Question: Does supply play a role in determining the direction of a commodity market's prices?
Answer: Absolutely, but not in the way the mainstream financial media paints it out to.
Here's the conventional understanding of commodities: They differ from other financial markets because of limited resources, and because Mother Nature can be quite unpredictable. When there's less of a product available (given consistent demand), prices rise to compensate for the deficit. Vice-a-versa: when stockpiles increases, prices fall to reflect a surplus.
And here's the reality: The relationship between commodity prices and available supply is far from the black-and-white notion above.
Case in point: crude oil. Over the past two years, oil prices have soared from a 4-year low in 2009 to a 2-year high in April 2011. During this time, most market observers credited falling output for crude's sustained uptrend. Word was, tensions in the Middle East were disrupting supplies abroad, while "Peak Oil"-related over-drilling was drying up oil reserves at home.
"Oil prices hit highest level since recession on supply fears." -- April 2011 Telegraph
But here are the facts. Below are two charts taken from the Energy Information Administration's website: Top chart plots Crude Oil Stocks (i.e. available supply, in million barrels) since July 2009; bottom chart shows Crude Oil Days of Supply since July 2009.
As you can see, while crude oil prices rallied from $50 per barrel (in 2009) to $108-plus per barrel (in April 2011) --- both supply and reserves of crude oil ROSE. Reuters reports that in May, US stockpiles of crude reached their loftiest levels since 1990.
In other words, as oil supplies and reserves were rising, so were prices -- the opposite of what the traditional supply-and-demand understanding of commodities says should have happened.
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