This content is first seen in the Trading Community inside by Nick D’Onofrio (Gallatin Research)

Community question: “How are energy and metals used to react to lower interest rates?”

Energy and metals are not manipulated to account for interest rate changes. Instead, prices are affected by interest rates due to demand changes and capital costs.

Interest rates tend to be lower in an environment where growth is falling. When growth is falling, inflation and consumer demand also falls for real assets. This is a reaction to lower wages, expendable income, access to capital, etc. In return, the prices for real assets will be lower until growth picks up.

Extraction industries (energy and metals) are very capital intensive and take time and money to bring production on and offline. This is where the cyclical nature of commodity markets come into place. When demand falls, prices fall, and operations start to close. This cycle happens until there is a supply constraint and then prices rise again. Being such capital intensive projects, they can be more likely to invest into new projects when interest rates are lower. The caveat here is that when rates are lower commodity prices are usually lower, meaning a lower ROI. A lower ROI means that it will be more difficult to raise capital for the project because the project will most likely not hold up so well under a stress test. When this happens, only high grade (cheap) minerals are extracted in an attempt to capture market share.

By the same logic, lower interest rates in a growth environment mean more exploration and production. When more production comes into the market, prices will drop, because there is more supply than demand.

The key term here is “lower”. Low is a relative term, and what it is relative to in the extraction industry is not historical rates, but operational and production costs relative to a company’s Ricardian Rent.

Ricardian Rent is the term used to describe the profits from the per unit difference between price and average variable cost.

Interested in learning more about the metals and commodities markets from Nick? Pro members of BetterTrader get access to his Metals & Commodities Livestream. Learn more under the Community tab on the web app.

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