It is truly shocking that so much can be written in the market place on the direction of commodity prices, while there is only a tiny amount of discussion and analysis of what causes commodity prices to move.

One aspect of this issue is relatively straightforward: supply and demand. While aggregate numbers for supply often lag measurements of consumption (or “demand”), we generally can know with a reasonable amount of certainty whether any particular market is getting “tighter” (i.e. demand exceeds supply), or whether there is a surplus (supply exceeding demand).

A debate has raged in recent months, due to the dramatic changes in these parameters caused by the global economic crisis. Prior to this episode of severe economic disruption, markets for many (if not most) commodities were getting steadily tighter – which partially explained why prices for many commodities were soaring.

However, it would be utterly reckless to price commodities based purely on the immediate supply/demand fundamentals, since (as we have just seen) those fundamentals can change with little or no warning. Thus, estimated future supply and demand for commodities must also be factored into current prices.

In the case of oil, an additional debate has taken place: the “peak oil” debate. The question here is whether, on a practical basis, it is even possible to increase future production to meet anticipated demand. By far, the most instructive commentary I've seen on this issue comes from Chris Martenson, in his superb “Crash Course”.

Martenson points out through compelling analysis, that “peak oil” is almost a moot point, given that a far more important variable in this “equation” is what Martenson calls “energy surplus”, which is how many units of energy can be produced from each unit of energy used to generate that production.

The obvious example here is U.S. ethanol. This was a scheme which was always doomed to spectacular failure for one obvious reason: 70% of the energy produced from this corn-ethanol process is consumed in its production. Thus, U.S. ethanol did virtually nothing to increase energy supplies, but did manage to drive corn prices sky-high, through this ridiculously wasteful consumption.

Therefore, attempting to view fundamentals for any commodity in isolation can easily lead to faulty analysis and conclusions. Instead, we can perhaps get a much better “feel” for commodity markets through a more simplified, “big-picture” analysis. Here, the parameters are totally clear.

We live in a world of rapid growth in population, and (except for the last few months) rapid growth in per capita income for most of the world's population (with Western industrialized economies being an exception). These two factors alone guarantee rapid growth in commodities demand – especially with respect to “soft commodities” (food products and related inputs).

When poor people start to get a little wealthier, they don't simply eat more food, they eat (arguably) better food – meaning a lower ratio of basic fruits, vegetables and grains, and a higher ratio of meat and dairy products. Since it requires several pounds of grains to produce each pound of meat/dairy products, this means that food consumption increases geometrically (i.e. at a faster rate than incomes rise).

At the same time, growing populations are rapidly depleting total arable land through a combination of environmental degradation, and “consumption” of this land through residential housing. Thus, irrespective of current economic conditions, the future trend is unmistakably toward “tighter” markets for soft commodities (if not an outright supply crisis) – and much higher prices.

With respect to “hard commodities” such as industrial metals, there is also rising demand, combined with much higher marginal production costs, because most of our most economical mineral deposits have already been depleted, or nearly so. Thus, if prices do not rise steadily to stimulate further exploration and development of new sources for these commodities, the result will be an inevitable supply-crunch, and “price shock” when we reach a point of depleted inventories combined with strong demand.

On the basis of these factors alone, it should be clear to most people that the temporary decline in demand for most commodities, combined with the ruthless destruction of commodity prices by the Wall Street crime syndicate, and the servile Henry Paulson cannot last. It is only a question of how soon demand fundamentals begin driving prices higher.

However, this is still only ½ of the analysis. The other driver of commodities prices are changes in the money supply. If an economy has 10 units of commodities, and $10 of currency in circulation, then if we assume full consumption, we should expect a price of $1 per commodity unit. But if we print more money, so that there is now $100 in circulation, then full consumption implies a commodity price of $10/unit.

What we have seen this decade is the rate of increase in the global money supply steadily rising, until the “credit crunch” began – and then a much more rapid rate of increase since that point in time.

Many commentators have equated money supply growth as “inflation”, since diluting currencies is the true source of all inflation. However, what is much more instructive is to look at the rate of dilution of a currency.

The rate of dilution caused by money-supply growth is the rate of growth in the money supply minus the rate of increasing wealth. If the money supply increases by 10%, but simultaneously the total wealth in an economy also increases by 10%, then there is no net dilution. Changes in the prices of goods are based on genuine supply/demand fundamentals. The best proxy for changes in wealth is GDP (assuming that statistic hasn't been manipulated beyond any resemblance to reality).

For people in North America, commodity prices are always expressed in U.S. dollars, so analysis of U.S. currency is most relevant. To begin with, both the growth of the U.S. money supply and its GDP are two of the most-manipulated statistics of any economy in the world.

It would take pages of exposition to discuss all the ways in which U.S. GDP is manipulated, so that subject will have to be dealt with at another time. With respect to the U.S. money supply, all that needs to be said regarding the farcical nature of this “statistic” is that the U.S.'s central bank, the Federal Reserve is unable (or, rather, unwilling) to tell anyone what has happened with trillions of dollars in “off-balance sheet transactions”.

Determining where those trillions ended up could double or triple the officially-stated growth in the money supply. However, even with “doctored” numbers, it can be easily shown what should be happening with commodity prices.

The most-narrow definition of growth in the money-supply is called “M1”. This would fit into the standard definition of what most people think of as “money”. After this number had been virtually “flat” from late in 2005 to early in 2008, this statistic has exploded higher – as “Helicopter” Ben floods the world with new Bernanke-bills.

Currently, this measurement is increasing by roughly 15% (as reported by Shadowstats.com one of the last sources of “honest statistics” for the U.S.). At the same time, during the last two quarters, U.S. (doctored) GDP is falling by over 6%. Thus the U.S. money supply is currently being diluted by more than 20%/year.

This dilution must be factored into future prices, along with the supply/demand fundamentals. For example, with such currency dilution, U.S. home prices would normally be assured to rise by 20% (nominally) to correspond with this currency dilution.

However, in the U.S. housing market there is currently the largest “overhang” of excess supply in global history. Millions of units were built purely to satisfy speculator demand, as Wall Street engineered its massive Ponzi-scheme, built atop this bubble. Currently, there are more than 20 million EMPTY units in the U.S.

Thus, even with massive dilution of the U.S. currency, there is virtually no hope of U.S. housing prices moving higher. Instead, this should simply lower the rate of price-collapse. The story with commodities is entirely different.

With the exception of a few base metals, and a VERY temporary glut of oil and natural gas, there is no “overhang” of inventory with commodities, but rather supply/demand fundamentals were already supportive of higher prices.

Thus, we can be certain that the “dilution” of the U.S. currency (by over 20% per year) must be translated directly into higher commodity prices. Armed with all of the “pieces of the puzzle”, there is simply no valid argument to be made by the “deflationists”, and the foolish commodity bears – who wrongly asserted that the previous spike in commodity prices was a “bubble”.

Armed with these parameters as a guide, it should now be much easier for investors to “interpret” current prices for commodities, in determining where they should deploy their investing dollars – and to brace themselves for the next wave of inflation which is sure to strike.

As both currencies and commodities, gold and silver will ultimately be the biggest beneficiaries of these trends, especially given the ruthless, price-fixing by the Comex criminals – which has kept bullion prices artificially low.

With very little inflation factored into markets today, now is the ideal time to “load up” on precious metals, and quality precious metals miners.

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