Commodity Prices and Their Ripple Effects

Jet fuel at a quarter of costs, against an 8% margin

The corporate channel is where a commodity move turns into an earnings miss. Take an airline where fuel is 25% of operating costs and the operating margin is 8% of revenue. Operating costs are therefore 92% of revenue, so fuel is 23% of revenue. Jet fuel rises 30%. That adds 6.9 points of cost, and an 8% operating margin becomes roughly 1%.

Hedging delays this rather than removing it. An airline hedged on half of next year's consumption takes half the hit now and the rest when the hedges roll at the new price. A software business with almost no physical input barely notices the same move. That dispersion is why "inflation is bad for equities" is too coarse to act on: one oil move compresses one sector's margins and expands another sector's revenue, and the index is only the weighted average of the two.

Three questions to ask before you read anything into the move

• Supply or demand? Oil rising on an OPEC production cut is a tax on global growth. Oil rising because Chinese manufacturing surveys turned is confirmation of growth. The two are identical on a price chart and imply opposite things for equities and for risk-sensitive currencies.
• The commodity, or the dollar? Almost all of them are quoted in dollars. A 3% fall in the dollar lifts the dollar price of everything without one extra tonne being demanded anywhere. Check the move in a second currency before calling it a commodity story.
• Spot, or the curve? The headline price is usually the front-month future, and that is not what a position earns. When the curve is in contango, rolling a long position forward costs the spread every month, so a flat spot price across a year can still be a losing position.

Correlations between a commodity and its currency are real and unstable. The rolling correlation between WTI and USD/CAD has spent long stretches between minus 0.6 and minus 0.8, and other stretches close to zero, usually when the two central banks involved were moving on different schedules. In April 2020 the front WTI contract settled at minus $37.63, an expiry and storage artefact rather than the price of a Canadian barrel, and the currency did not follow it anywhere near proportionally.

Four prices, and one sentence each

Four prices carry most of the information: Brent for energy, copper for industrial demand, gold for the rates and dollar story, and a broad agricultural index for the food component of the inflation basket. Write down the week's change and, next to each one, a single sentence on whether supply or demand caused it. That sentence is the part that matters and the part almost nobody writes down.

Then check your own book for exposure you did not intend to take. Long Australian dollar, short USD/CAD and a long copper position are close to the same trade three times over, and a sizing rule applied to each in isolation understates the real risk badly. This is the correlation problem set out in the risk rules, and commodity exposure is the version of it that hides best. Size the cluster rather than the ticket, running the combined risk through the position size calculator instead of each leg separately.

The wider point is that commodities are an input into a macro read rather than a separate market to bolt on. They tell you what is about to happen to the inflation print, which tells you what is about to happen to policy expectations, which is what actually moves a currency pair week to week. Reasoning backwards along that chain, from the currency to the barrel, is where the analysis usually goes wrong.