Fundamentals or Fads? Pipes, Not Punting, Explain Commodity Prices and Volatility

In assessing drivers of commodity prices and volatility at this stage of the current super-cycle in commodities (year 12 of a projected 25), it is vital to understand that production cost is a fundamental. Moreover, marginal production costs are among the most powerful drivers of commodity prices. This might sound obvious. However, cost analysis is surprisingly absent in the most prominent papers on commodity price formation and the role of speculators. Nowhere in these papers do we find the asking or the answering of the essential business question: how long is the pipe? Changes in extraction requirements and associated production costs are a critical factor in setting prices: the 4,500 meter drill pipe used offshore Brazil in the Roncador oil play in 2003 is not long enough to reach the presalt oil supplies of the nearby Lula field discovered in 2007. The two miles of extra steel to make the drilling well long enough are not costless. The extra cost raises the market price required to break even on getting oil from Lula instead of Roncador - large incremental supplies needed to meet global demand growth. To ignore the cost of doing business and how it changes over time too narrowly defines “fundamentals.” Statistical analyses that implicitly treat cost as non-fundamental will struggle to avoid circular logic and false conclusions about causality. Data on production costs are abundant and transparent. In this brief paper, we present simple, empirical evidence on dozens of input costs for commodity production at all the major stages of processing. These data show what is really driving commodity prices: pipes, not punting