Commodities are among the most valuable asset classes, along with stocks, bonds, and real estate. This guide will describe what they are in detail, provide some examples of the most common commodity types, and explain what causes their prices to fluctuate. You’ll also learn how commodity trading works and the key investment strategies.
A commodity is an essential good or material used in commerce to produce and manufacture other goods or services. Commodities are used as inputs in the manufacturing process and are often interchangeable with similar goods.
Commodity assets include agricultural products such as cotton or wool, metals like gold, silver, or aluminum, and energy sources, namely oil, gas, and electricity. They are generally traded between businesses to secure a price for a specific period or by individual investors to earn a profit.
Examples include raw materials and agricultural products like grains, coffee, meat, sugar, wool, metals like gold or silver, or energy like oil or coal. For instance, airline companies use gasoline to offer flight services, grains are used to produce flour, pasta, cereal, or bread, electricity to heat buildings, and gasoline is used for cars.
Determining the price of commodities
Commodities are raw materials that we come across in our daily lives – if prices of essential goods go up and down, it can directly impact the cost of our grocery shopping. If the price for grains like wheat is rising, this is likely to reflect in the price of bread or flour, while an increase in the price of cotton will almost certainly have a direct effect on clothing costs.
However, commodities can also be sold and bought as an investment opportunity. Industries from clothing production (cotton), to airlines (oil), to packaged goods (plastic made out of coal, cellulose, salt, and crude oil) rely on these.
Companies buy commodities that need these essential goods for a fixed price in the long-term; for example, in the production process, invest through futures contracts. What is more, individual traders also invest in commodities in the hopes of making a hefty profit.
Due to the more intricate investment methods, higher risks, and knowledge and research required for commodities, investing in commodities is not as easy as investing in stocks or bonds, and it is not always the best choice for novice investors.
This asset class can be fungible, meaning that if they are of the same grade, they can be swapped with each other. For example, beef cattle grown on a farm in Texas are of the same quality as beef cattle raised on a farm in Oklahoma. So for the buyer, it doesn’t matter where the beef cattle are produced. It can be interchangeable if it is of the same quality and serves an identical practical purpose.
In contrast, commodity assets like gold, diamonds, baseball cards, or a new digital asset class non-fungible tokens (NFTs), as the name suggests, aren’t fungible, as each unit has its unique qualities and differs from each other.
We use commodities to produce groceries, heat our apartments, and unlike stocks or bonds, a commodity is a crucial product that affects the prices of everyday items or what we pay for services.
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A brief history of commodity trading
Historically, commodity trading predates other asset classes such as stocks and bonds by centuries, dating back to the 16th century, when commodity futures markets first appeared in Western countries.
However, it wasn’t until 1848 when the earliest official commodity trading exchange, the Chicago Board of Trade (CBOT), was formed, with the London Metals and Market Exchange founded in England in 1877.
Commodities have been the driver of economic growth for civilizations and are the oldest form of investing, connecting countries that trade their commodities with each other. For example, the Silk Road formed ties between Asia and the Western world. All of which directly linked to the creation of complex bartering exchanges and facilitation of the commodity exchanges.
Main types of commodities
Commodities divide into two separate categories: soft commodities and hard commodities.
Soft and hard commodities are then divided into four main sub-categories:
- agriculture (grains, cotton, coffee);
- livestock (meat) for soft commodities;
- metals (gold, aluminum, copper, platinum);
- energy (renewables, oil, coal, electricity) for hard commodities.
1. Soft commodities
Soft commodities are traditionally grown or farmed, like cotton or beef cattle.
Agriculture in the soft commodity category includes essential goods farmed and grown, such as corn, wheat, rice, coffee beans, cocoa beans, cotton, or sugar. In this sector, commodity prices can be highly volatile during the summer months, as they are affected by the weather.
As there is an ever-increasing demand for agricultural commodities, driven by the growth in population, it can provide opportunities to make a profit for investors.
Livestock is animals raised and farmed in agriculture to produce meat, eggs, fur, leather, or wool. It is a labor-intensive process, where animals are raised for the sole purpose of consumption or to make other products. For example, cattle, sheep, and goats fall under the livestock category.
2. Hard commodities
Hard commodities require mining to obtain them, such as gold or oil.
The commodity category of metals includes goods like gold or silver and platinum, aluminum, or copper. During bear or down markets, precious metals tend to be a safer and more reliable investment, as metals, particularly gold, can offer sustainable value and act as a hedge against inflation.
Energy commodities include crude oil, petroleum, natural gas, or electricity. Global economic factors can have a direct impact on price fluctuations.
For example, investors should look out for new technological advances in alternative energy sources like solar energy, wind energy, or biofuel, reducing the demand and prices of traditional commodities like crude oil as primary energy sources.
What are commodity futures?
Commodity futures are legal agreements that oblige two parties into a contract. An example of a standardized agreement would be to purchase or sell an underlying commodity, for example, barley, at a specified later date for a fixed, already agreed-upon price.
Goods like metals, grains, cotton, or other goods, including the US and foreign currencies, are traded in the futures market. Execution of these contracts required physical presence, for example, in the Chicago Mercantile Exchange (CME) or the New York Mercantile Exchange (NYMEX); however, since it is now possible to trade online, it has become decentralized and can happen from almost anywhere in the world.
What causes commodity prices to rise and fall?
Commodities are riskier than average investment, mainly because the prices can fluctuate due to several unpredictable factors. Uncertainties such as pandemics, epidemics, natural disasters, wars, and unusual weather patterns, both natural and artificial, can affect supply and demand.
For example, the Covid-19 pandemic in 2020 caused oil prices to crash due to restrictions on travel and tourism, where the supply drastically increased and demand decreased, making the prices tumble.
As opposed to other asset classes such as stocks or bonds, commodity prices tend to have a different pattern in correlation to the economic cycles. Where stocks gain value, commodities decrease in value, and vice versa, which is why commodities are a good way to diversify portfolios and serve as a hedge against inflation.
Conclusively, the supply and demand in the market drive the commodity price ups and down in value. High demand and low supply equal higher prices, whereas low demand and high supply equal lower prices -for example, a significant disruption such as wildfires can lead to crop shortages.
But economic factors can also play a part: manufacturing, as a huge part of China’s economy, increases their need for metal and steel compared to the rest of the world.
Commodities and the economic cycle
Commodity prices are cyclical, and in contrast to stocks or bonds, often increase and decrease in different economic cycles, implying that the performance of commodities during economic recessions is the opposite of stocks or bonds.
The four economic cycles are expansion, peak, contraction, and through, forming a wave-like pattern as seen below.
Note: Stock prices usually decrease during an economic downturn or a bear market and increase during economic prosperity or a bull market. In contrast, commodities tend to perform well in different phases – during the economic expansion and in the early recession periods.
When the economy starts to slow down, interest rates decrease to promote economic activity, which also helps with commodity performance. What is more, the demand for tangible assets like gold often rises and is protected against inflation.
Therefore, people looking to profit from their investment during all phases of the economic cycle or diversify their portfolio would invest in commodities. However, it is essential to note that this is in no way guaranteed, and commodities can also act independently of the business cycle, making them a risky investment.
How are commodities traded?
There are a few ways to invest in commodities – the most common is through futures contracts, exchange-traded funds (ETFs), or direct purchases.
Precious metals such as gold and silver can be bought directly, whereas goods like grains or oil are usually through futures contracts. In general, commodities are traded on a futures market – suppliers negotiate directly with the buyers, agree on a fixed price, and set a date on when they will deliver these goods in the future.
Businesses who need to buy essential goods to be used in production, farmers and miners who want a set long-term price, speculators seeking a profit, and individual consumers seeking to protect themselves against inflation are all examples of those who trade in commodities.
1. Bought directly
People can buy precious metals like gold or silver outright as physical assets; individual investors looking to trade these items can be individual commodity buyers.
Individuals can purchase commodities directly through numerous ways, like through online dealers or pawn shops. An individual buyer could decide to buy large amounts of gold, keeping it in a safe place as a hedge against inflation. However, the risk of owning the physical asset is that you need to find a safe place to store it.
2. Through futures contracts
There are two main types of investors who buy commodities through futures contracts: business users wishing to secure prices and speculative investors who want to profit.
Trading through futures is the most common method of investing in commodities; however, it isn’t necessarily the most accessible way and comes with a high risk.
A futures contract can protect businesses, suppliers, and manufacturers against unexpected price changes. For manufacturers to secure their margins, futures contracts are created with suppliers who guarantee a fixed price at a set time in the future and avoid any future price increases.
a) For example, Mars Incorporated, a multinational confectionery manufacturer, owns multiple chocolate brands like Galaxy, M&M’S, Snickers, Twix, and Milky Way. They know they need bulk quantities of cocoa beans to produce chocolate bars.
This bulk purchase can be made at today’s prices through futures contracts, meaning that the production costs of making chocolate will remain more stable and won’t be affected by price fluctuations.
b) Or a farmer is selling his corn in the futures market – he is in the seller position, gets a contract with the buyer for selling his corn at a set price rate, promising to deliver the corn at a set time in the future. This way, the seller is guaranteed an order at a fixed price, so even if the price declines between the production and the sell-by date, he gets the same price.
c) Another example is airlines, which often use futures contracts to guarantee their fuel supply at a fixed rate to avoid any unexpected price increases in oil and gas.
Others who participate in exchanges in futures markets are speculative investors, who trade commodities through futures contracts for short periods to generate profits from price changes. This strategy involves closing out their contracts before they are due, as they don’t actually need to commodity but only wish to make profits from the price fluctuations. Trading this way isn’t as easy and requires a brokerage account and a minimum deposit.
A minimum deposit is required to cover the cost if the commodity price (value of the contract) decreases. If the value goes down, investors may also be required to deposit more money into the account to keep it open. Therefore, due to high volatility and several external factors, a futures contract can either gain significant returns or experience large losses over a short period.
3. Investing in commodity-related stocks
An alternative and easier way to invest in commodities is by buying into commodity-related businesses. For example, people interested in purchasing gold could instead purchase stocks of mining companies or refineries, or for energy commodities like oil, investors can opt to buy stocks of refineries or tanker companies.
However, on top of the economic and other external factors impacting commodity prices, stocks are also affected by company-related issues that have nothing to do with the commodity price changes. Therefore, investors need to know whether the commodity is a good investment as well as check whether the company is doing well overall financially.
But there are quite a few favorable advantages to investing in commodities through stocks. Firstly, public information about a company is already available, and it is also easier to invest in stocks than in futures contracts. Moreover, stocks are generally less prone to price swings than futures contracts.
4. Using exchange-traded funds (ETFs)
Most commodities, however not all of them, trade on commodities exchanges. There are a few most common exchanges: the Chicago Board of Trade (CBT) and the New York Mercantile Exchange (NYMEX) or the London Metal Exchange (LME).
Some funds focus on the same single commodity and hold it in physical storage (physically-backed funds), funds that invest in futures contracts (futures-based funds), or funds that invest in commodity-related stocks (ETFs in commodity-related stocks).
There are four most common types of commodity ETFs:
- ETFs that invest in commodity-related stocks;
- Exchange-traded notes (ETNs);
- Physically backed funds;
- Futures-based funds.
Exchange-traded funds are an additional way to invest in commodities; investors can benefit from price fluctuations in commodity prices to profit.
Some ETFs hold physical commodities in their possession, dealing with precious metals like gold. However, in most cases, the fund managers aren’t purchasing the real thing either and investing in companies that deal with a particular commodity, such as oil or gold, or invest in futures contracts.
5. Commodities pools
Another way is to invest in commodity pools – investment structures where individual investors can combine their money to trade in futures contracts under a single entity to gain more leverage and diversify the assets.
These are different from traditional exchange-traded funds. Investors won’t own a share of an asset but instead buy into the right to sell them during a short time window, which can be even riskier than other ways of investing in commodities.
Before you start investing in commodities
Commodities are one of the five major asset classes; however, they aren’t considered a good option for new or individual investors due to the high risk involved. They are affected by the economic cycle and unpredictable disruptions like natural disasters. What is more, investing in commodities tends to be more complicated than buying stocks or bonds.
However, there are several upsides in buying commodities for businesses, suppliers, and individual investors.
Things to keep in mind when investing in commodities:
- When an individual investor trades commodities, it comes with the obligation to buy or sell the commodity futures without getting the asset. This trading model can be somewhat confusing and requires a thorough understanding of the risks involved;
- Commodities are generally invested through commodity futures by suppliers or manufacturers who want to secure the price of an asset for a period or by speculative investors to make a profit;
- They are riskier investments, as the performance of certain commodities can be unpredictable. Commodities are affected by the economic cycles, human-made disruptions, and factors like natural disasters, floods, or draughts, all of which can suddenly impact the prices. For instance, oil prices can be affected by political activity in the Middle East or crops impacted by wildfires in Australia;
- Commodities in a broader portfolio are encouraged for portfolio diversification, as they tend to perform in opposite economic cycles to other asset classes like stocks and bonds;
- High earning potential but comes with a high risk-reward balance;
- Exchange-traded funds can provide lower risks than futures contracts, as futures are more speculative. What is more, the stakes are higher due to margin requirements.;
- Despite high risks, commodities can act as a hedge against inflation. For example, in particular, precious metals like gold can be a solid investment in a market downturn;
- There are also certain ethical factors to consider.
Like any investment, commodities come with a high risk-return tradeoff; people need to understand the market thoroughly and know what makes commodity prices go up or down.
It is essential to analyze how each commodity is affected separately. A background in a specific sector of a particular commodity is, therefore, extremely beneficial when it comes to making the right decisions, as investing in these essential goods involves more than analyzing public information about business performance.
FAQs about commodities:
What are commodities?
Commodities are essential goods or materials used in commerce to produce and manufacture other goods or services. These basic goods are used as inputs in the manufacturing process and are often interchangeable with other similar goods.
We come across these raw materials in our daily lives – when prices of these essential goods go up, it can have a direct impact on our grocery shopping costs. For example, if the price of wheat is rising, it can be seen in the prices of bread or flour, and if cotton prices increase, it can directly impact the retail prices of apparel.
What are the main types of commodities?
Commodities are divided into two separate categories: soft commodities (traditionally grown or farmed, like cotton or beef cattle) and hard commodities (require mining to obtain them, such as gold or oil).
How are commodities traded?
The most common ways to trade commodities are through futures contracts and exchange-traded funds (ETFs), but also via direct purchases. Precious metals like gold or silver could be bought directly, whereas agriculture and energy sources are traded on a futures market. Suppliers and manufacturers that need large amounts of raw materials to guarantee a fixed price in the long term would invest in commodities through the futures market.