Almost all of the price movements are driven by fundamentals. I say “almost” because there's always some short term noise from hour-to-hour, day-to-day that is probably driven by non-fundamental factors. But the evidence is pretty clear that these markets are dominated by the fundamentals, particularly once you get past very short run intervals.
Hedder: Are there any specific commodities or instances where this relationship seems weaker than expected?
Irwin: Over the years, there's probably been more questions about prices and fundamentals in the cattle complex here in the US than anywhere else. I think it is harder to get a handle on the fundamentals there because of the very long cycles of cattle production, so that makes very long lag times between production decisions and reaching the market. The data is not as rich on exactly what's going on day-to-day, week-to-week in the cattle complex. So, that's probably the market that's had the most concerns over the years.
Hedder: From a trader’s perspective, to what extent have you found that supply and demand fundamentals tend to be solid predictors of price movements in futures markets?
Christie: Over the long run, supply and demand fundamentals are what drive prices and ultimately determine where things settle. But I certainly believe that in the short run, there can be a lot of volatility around those same supply and demand fundamentals while the market's trying to weigh and sort out where the final resting spot may be.
Hedder: Are there times where regulatory changes or interventions have overridden the supply and demand signals and influenced futures prices?
Christie: Policy changes certainly can impact markets and prices. One large example of that is in the area of biofuels where we may have a tight supply and demand situation for a product like corn or soybean oil, and really you wouldn't think based on prices that you'd be diverting that supply into another channel. But if we have an environment where there's a mandate or an incentive to move things into a non-traditional channel, you can see that flow and impact prices. So, there certainly is a potential for policies to impact what would've been the existing supply and demand fundamentals.
Hedder: Complex factors such as climate change, evolving consumer preferences, shape the agricultural landscape. How do you account for these longer term trends within short-term supply and demand?
Irwin: It's probably on the supply side that the problems are most acute because climate change can change weather patterns, and weather is so critical to supply trends and projections in the agricultural sector. We are always dealing with weather uncertainty, and if that is magnified because of the impacts of climate change, that just makes market analysis much harder.
Hedder:Market sentiment and behavioral biases are known to influence trading decisions. How much of a role does psychology play in driving short-term price fluctuations? And how does this compare to what economic theories suggest?
Christie: Psychology is a big factor in day-to-day trading, no doubt. Fear and greed are big drivers in making market decisions for traders. So anytime you have those emotions or those sentiments prevailing it can move prices. And I certainly believe that in the short term, psychology and expectations can be a big driver.
An example would be we might have a weather event, let's say a hurricane or a late season storm, and that weather event is having a fundamental impact, but the market's really trying to determine, is the impact greater than expected or less than expected? Sometimes an event that comes to take place really can be a disappointment to the market if it's less than what was anticipated. And so, you get this disappointment effect or disappointment psychology even though you've had a fundamental event occur that was consistent with the pre-existing bias.
Hedder: We know that the day-to-day of agribusiness involves managing the entire supply chain. How do logistical challenges like storage and transportation, introduce complexities that may lead to price deviations?
Christie: That's a great question. We've seen a recent example of that with a situation that's going on in the Ukraine and the Black Sea, where you have a large production base there. You see a price reaction because that supply is now stranded. So in the immediate aftermath of the first invasion, we saw a big runup in prices in anticipation that the supply was not going to be available for the market. Ultimately, it was able to get evacuated and prices moderated. So, commodities are only worth something when they're in the place where they need to get consumed, and so those dislocations can have short and long-term price implications.
Hedder: Based on your individual experiences, what is the most misunderstood aspect of agricultural futures markets?
Irwin: In my mind, it's the role of policy. I've most experienced that in the biofuels arena where the interface between what I call agricultural politics and the markets, and then the policies and regulations that come out have been really confusing to sophisticated players in the energy space. These go back a long, long time, and I just think agricultural politics are a mystery to most people outside of agriculture.
Christie: I think that there's a perception sometimes that futures markets are very complicated or hard to navigate, and they certainly have a lot of volatility. But I think I would say that the markets are really incredibly efficient and they do a great job of transmitting all the signals that are coming every day into price discovery. And so, I think it's a place where if you're interested in information and interested in following world events and weather events and all kinds of things like that, the futures markets are really a great place to spend some time and devote some energy because they are incredibly efficient and dynamic price discovery mechanisms.
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