Understanding the Essence of Commodities and Their Role in Global Trade

Explore the world of commodities and their significant role in global trade. Understand what commodities are, how they're traded, and why they're crucial in a diversified investment portfolio. Discover the difference between hard and soft commodities and learn how they can serve as a hedge against inflation.

INVEST WISELY

James Davis

7/21/20236 min read

Defining Commodities

Commodities are fundamental goods that are used in commerce and can be exchanged with other similar goods. They are often utilized as raw materials in the creation of other goods or services. The term 'commodity' typically refers to a raw material that is used to manufacture finished goods, while a 'product' refers to the finished good that is sold to consumers.

The quality of a specific commodity may vary slightly, but it is essentially consistent across different producers. When commodities are traded on an exchange, they must meet certain minimum standards, also known as a basis grade.

Key Points to Remember

  • Commodities are basic goods used in commerce that can be exchanged with other commodities of the same type.

  • Commodities are frequently used as inputs in the production of other goods or services.

  • Investors and traders can directly buy and sell commodities in the spot (cash) market or via derivatives such as futures and options.

  • Hard commodities refer to energy and metals products while soft commodities are often agricultural goods.

  • Including commodities in a diversified portfolio is recommended as a hedge against inflation.

Delving Deeper into Commodities

Commodities are the raw materials used in the production of goods. They may also be basic staples such as certain agricultural products. The crucial characteristic of a commodity is that there is very little, if any, differentiation in that good whether it is coming from one producer or another. A barrel of oil is essentially the same product, regardless of the producer. The same applies to a bushel of wheat or a ton of ore. Conversely, the quality and features of a given consumer product will often be quite different depending on the producer (e.g., Coke vs. Pepsi).

Traditional examples of commodities include grains, gold, beef, oil, and natural gas. More recently, the definition has expanded to include financial products, such as foreign currencies and indexes. Technological advances have also led to new types of commodities being traded in the marketplace. For example, cell phone minutes and bandwidth.

Commodities can be bought and sold on specialized exchanges as financial assets. There are also well-developed derivatives markets where you can buy contracts on such commodities (e.g., forwards, futures, and options). Some experts believe that investors should hold at least some portion of a well-diversified portfolio in commodities since they are not highly correlated with other financial assets and may serve as an inflation hedge.

Experts generally recommend that around 5-10% of a portfolio be allocated to a mix of commodities. Those with a lower risk tolerance may consider a smaller allocation. Ordinary investors can look to one of several commodities ETFs or mutual funds to gain exposure.

Commodities: Buyers and Producers

The sale and purchase of commodities are usually carried out through futures contracts on exchanges that standardize the quantity and minimum quality of the commodity being traded. For example, the Chicago Board of Trade (CBOT) stipulates that one wheat contract is for 5,000 bushels and states what grades of wheat can be used to satisfy the contract.

There are two types of traders who trade commodity futures. The first are buyers and producers of commodities that use commodity futures contracts for the hedging purposes for which they were originally intended. These traders make or take delivery of the actual commodity when the futures contract expires.

For example, the wheat farmer who plants a crop can hedge against the risk of losing money if the price of wheat falls before the crop is harvested. The farmer can sell wheat futures contracts when the crop is planted and guarantee a predetermined price for the wheat at the time it is harvested.

Speculation in Commodities

The second type of commodities trader is the speculator. These are traders who trade in the commodities markets for the sole purpose of profiting from the volatile price movements. These traders never intend to make or take delivery of the actual commodity when the futures contract expires.

Many of the futures markets are very liquid and have a high degree of daily range and volatility, making them very tempting markets for intraday traders. Many of the index futures are used by brokerages and portfolio managers to offset risk. Also, since commodities do not typically trade in tandem with equity and bond markets, some commodities can be used effectively to diversify an investment portfolio.

Special Considerations

Commodity prices typically rise when inflation accelerates, which is why investors often flock to them for their protection during times of increased inflation—particularly unexpected inflation. As the demand for goods and services increases, the price of goods and services rises, and commodities are what's used to produce those goods and services.

Because commodities prices often rise with inflation, this asset class can often serve as a hedge against the decreased buying power of the currency.

Those interested in learning more about commodities and other financial topics may want to consider enrolling in one of the best investing courses currently available.

Examples of Commodities

Commodities are basic goods and materials that are widely used and are not meaningfully differentiated from one another. Examples of commodities include barrels of oils, bushels of wheat, or megawatt-hours of electricity. Commodities have long been an important part of commerce, but in recent decades the trading of commodities has become increasingly standardized.

Relationship Between Commodities and Derivatives

The modern commodities market relies heavily on derivative securities, such as futures contracts and forward contracts. Buyers and sellers can transact with one another easily and in large volumes without needing to exchange the physical commodities themselves. Many buyers and sellers of commodity derivatives do so to speculate on the price movements of the underlying commodities for purposes such as risk hedging and inflation protection.

Determinants of Commodity Prices

Like all assets, commodity prices are ultimately determined by supply and demand. For example, a booming economy might lead to increased demand for oil and other energy commodities. Supply and demand for commodities can be impacted in many ways, such as economic shocks, natural disasters, and investor appetite (investors may purchase commodities as an inflation hedge if they expect inflation to rise).

Difference Between a Commodity and a Security or Asset

Commodities are physical products that are meant to be consumed or used in the production process. Assets, on the other hand, are goods that are not consumed through their use. For instance, money or a piece of machinery are used for productive purposes, but persist as they are used. A security is a financial instrument that is not a physical product. It is a legal representation (e.g., a contract or claim) that represents certain cash flows generated from various activities (such as a stock representing the future cash flows of a business).

Types of Commodities

Hard commodities are usually classified as those that are mined or extracted from the earth. These can include metals, ore, and petroleum (energy) products. Soft commodities instead refer to those that are grown, such as agricultural products. These include wheat, cotton, coffee, sugar, and soybeans, among others.

Where Are Commodities Traded?

The major U.S. commodity exchanges are ICE Futures U.S. and the CME Group, which operate four major exchanges: the Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange (NYMEX), and the Commodity Exchange, Inc. (COMEX). There are also major commodities exchanges located around the world.

"Gold is a great thing to sew into your garments if you're a Jewish family in Vienna in 1939, but I think civilized people don't buy gold, they invest in productive businesses." - Warren Buffett

Conclusion

Commodities play a vital role in the global economy, serving as the building blocks for the production of goods and services. They offer a variety of investment opportunities, from direct buying and selling in the spot market to trading in derivatives such as futures and options. Commodities also provide a hedge against inflation and a means of diversification for investors. Understanding the nature of commodities, their types, and how they are traded can help investors make informed decisions and potentially enhance their investment portfolios.

Frequently Asked Questions

1. What is a commodity?

A commodity is a basic good used in commerce that is interchangeable with other goods of the same type. Commodities are most often used as inputs in the production of other goods or services.

2. What are some examples of commodities?

Traditional examples of commodities include grains, gold, beef, oil, and natural gas. More recently, the definition has expanded to include financial products, such as foreign currencies and indexes.

3. How are commodities traded?

Commodities can be bought and sold on specialized exchanges as financial assets. There are also well-developed derivatives markets where you can buy contracts on such commodities (e.g., forwards, futures, and options).

4. What is the difference between hard and soft commodities?

Hard commodities are usually classified as those that are mined or extracted from the earth, such as metals, ore, and petroleum (energy) products. Soft commodities instead refer to those that are grown, such as agricultural products like wheat, cotton, coffee, sugar, and soybeans.

5. Why are commodities important in an investment portfolio?

Including commodities in a diversified portfolio is recommended as they provide a hedge against inflation and are not highly correlated with other financial assets. This means they can offer a level of protection in volatile market conditions.

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