The Economics of Commodity Markets

Part III

Commodities and Fundamental Value

How do commodity markets value common factors? What factors should be used to construct a model capturing the fundamental value of commodity prices? Part III aims at addressing such questions related to the factors that are common to various segments of commodity markets, as well as the ability of the econometrician to build models incorporating such factors.

Cross-commodity relationships imply that two or several commodities share an equilibrium that links prices in the long run. These long-term connections – or inter-commodity equilibrium as denoted by Casassus et al. (2009) – include production relationships1 where an upstream commodity and a downstream commodity are tied in a production process, and substitute/complementary relationships where two commodities serve as substitutes2 or complements3 in consumption and/or production. The existence of inter-commodity equilibrium usually indicates long-term co-movement among commodity prices. Temporary deviations from this equilibrium (because of demand and supply imbalances caused by macroeconomic factors and inventory shocks, etc.) will be corrected over the long run.

RATIONALE BEHIND COINTEGRATION

One of the most popular economic models that analyzes long-term relationships among variables is the cointegration model or Error Correction Model (ECM). This model allows the researcher to analyze the balance of long-period relationships. Cointegration is interpreted as a long-term relationship ...