What is a Commodity Price Index and How Does It Work?

Oil, gas, metals, gold, timber—these are all commodities traded by thousands (if not millions) of traders around the world. However, keeping track of every single quote can be very problematic and time-consuming. If only there were a tool that allows you to see commodity market trends on a single chart…

Fortunately for us, there is such a tool! It is called the Commodity Price Index. In this article, we will discuss what a Commodity Index is, its types, and how to use it for trading.

What is Commodity Price Index?

Commodity Price Index is an index that reflects the dynamics of commodity prices. It is based on averaged quotes from different sectors. For example, energy, agriculture, metallurgy, and other commodities. Thus, a kind of “basket” is formed, looking at the price at which you can draw a conclusion about the market’s direction as a whole.

Note from the author: What are Commodities?
Commodities are a general term referring to various materials that are present in the environment or can be extracted from it. Examples include oil, natural gas, iron ore, grain, timber, diamonds, gold, other precious and non-precious metals, etc. Most commodities are traded on the commodity exchange.

However, not all indices (or indexes, whatever you like them to be named) are the same. Next, we will discuss the types of commodity indices and how they are calculated.

How is a Commodity Price Index Calculated?

The commodity index is usually based on the principle of weighted average. In this case, not all commodities contribute equally to the basket price; each has a larger or smaller portion, depending on its relative importance to the economy. For example, market prices or consumption in the real economy may be taken into account.

Also, depending on the company that maintains the index, its specialization varies. Some commodity indices (or indexes, again, this is the same) are more focused on the energy sector, so energy will have a more important position in the index. However, there are also Commodity Indices where each commodity contributes an equal portion.

Let’s examine how the Dow Jones Commodity Index (DJCI) is calculated as an example. Thanks to the published methodology, we know that it happens in three steps:

• Liquidity Weighting: Each commodity is weighted based on trading volume (Total Dollar Value Traded (TDVT) over the past five years. This ensures that more liquid commodities have a greater impact on the index.
• Component Restriction: Restrictions are applied to prevent excessive concentration on any one commodity or group of commodities. For example, no commodity group (e.g., crude oil or wheat) can exceed 32% of the index. Other groups are capped at 17 %, and any overweighting is redistributed among smaller components.
• Sector Equalization: The index is divided into three sectors: Energy, Agriculture and Livestock, and Metals. Each sector is assigned the same weight, and the commodities within each industry are adjusted accordingly.

The index is rebalanced monthly, meaning the weights are set to specified levels at the beginning of each month.

What Are the Different Types of Commodity Price Indices?

We’ve probably already caused some confusion with these different types of indices. Now it’s time to sort it out. Conventionally, there are four main categories of commodity price indices.

• Broad-based indices: These do not have a specific focus. These indices track a wide range of commodities in different sectors.
• Sectoral indices: These commodity price indices have a specific focus, such as energy, metals, or agricultural and livestock commodities.
• Sliding indices: They reserve the right to adjust the coefficients for groups of commodities depending on market conditions. In other words, if a country’s storage facilities are bursting with natural gas and its purchase has fallen sharply, its impact on the overall basket will be more negligible.
• Fixed-weight indices: These maintain a clear weighting structure for groups of commodities. The coefficients may change, but only once in an extended period.

When opening commodity price index charts, we recommend reading the company’s calculation methodology beforehand. This will help you figure out what index you are looking at and if it fits your trading strategy.

Why Are Commodity Price Indices Important?

Commodity price indices are used by ordinary traders, seasoned investors, and even politicians. They are an essential tool, often described as something that would have to be invented if it didn’t exist. We have highlighted some of their key functions.

So, commodity price indices:

• Provide a simple and standardized way to detect and analyze incipient trends in the commodity market, which is especially important for financial market participants;
• Help to intelligently evaluate trading strategies and the performance of the commodity investments by acting as an investment benchmark. Investors use commodity indices to compare the performance of commodity mutual funds, ETFs, and other investment products;
• Provide a complete picture of the balance of supply and demand in various sectors of the real economy, allowing businesses to use commodity indices to hedge risks associated with commodity price fluctuations;
• Help gauge inflationary pressures quickly and accurately. Governments and central banks use them to monitor inflation and adjust monetary policy;
• Allow for investment performance analysis by helping to track historical trends in commodity prices.

Perhaps you can find other uses for commodity price indices! We look forward to your research papers!

What Are the Main Commodity Price Indices?

After reading this article, you probably already wanted to search Google for the best commodity price indices. No need, we have done it all for you. Below is a table with the main index names and their brief descriptions.

Top 5 Most Popular Commodity Indices

Remember that indices should be chosen depending on your trading strategy. The most popular one is not necessarily the most suitable.

Factors Affecting Commodity Price Indices

Finally, let’s wrap up with some insightful information. Understanding what drives changes in commodity price indices and the key events that influence them is crucial. There are three main factors that impact commodity prices (and, consequently, the indices):

1. Supply/demand balance: In our unpredictable world, global events can cause fluctuations in the consumption and production of certain commodities, affected by nearly every aspect of economic and political policy. When demand decreases, prices fall; when demand increases, prices rise. On the supply side, the logic is reversed: an increase in supply drives prices down, while a decrease pushes prices up.
2. Trade stability: The stability of supply chains and trade agreements is very important for commodities. If one country imposes tariff regulations or starts a trade war, commodity markets react with strong volatility.
3. Weather: Droughts, natural disasters, and uncharacteristic temperatures can all reduce agricultural production. From point #1, we know that with lower production and the same level of demand, the price should rise.

The chart below clearly illustrates the sharp declines in commodity prices during major economic crises. You can see the 2008 financial crash, the 2014-2015 drop caused by U.S. airstrikes on oil fields and the war against ISIS, and the 2020 collapse when the pandemic lockdowns disrupted global supply chains, catching markets off guard.

In general, as you can see, there are many reasons for price changes in commodity indices—just like in all other financial markets.