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Understanding the Role of Commodities in the Economy

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Jerry's Weekly Newsletter

March 28 · Issue #13 · View online

I'm Jerry, a software engineer, YouTuber, and blogger. Every weekend I write about some thoughts, life lessons, and interesting things I came by for the week. I'd love for you to join.


Hi friends,
This week I decided to take a peek into commodities. I’ve been reading about how lumber prices are nearly double, how oil prices are increasing, but I never really understood what that meant in the grand scheme of the world economy overall. After taking a look, I finally started demystifying the first layer and wanted to share with you my learnings.
Tracing Dependencies
The entire economy is basically a very very large and complicated dependency tree. Every company depends on something else, whether that something else is another company providing products/services, which depends on something else, which depends on something else, etc.
That dependency tree continues as far as you can imagine. But it must eventually end somehow.
Guess what sits at the bottom? Commodities.
Commodities are at the bottom of the tree since they are often the raw materials required for any physical product. Services are technically also dependent on commodities too, though less directly.
Below, I’ll provide two examples in the form of lumber and oil. In case you’re curious, here’s a list of commodities.
Lumber
The price of lumber is up nearly triple since 1 year ago.
Why?
Well, yes we do have a pandemic. The pandemic triggered an economic panic, and the Fed lowered interest rates in response to try and stimulate the economy. That made borrowing money cheaper. Specifically, it caused mortgages rates to be at historical lows.
That caused many people to buy homes, which caused a surge in demand for homes. Pandemic also caused people to stay at home, which means they want bigger and more comfortable homes. They might also want to do some home-improvement as well.
Construction companies that build homes are having amazing business since there are too many contracts to fulfill. Lumber mills have slowed down and are no longer operating at full capacity due to pandemic restrictions.
What we get is high demand for homes and low supply of lumber. That makes lumber more expensive.
Here’s a dependency graph:
Okay, now we know the reason. How is the market responding?
On the construction side, home-builders are raising construction prices to account for the increased lumber costs (raising prices by $24k on average per built home). Some construction companies are delaying construction on purpose in hopes that lumber prices will fall.
Oil
If we observe oil prices over the last year, we notice that at the beginning of the pandemic, oil prices were really low. That’s because everyone was staying home and nobody was traveling. Cars, trains, airplanes consumed a lot less oil.
As the pandemic started to recover, oil prices are rising back up to pre-pandemic levels.
Sometimes, if there are political problems in the middle-east or in Russia, that can affect oil prices too since those two regions have economies that are heavily dependent on exporting oil.
Furthermore, there’s the Suez Canal that got blocked by a huge ship, which is causing shipping delays on everything that goes through it, which is 10% of world trade. The Suez Canal and the Panama Canal are the two most important trade lines in the world because of the shortcut they offer through oceans (respectively India/Atlantic, Pacific/Atlantic).
Of course, I realize I’ve barely scratched the surface when it comes to tracing the economic dependency tree. There are so many middle layers that I don’t know about and probably will never know about. But at least I found it helpful to understand what sits at the very very bottom.
When these prices change, it affects everything else that depends on it. I’ll continue to explore commodities since this was only my initial dive.
That’s all for this week! Have a great one!
Best,
Jerry
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