From the May 01, 2007 issue of Futures Magazine • Subscribe!

Understanding demand in cash-based metals

Focusing on short-term commodity price trends, many investors and other market observers conclude that fundamentals do not affect prices, and that prices are determined primarily by speculative trading activities. These observations and hypothetical conclusions are understandable, given a cursory view of commodities markets.

They also are wrong.

Clearly, speculative trading activity has a lot to say about short-term and intraday price patterns. Longer term, however, fundamentals are extremely important to price levels and the trends that take them there. Investor and speculative trading patterns influence long-term price moves too, but it is the fundamental ebb and flow of supply and demand, including investor demand, that determines long-term commodities prices.

There are several key points to come to grips with before you can fully understand the role of fundamentals in prices.

First, it might sound overly simplistic, but it’s necessary to define what a fundamental is. Most of the purported and half-considered commodities analyzes published by partisans in the markets do not properly define the fundamentals. Many probably do not even know a proper definition of a commodities market fundamental.

Second, fundamentals must be measured accurately. This is an area in which most commodities markets suffer from inadequate provision of accurate measurements of supply, demand and other fundamental factors. The importance and the function of each fundamental in the price-determining process must be considered.


The concept of what fundamentals are fundamental in a commodities market sometimes is not clear—or it’s blatantly fudged.

Clearly one fundamental factor is investment demand. This is especially true for gold and silver. Often it is the most important factor in determining the price of a commodity. It is in gold, at least. However, it often is either ignored in a poor attempt at fundamental analysis, or it is distorted in its function and how it is viewed.

Investment demand is an off-balance sheet item in a classical commodities market analysis. In standard commodities research the supply-demand balance is measured as total supply, including primary production, secondary recovery and other sources of material, depending on the commodity, relative to fabrication or consumption demand.

Investment demand, however, is excluded here for several reasons. Commodities bought by investors retain their commodities form and are not transformed into products. They can be easily resold as their original commodities at a moment’s notice. And, investors buy differently than consumers. Consumers tend to buy less of a commodity as its price rises. Investors tend to buy more as the price rises.

Some market observers do not understand investment demand, so they exclude it; and that is a big mistake. For example, a recent palladium report by a palladium producer concluded that palladium prices were grossly overbought and should fall by more than half because industrial demand for palladium for use in fabricated products is so much lower than the annual total newly refined palladium supplies entering the market.

All of that is true. However, the surplus of newly refined supplies relative to fabrication demand in palladium at present is less than the amount of physical palladium that institutional investors have been wanting to buy.

As a result, the palladium price has risen from $180 in August 2005 to nearly $410 in May 2006, and currently is trading around $350 per ounce, which a high price on a historical basis. Palladium prices have risen in this way because of strong investment demand — not consumer demand — for physical metal. That is a fundamental factor in the market. To ignore it is to too narrowly define what a fundamental is.

To lump investor demand in with fabrication demand, as others do, is to ignore that those investors who have bought so much metal through the past 18 months could just as easily sell it. In fact, it’s often the case that a large individual investor will start to dump his position on the market.

This has indeed been happening in the palladium market lately. The palladium price was rising even as this institutional investor was selling several hundred thousand ounces of palladium. How could the price rise in the face of such heavy selling? It’s simple. Other investors were ready buyers, expecting prices to rise even further.


Even if you understand what is and is not a fundamental, and even if you have reasonably good data for measuring fundamental trends, you can still misunderstand what a fundamental means to price.

In 2000-01, for example, a major commodities trading bank almost convinced a consortium of gold mining companies to pay it $450 million throughout three years to promote gold use in jewelry. The argument the bank made to justify this was that the producers needed higher gold prices — the price was around $275 per ounce at the time — to survive financially, and that the way to get gold prices higher was to promote gold use in jewelry.

The problem was that gold use in jewelry is price elastic. If and when gold prices rise, gold use in jewelry will fall sharply. Gold prices had languished for two decades by 2000, and, interestingly, gold use in jewelry had more than tripled in volume. Lower jewelry demand was not driving prices lower. Lower investment demand, heavy short-selling by proprietary traders at banks and dealers and heavy central bank gold sales were driving prices lower. As the price of gold fell, gold was cheaper for both jewelry manufacturers and for jewelry consumers. Classically, they bought more gold at lower prices.

As prices later rose after 2001, jewelry demand fell sharply.

Jeffrey Christian is managing director of CPM where he is responsible for the total operation of CPM Group, supervising a group of analysts dedicated to precious metals and commodities market research.

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