Fundamental Analysis of Commodities — supply, demand, the dollar and the hedge

Where this chapter sits

Chapter 11 carries 5% of the paper. It is short, self-contained and heavily conceptual — there is exactly one formula, and the rest is cause and effect.

The exam: 120 minutes, 100 marks, 60% to pass, 25% negative marking.

The one sentence that frames everything

The fundamental analysis of commodities is largely dependent on the supply and demand dynamics of a particular commodity whereas in equity market, it is largely the study of balance sheet, profit and loss account as well as cash flow statement and performance of the company, industry and economy.

That contrast is the chapter's organising idea. A barrel of crude has no balance sheet, no management quality, no dividend policy. All that matters is how much is coming out of the ground and how much the world wants to burn.

Supply side factors

Supply in commodity markets depends on availability and production capacity. The drivers:

• Production Levels — crop yields, mining output, oil drilling capacity
• Weather and Natural Disasters — droughts, floods, hurricanes can disrupt agricultural and energy supplies
• Geopolitical Events — wars, sanctions, trade restrictions, and OPEC decisions affect energy and metals
• Technology and Infrastructure — better farming methods, mining technology, and transport reduce supply risk
• Government Policies — subsidies, tariffs, export bans, and regulations alter supply availability
• Cost of Production — rising labour costs, energy costs, or other input costs

Demand side factors

Demand reflects consumption needs and economic activity.

• Global Economic Growth — expansions boost demand for energy, metals, and food whereas recessions reduce the demand
• Industrial and Infrastructure Development — steel, copper, and other related commodity demand rises with construction and manufacturing
• Consumer Preferences and Lifestyle — shift toward renewable energy increases demand for lithium and silver
• Population Growth and Urbanization — expands food, energy, and housing needs
• Substitutes and Alternatives — electric vehicles reducing oil demand; plant-based food affecting demand for meat
• Seasonality — higher fuel demand in winter, crop demand post-harvest, festive consumption spikes

The concentration problem

Country specific factors also lead to situations that influence the demand and supply of commodities.

Copper is largely produced in Chile, a South American Country, which is largely affected by weather aberrations, labour strike and many more, that affects supply of copper to the world market.

Crude oil is largely produced in North America, Middle East and Russia. Any geopolitical tension, which normally happens in the Middle East affects crude oil supply across the globe. For instance, the Russia-Ukraine war affected the supply of Russian Crude Oil to the world market.

On the demand side, expanding economic conditions create an additional demand for consumption of precious metals like gold and silver in that country and vice versa.

This is why commodity analysis needs a map in a way equity analysis does not. A strike in one Chilean valley moves copper prices in Mumbai.

Major producers and consumers

The price movement of commodities is influenced not only by supply and demand but also by the dynamics of major producing and consuming nations.

The flow of commodities between these countries reflects their economic health, where macroeconomic conditions, weather patterns, and political stability play a critical role in shaping market outcomes.

Disruptions such as slowing economic growth or political instability in key producing regions can constrain supply and disturb global market equilibrium. Additionally, factors like trade sanctions, volatility of the currency, and trade policies further contribute to fluctuations in the commodity market.

The workbook's footnote gives the actual league tables:

Gold — as per the World Gold Council's June 2025 Report, China, Australia, Russia, USA, Canada are largest producers of Gold in the world and China, India, USA, Germany and Saudi Arabia are the largest consumers.

Crude oil — as per EIA Report, USA, Russia, Saudi Arabia, Canada, China are the major producers of Crude Oil, whereas USA, China, India, Germany, Japan are the largest consumers in the world.

Note that India appears on both consumer lists and neither producer list — which is exactly why a weakening rupee hurts so much.

Why commodities are priced in dollars

As a result of globalization, many nations are dependent on one another to meet their commodity consumption requirements due to either comparative cost advantages, or scarcity of the required commodity, or the availability of the relevant technology for production. Countries which are surplus in a certain commodity export to those in scarcity.

When the settlement for this cross-border trade arises, the preference for a specific currency arises. Typically exporting nations use the foreign currency they earn on import of certain other commodities, technology, products which are in short supply.

Receiving a particular foreign currency and paying in another foreign currency, forces the countries to convert the currencies via the forex markets. This leads to currency risk due to the excessive fluctuations of foreign currency markets.

Therefore, as a convention the countries of the world started quoting and settling in internationally acceptable, convertible and most easily available currencies.

US Dollar, right from the post world war period, has established itself as the most preferred internationally convertible currency. It has assumed the importance as international reserve currency due to the preference by central banks of many countries.

Therefore, commodities' trade across the world uses US Dollar, then followed by Euro, as the two most preferred currencies to quote and trade in the commodities.

The dollar index

All those factors which influence each of the major currencies like Euro, UK Pound, Japanese Yen make it complex for any analyst to assess their impact on commodity price movements. Hence, the dollar index was discovered to gauge the overall currency movement.

It is an easy way to analyze the impact of significant international currencies on the prices of commodities.

The dollar index is a measure of strength of U.S. Dollar against six major currencies viz., Euro, Japanese Yen, Pound Sterling, Canadian Dollar, Swedish Krona and Swiss Franc.

Six currencies. Learn them. They are the most examinable list in the chapter.

The inverse relationship — the single most important mechanism here:

Since most commodities — such as crude oil, gold, silver, and agricultural products — are priced and traded internationally in U.S. dollars, any fluctuation in the dollar index directly impacts their value.

When the dollar strengthens against other currencies, commodities typically become more expensive for buyers using non-dollar currencies. This often reduces global demand and puts downward pressure on commodity prices.

Conversely, when the dollar weakens, commodities appear cheaper in other currencies, encouraging demand and driving their prices upward. For example, a weaker dollar often supports higher demand for gold and crude oil.

Dollar up → commodity prices down. Dollar down → commodity prices up.

And the two-sided effect on countries: emerging markets with weaker domestic currencies face higher import costs for dollar-denominated commodities, influencing inflation and consumption patterns. On the other hand, exporters of commodities may benefit when their local currency weakens, as dollars revenues lead to more home currency revenues, when converted back.

In essence, the dollar index serves as a key barometer for commodity traders and investors.

The global benchmark exchanges

Commodity trading evolved from a barter system in ancient times to the modern cross-border trade between nations. More importantly, the organized commodity exchanges started operating in mid-19th century and they become global trade hubs. These hubs led to formation of commodity exchanges which have eventually become global benchmark setting organizations.

And the Indian link: the derivatives products traded on Indian exchanges are replicas of their global counterparts and their prices strongly correlate to their international exchange prices.

For example, changes in crude oil prices on the New York Mercantile Exchange (NYMEX) directly impact fuel prices and inflation in importing countries like India. Similarly, base metal prices in India closely follow trends on the London Metal Exchange.

But the correlation is not perfect. Domestic commodity markets are also influenced by currency fluctuations, trade policies, and import-export dynamics. A weakening domestic currency against the U.S. dollar can make imports more expensive, amplifying the impact of global price rises.

On the other hand, strong local demand, government interventions, and seasonal supply variations can sometimes cause domestic prices to diverge from international benchmarks.

The conclusion: in a globalized economy, domestic commodity markets cannot function in isolation, and the interplay between international trends and local factors ultimately determines price discovery, volatility, and trading opportunities.

Crop reports and weather reports

Crop reports and weather reports play a critical role in agricultural commodity fundamental analysis, as they directly influence supply, demand, and price trends.

Crop reports provide detailed insights into acreage, planting progress, yield estimates, production levels, and inventory status of key crops. These reports, released by government agencies or research organizations, help traders, processors, and policymakers gauge the availability of commodities such as wheat, corn, soybeans, cotton, and pulses.

The reading rule: a higher-than-expected production report generally leads to price declines, while lower output projections can drive prices upward.

Weather reports are equally important because agricultural commodities are highly sensitive to climatic conditions. Rainfall patterns, temperature fluctuations, droughts, floods, and unexpected frosts can significantly impact crop yields.

For instance, delayed monsoons in India affect rice and sugarcane production, while adverse weather in Brazil can disrupt coffee and soybean supply.

Traders closely monitor short-term forecasts and long-term weather trends, such as El Niño or La Niña, as these can create substantial shifts in global supply chains.

Inventory, production and consumption

Inventory data, production, and consumption trends are core pillars of commodity fundamental analysis, as they directly reflect the balance between supply and demand.

Inventory data indicates the quantity of a commodity held in storage at a given time, whether in warehouses, exchanges, or government reserves. High inventory levels often signal oversupply, leading to downward pressure on prices, while low inventories suggest scarcity and potential price increases.

Production trends reveal how much of a commodity is being supplied to the market. For instance, an increase in oil output by OPEC members typically exerts downward pressure on global crude prices, while reduced mining activity can lift base metal prices.

Consumption trends, on the other hand, reflect demand dynamics. Rising industrial demand for metals, growing energy consumption, or changing dietary patterns in emerging economies directly shape commodity usage. A surge in demand without a matching increase in supply often drives prices higher.

Macroeconomic indicators

Since commodities are the raw materials for industries and essentials for consumption, their demand and supply are deeply connected with broader economic trends.

GDP growth — one of the most influential indicators. Strong economic growth boosts industrial production and consumer spending, thereby increasing demand for commodities like energy, metals, and agricultural products. Conversely, slowing growth or recession reduces demand, often leading to price declines.

Inflation — rising inflation typically pushes investors toward commodities, especially precious metals like gold, which act as a hedge. Higher inflation also increases the cost of production and transportation, raising commodity prices.

Interest rates — low interest rates encourage borrowing and spending, lifting demand for commodities, while higher rates strengthen currencies and often reduce commodity prices.

Trade balances and geopolitical indicators — import-dependent countries face higher prices when global supply chains are disrupted, while export restrictions can tighten global markets.

And the broader demand read: employment data, consumer sentiment, and industrial production figures reflect underlying demand trends.

Government policy and geopolitics

Uncontrolled cross border trade affects the local merchandise thereby causing impact on the countries trade balance. Hence, in order to maintain equilibrium between domestic market and global trade, governments frame policy to protect the interests of their domestic market through trade policy.

Import-export regulations, subsidies, tariffs, and quotas often determine how much of a commodity enters or exits a country. For example, an export ban on wheat or rice can tighten global supply, driving prices higher. Similarly, subsidies on fuel can reduce production costs, encouraging higher agricultural output.

Environmental regulations also play a role; stricter mining or emission laws may reduce commodity production, affecting metals and energy markets.

Monetary and fiscal policies further influence demand, as interest rate changes, taxation, or infrastructure spending directly impact industrial consumption of commodities.

On geopolitics: conflicts in oil-producing regions, such as the Middle East, often lead to supply disruptions and sharp increases in crude oil prices. Trade wars or sanctions can restrict the flow of key commodities. Political instability in major producing nations — such as strikes in mining regions or unrest in agricultural hubs — can cause sudden supply shortages.

And producer alliances: strategic decisions like forming producer alliances (e.g., OPEC's output agreements) significantly affect pricing power and market stability. Global tensions, such as those involving shipping routes or energy pipelines, further add to commodity risk premiums.

Hedging in commodities

Hedging in commodities is a crucial risk management strategy used by producers, consumers, and investors to protect themselves from adverse price fluctuations.

At its core, hedging involves taking an opposite position in the futures or options market to offset potential losses in the physical or cash market.

Two worked illustrations from the workbook:

A farmer expecting a harvest of wheat can sell wheat futures contracts in advance. If wheat prices fall at the time of harvest, the loss in the cash market will be compensated by gains in the futures market.

An airline company exposed to rising fuel prices can buy crude oil futures to lock in costs and protect profitability.

Note the direction in each case. The farmer will have wheat, so he sells futures. The airline will need fuel, so it buys futures. A hedger takes the futures position opposite to his physical exposure.

Who hedges: hedging is not limited to producers and consumers. Traders, importers, exporters, and investors also use hedging tools to minimize exposure to price volatility.

And the purpose, stated plainly: the goal is not to make profits from hedging but to ensure stability and predictability in cash flows.

With a warning: over-hedging or incorrect strategies can increase risk instead of reducing it. Additionally, transaction costs and margin requirements are important considerations.

Hedge ratio

Once the commodity stakeholders understand the need of hedging to protect the price risk, then there is a need to know the quantum of hedging, which can be measured through Hedge Ratio.

It refers to the proportion of a position that is hedged through the use of derivative instruments such as futures or options. In simple terms, the hedge ratio measures how much of the exposure to price risk is covered by a hedge.

The formula:

The workbook's copper example. ABC Company is into manufacturing of copper wires and their monthly copper requirement is 500 MTs. From the twelve months of price changes tabulated:

Hedge Ratio = 0.9853 × (9.02 ÷ 9.71) = 0.9853 × 0.9289 = 0.915.

And the conclusion: to cover the risks of 100 MTs, ABC Company has to hedge 91.5 MTs of copper, which is 37 contracts as the copper contract on MCX is 2.5 MTs contract.

91.5 ÷ 2.5 = 36.6, rounded up to 37 contracts.

A note on the workbook's own numbers: the text opens with a 500 MT monthly requirement but the worked answer is computed on 100 MT (0.915 × 100 = 91.5). Learn the method — ratio × exposure ÷ lot size — and apply it to whatever exposure a question actually gives you.

Advantages and disadvantages of hedging

Advantages:

• The most important benefit is risk reduction. By using instruments like futures and options participants can lock in prices and protect themselves against adverse market movements
• This ensures stability of earnings and cash flows, which helps companies plan budgets, investments, and operations with confidence
• For investors, hedging acts as a form of insurance, safeguarding portfolios during volatile periods
• It also enables businesses to focus on their core operations rather than constantly worrying about unpredictable price swings
• In industries with thin profit margins, hedging can be the difference between profit and loss

Disadvantages:

• The most significant is the cost of hedging. Futures contracts involve margin requirements, while options require premium payments, which can reduce profitability
• Hedging often caps potential gains. If market prices move favorably, the hedge prevents participants from fully benefiting
• Poorly designed hedge strategies or incorrect hedge ratios can even increase risk instead of reducing it
• Hedging requires specialized knowledge, constant monitoring, and administrative effort, which may not be practical for smaller businesses or inexperienced traders