Price Formation

Understanding how commodity prices form is fundamental to trading. Prices emerge from the interaction of supply and demand across global markets, filtered through inventory dynamics, market structure, and participant behavior.

Supply-Demand Fundamentals

The Basic Framework

PRICE DETERMINATION
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SUPPLY > DEMAND → Prices fall (surplus)
SUPPLY < DEMAND → Prices rise (shortage)
SUPPLY = DEMAND → Price equilibrium

But it's more complex:

PRICE = f(Current S/D, Expected S/D, Inventories,
          Market Structure, Sentiment, Technicals)

Supply Factors

Factor	Description	Price Impact
Production levels	Output from mines, wells, farms	Higher supply → lower price
Capacity utilization	How much capacity is running	High util → constrained supply
Investment	New projects coming online	Future supply increase
Disruptions	Outages, weather, strikes	Sudden supply reduction
Government policy	Export quotas, production limits	Supply constraints

Demand Factors

Factor	Description	Price Impact
Economic growth	GDP, industrial production	Growth → higher demand
Seasonal patterns	Heating, cooling, harvest	Predictable cycles
Substitution	Alternative commodities	Dampens price moves
Policy changes	Environmental, energy policy	Structural shifts
Inventory building/draw	Strategic stockpiling	Amplifies demand

Inventory Dynamics

Why Inventories Matter

INVENTORY IMPACT ON PRICES
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HIGH INVENTORIES:
- Buffer against disruptions
- Contango more likely
- Downward price pressure
- Spot premium minimal

LOW INVENTORIES:
- Vulnerable to disruptions
- Backwardation more likely
- Upward price pressure
- Spot premium (convenience yield)

"Price of storage = Futures - Spot - Carry Cost"

Key Inventory Indicators

Commodity	Key Indicator	Source	Frequency
Crude Oil	US crude stocks	EIA	Weekly
Products	US product stocks	EIA	Weekly
Copper	LME warehouse stocks	LME	Daily
Grains	USDA ending stocks	USDA	Monthly
Natural Gas	US storage	EIA	Weekly

Stocks-to-Use Ratio

STOCKS-TO-USE ANALYSIS
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FORMULA:
Stocks-to-Use = Ending Stocks / Annual Consumption

EXAMPLE (Corn):
Ending stocks: 50 million MT
Annual consumption: 300 million MT
Stocks-to-Use: 16.7% (about 2 months)

INTERPRETATION:
>25%: Comfortable supply, bearish
15-25%: Normal range
<15%: Tight supply, bullish

HISTORICAL RANGES:
Corn: 12-25%
Soybeans: 10-30%
Wheat: 15-35%
Oil: ~60 days (measured in days cover)

Market Participants and Price Impact

Participant Categories

Participant	Behavior	Price Impact
Producers	Sell forward, hedge production	Steady selling pressure
Consumers	Buy forward, hedge costs	Steady buying
Physical traders	Arbitrage, position taking	Price efficiency
Financial speculators	Directional bets	Amplify/dampen moves
Index investors	Passive, roll exposure	Calendar spread impact

Commitment of Traders (COT)

COT REPORT ANALYSIS
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CATEGORY: Managed Money (Speculators)

Position      Long       Short      Net
─────────────────────────────────────────
Last week     250,000    180,000    +70,000
This week     280,000    160,000    +120,000
Change        +30,000    -20,000    +50,000

INTERPRETATION:
Speculators increasing net long position
→ Currently bullish sentiment
→ Potential for liquidation if wrong

EXTREME READINGS:
Net long at record → Market may be overbought
Net short at record → Market may be oversold

USE: Contrarian indicator at extremes

Price Discovery Mechanisms

Physical Market Pricing

PHYSICAL PRICE DISCOVERY
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PROCESS:
1. Buyers and sellers negotiate
2. Deals reported to price agencies
3. Agencies assess "fair market value"
4. Published benchmark prices

PRICE REPORTING AGENCIES:
- Platts (S&P Global)
- Argus
- ICIS
- OPIS

ASSESSMENT WINDOW:
Crude: 4:00-4:30 PM London (Platts)
Products: Various windows by market
Metals: LME closing rings

EXAMPLE (Dated Brent):
Platts collects bids, offers, trades
Assesses "fair value" at 4:30 PM
Publishes as "Dated Brent"
This becomes the benchmark

Exchange Trading

EXCHANGE PRICE DISCOVERY
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MECHANISM:
Continuous auction (order book matching)
Transparent, visible to all

PRICE FORMATION:
Bid: Highest price buyer will pay
Ask: Lowest price seller will accept
Trade: When bid meets ask

EXAMPLE:
Bid: $75.00 for 100 lots
Ask: $75.05 for 50 lots
↓
Seller lowers ask to $75.00
Trade: 50 lots @ $75.00

TRANSPARENCY:
Volume, open interest, price history
All visible to market participants

Forward Curve Structure

Reading the Curve

FORWARD CURVE INTERPRETATION
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SHAPE REVEALS MARKET VIEW:

STEEP CONTANGO:
Spot: $70  M3: $73  M6: $76  M12: $80
Message: Surplus now, store for later

FLAT:
Spot: $75  M3: $75  M6: $75  M12: $75
Message: Balanced, no time arbitrage

BACKWARDATION:
Spot: $80  M3: $78  M6: $76  M12: $74
Message: Shortage now, supply coming

KINK/INFLECTION:
Spot: $75  M3: $78  M6: $76  M12: $74
Message: Near-term event expected (M3)

Forward Curve Drivers

Factor	Impact on Curve
Inventory levels	High → contango; Low → backwardation
Interest rates	Higher rates → steeper contango
Storage costs	Higher costs → steeper contango
Expected supply change	Disruption → front-month premium
Seasonality	Expected tight months → premium

Price Volatility

Volatility Patterns

VOLATILITY CHARACTERISTICS
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BY COMMODITY (Annualized):
Crude Oil: 25-40%
Natural Gas: 40-60%
Copper: 20-35%
Corn: 20-35%
Gold: 15-25%

VOLATILITY CLUSTERING:
High vol periods followed by high vol
Low vol periods followed by low vol

MEAN REVERSION:
Extreme volatility tends to normalize
Plan for volatility to persist short-term

ASYMMETRY:
Downside moves often faster than upside
Supply disruptions cause spikes

Implied vs Realized Volatility

VOLATILITY COMPARISON
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IMPLIED VOLATILITY:
Derived from option prices
Market's expectation of future vol
Example: 30-day implied vol = 32%

REALIZED VOLATILITY:
Calculated from actual price moves
Historical fact
Example: Last 30-day realized = 28%

INTERPRETATION:
Implied > Realized: Market expects more vol
Implied < Realized: Market expects calmer

TRADING USE:
If you expect vol to fall: Sell options
If you expect vol to rise: Buy options

Geopolitical Impact

How Geopolitics Affects Prices

Event Type	Commodities Affected	Typical Impact
Middle East tension	Oil, gas	+5-20% spike
Trade war	All commodities	-5-15%
Sanctions	Targeted commodity	+10-50%
Weather event	Agricultural, energy	±10-30%
Financial crisis	All commodities	-20-50%

Event-Driven Pricing

GEOPOLITICAL EVENT RESPONSE
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EVENT: Major pipeline attack

IMMEDIATE (0-24 hours):
- Price spikes 5-15%
- Volatility jumps
- Speculative buying

SHORT-TERM (1-7 days):
- Assessment of damage
- Supply alternatives emerge
- Price stabilizes or retraces

MEDIUM-TERM (1-4 weeks):
- True impact becomes clear
- New equilibrium found
- Volatility normalizes

TRADING RESPONSE:
Don't chase initial spike
Wait for information to clear
Position on fundamental impact

Key Takeaways

1. Supply and demand fundamentals drive prices — But not alone
2. Inventories are the buffer — High stocks = bearish; low = bullish
3. Market structure affects price formation — Contango/backwardation signals
4. Participants have different motives — Physical hedgers vs speculators
5. Volatility clusters — Prepare for persistence
6. Geopolitics creates short-term dislocations — Opportunity for patient traders

References

• EIA Short-Term Energy Outlook
• USDA World Agricultural Supply and Demand Estimates
• CME Group Market Data
• Platts Methodology Guides