Understanding Commodities
Commodities are the essential foundation of the global economy. They are the raw materials people use to eat, create and sustain themselves. For example, agricultural products are used for food, metals are used to build tools and energy is used to drive everything.
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Another important trait of commodities is that every commodity class is uniform and each individual unit within that commodity class is identical to the other, serving the same purpose. For example, a head of cattle is basically the same as any other head of cattle, and the same is true for sugar, cocoa, coffee, orange juice and other commodities.
The Main Commodity Classes
There are three main commodity classes that are tradable, namely agricultural commodities, metals and energy. To be considered a commodity the goods themselves need to be raw materials.
Energy Drives the World
The energy class is one of the best investments simply because energy is indispensable not only to survival but also to development and expansion. The main forms of energy that garner the interest of investors all over the world trying to profit from humanity’s constant need for energy include crude oil, natural gas, coal, uranium, electricity and renewable energy. Of course, there are others but these are the main energy commodities that present profit potential for investors.
Crude oil can be considered the star of commodity trading on a global level. It is one of the most traded commodities and accounts for more than forty percent of global energy consumption. However, unlike other commodities, the price of crude oil is determined more by the level of supply than demand. This means that anything that affects the supply of oil from production issues to civil unrest can impact the price of oil and drive it up. Likewise, if supply increases and there is plenty of crude oil in demand, the price has a tendency to drop.
Metal Drives Development
Metals have always been critical to civilizations throughout history. Essentially, those who succeeded in producing and using metals have always been able to not only survive but thrive. Virtually everything we use today contains metal to some degree and without it we would still be living in the Stone Age.
There are two main categories of metals, namely industrial metals and precious metals. Precious metals have always been an excellent investment and they include gold, silver and platinum. While these also have applications in industry, they are still considered a separate class.
Gold, for example, is probably the most desired metal on a global level for the simple reason that it is virtually indestructible. Gold cannot be eroded and the almost 150,000 tons of gold that have been mined since the time of the Pharaohs are all still in existence today. Add to that the fact that it is quite rare compared to other metals and you have an asset that deserves to be in a class of its own.
Like oil, gold prices behave differently to other commodities and investments in general. Gold has always been considered the one investment that maintains its value, no matter the state of the economy or society. Therefore, it has always been used as a risk management tool during downturns and periods of civil unrest such as wars, with most investors converting the majority of their investment portfolio into gold. The result is that the price of gold tends to rise significantly during recessions and is an excellent hedging asset against inflation.
During periods of economic growth industrial metals are a sound investment such as steel, aluminium, copper and nickel. The more the global population grows and the more society shifts from being mainly rural to urban, the higher the demand of industrial metals will be. Considering that the population of the globe is expected to reach just under 10 billion by 2050 and the degree of urbanization has increased exponentially, industrial metals make for a sound, long-term investment.
Agriculture Drives Humans
No food, no people. Quite a simple conclusion. While the price of food might fluctuate according to various factors from supply and demand, to weather, diseases, social unrest and more, people will always need it to survive. Therefore, it goes without saying that it can present some interesting opportunities.
Agricultural commodities include everything from coffee, cocoa, sugar and frozen concentrated orange juice to live cattle, lean hogs and frozen pork bellies. Despite encompassing such a wide range of commodities, each of the constituents has a different reaction in terms of pricing. For example, when pricing livestock one needs to understand the cyclical nature of growing cattle, when looking at coffee one needs to consider that harvests can be affected by many things, with the most important being nature and so on.
Commodity Trading: The Basics
Commodity trading takes place on different markets allowing investors the option to invest directly or indirectly. Commodities can be traded on spot markets, futures and options markets and equity markets.
Spot Markets
On spot markets a commodity is traded directly for cash or bartered for another commodity. For example, buying an ounce of gold in exchange for cash at a jewelry store is considered a spot trade. It’s called as such because the trade is being made ‘on the spot.’ The same applies for livestock auctions where herds of cattle are bought and paid for on the spot.
Futures and Options Markets
Futures contracts on commodities are used both for hedging as well as speculation. A futures contract is a contractual agreement between two parties where one party agrees to purchase a certain quantity of a commodity for a certain price at a certain date in the future and the other party agrees to make the sale under these conditions.
Many companies use futures contracts as a hedge against price volatility. For example, a bread manufacturer might enter into an agreement to buy a certain quantity of grain at a fixed price at a certain date in the future. This allows the manufacturer to hedge against the possibility that the weather might not “play nice” and the resulting harvest would not be as good as expected and lead to a rise in price. The futures contract allows a company to lock the price of the commodity and defend against volatility.
Of course, this can backfire if the price drops below that of the agreement but a futures contract creates an obligation meaning that the purchase has to go through, no matter the market conditions.
On the other hand, options are also contractual agreements with similar conditions to futures contracts, except that they give the holder only the right to exercise the option and not the obligation. In other words, if our bread manufacturer were to buy options on grain then they would be defending themselves against volatility while also being able to withdraw from the purchase if the price falls since they are not obligated to make the purchase. However, they will lose their initial investment in the option.
Both futures and options are ideal commodity trading instruments for speculators or traders. Speculation essentially means anyone that is looking to make a profit on the instrument in question, without necessarily being interested in the deliverable. In other words, if you were to invest in cattle directly, you would have to store the cattle if you took delivery until you could sell them. On the other hand, a futures contract or an option gives you the ability to invest in the commodity without taking delivery as long as you make the sale before the futures contract expires.
Equity Markets
Despite the fact that futures and options are the most direct way to invest or trade commodities, equity markets also provide a good investment opportunity. Essentially, you would be investing or trading the stock of companies that produce, transform and distribute commodities. The problem with equity markets is that you will have to take into account other factors that can affect the price that have nothing to do with the commodity itself, such as management, profit margins, debts and so on.
Commodity Trading vs Investing
Commodities are excellent both for investors as well as traders. While they have not always been seen as a good investment, the fact that you can take a bullish or bearish position depending on market conditions makes commodity trading an excellent money-making opportunity.
Traditionally speaking, commodities are not considered to be an ideal investment because they are made to be consumed and not to provide a financial return, like stocks or bonds. However, the past few years have shown that commodities are starting to gain power and significant growth has been witnessed.
Commodities make a good investment for the simple reason that most of them are inelastic goods. Economically speaking, elasticity determines the effect price has on supply and demand, namely it is a formula used to work out exactly how much price changes will affect the level of supply and demand.
In the case of commodities, the majority are considered inelastic because demand does not fluctuate significantly with an increase in price because they are essential to our existence. For example, if the price of a television goes up then there will be fewer people willing to pay this price and demand will drop, making it elastic. However, if the price of eggs goes up, the effect on demand will be minimal because people still need to eat, making it inelastic.
This means that as long as humans exist and are trying to create a decent lifestyle then you can be certain of the fact that commodities will be in demand. As previously mentioned, another good reason to invest in commodities is the explosion of the global population and a high degree of urbanization. This will lead to a higher demand for commodities and implicitly a steady increase in price.
As a trader, though, the situation changes slightly. This is because whether the market is moving up or down you can still make a profit for the simple reason that you can go short or long. In fact, by trading futures and options the potential for profit can be incredible. However, in the case of futures, the potential for loss is just as great, which is why commodity trading should be treated just like any other type of trading.
Commodity Trading: The Mechanics
The easiest way to understand how commodity trading works is by looking at an example. So, returning to our bread manufacturer and farmer, we will add a trader to the mix. Let’s presume that the current market price for a metric ton of wheat is $189 but the farmer expects it to drop to $165 in September when he can deliver because that’s what happened the year before.
On the other side, you have the bread manufacturer who thinks that the price of wheat will increase because the weather has been less than conducive to a good harvest. The company fears they will be looking at an increase of up to $250 for a metric ton of wheat. So, they want to make sure that they enter a futures contract to lock in the current price, even if delivery will be in September and it’s currently February.
In comes the trader and his profit. The trader will buy a futures contract from the farmer either for the current market price or a slightly lower price, because the farmer is afraid he will lose all his profit and prefers to lose a little now rather than a lot later. So, our trader buys the futures contract at $187 but he’s not worried because he also believes that the price will rise, just like the bread manufacturer.
He holds on to the futures contract for a month, when the price has already started to rise. Since he’s not interested in taking delivery of the wheat and he thinks the current price of $205 will give him a good return, he now decides to sell the contract. The bread manufacturer, who is still worried about the price hitting $250, will quickly buy the contract to save $45 per metric ton of wheat. The farmer will then deliver the wheat to the bread manufacturer on the appointed date and our trader has made a profit of $18 per metric ton. Considering that wheat is moved by the thousands of tons, our trader would have made a rather nice profit.
As you can see, commodity trading can be very lucrative. However, as with any type of trading, before you embark on this venture you will need to learn all you can about how the markets move and what affects the prices of the commodities you are trading or you could end up losing a lot of money.
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