Commodities are natural resources that have a global market, most of which fall into the category of agriculture, energy, or metals. The main characteristic of commodities is that they are needed by modern societies and they greatly fluctuate in price. The commodity markets help to maintain price stability through forward and futures contracts by allowing suppliers to lock in the price of their commodity before they can deliver it to the consumer, which also fixes the future price for consumers.
Most commodities have a limited geographic distribution. Only certain nations, regions, or companies have economic access to these specific resources, but virtually every region needs the resources. Hence, a large global market has developed to enable the distribution of commodities from their most economical sources to where it is needed.
Uniformity and fungibility are other qualities of commodities—gold is gold and platinum is platinum. Since the commodity is not uniquely identifiable, it is fully fungible (interchangeable). While there are some differences in the quality of some commodities, especially oil and many agricultural products, these commodities are graded and classified as a specific type so that their characteristics are fairly uniform and therefore fungible, since it would be very difficult—in some cases, impossible—to inspect the whole product. Of course, it is only because inspection is not necessary that the large commodity markets, with its many traders and speculators who can't inspect the product, can exist today.
Hence, most commodities can be characterized by the following qualities: natural resources needed by most nations or regions; large price fluctuations; economical sources in limited geographic regions; and uniformity of the product.
Types of Commodities
Some examples of commodities include the following:
- orange juice
- pork bellies (bacon)
- rough rice
- soybean meal
- soybean oil
- crude oil
- heating oil
- natural gas
Investment Characteristics and Risks
Commodity prices, like the prices of everything else, depends on supply and demand. Increased demand and lower supply increases prices, and vice versa. And because the supply-demand equilibrium for any commodity continually changes, so does its price.
The prices of many commodities are also affected by the season, especially agricultural products. For instance, corn usually peaks in March and April before the growing season, and reaches a low in September and October, after all the crop has been harvested. Seasonality is caused not only be the weather, but also by varying seasonal demands. For instance, crude oil prices tend to rise in the summer because of increased driving for vacations, while natural gas peaks in the winter since its main use is to heat homes.
Diversification is one of the main benefits of investing in commodities—commodity prices tend to rise and fall at different times and rates from other investments, such as stocks or bonds.
Commodities are a natural hedge against bad economic times. Since most commodities are necessities, especially agricultural products and energy, their demand, and therefore their prices, remain buoyant even when the economy sours—in other words, their prices are inelastic at the lower end of the demand curve.
Commodities, like real estate, are also a natural hedge against inflation. In fact, a rise in commodity prices may be the 1st sign of inflation. Indeed, if rapid inflation seems imminent, then commodities may rise even faster, because people will be moving money out of investments that don't offer a hedge against inflation to the commodity markets, to protect their assets. This is what happened in 2008 after the real estate bubble finally popped, when prices were deflating, and many bonds that were dependent on mortgage income, such as mortgage-backed securities, were rapidly losing value as more people defaulted on their mortgages. This, in turn, greatly depressed consumer confidence and spending, which caused a downturn in the economy, which caused the stock market to suffer. As people moved much of their money out of stocks, bonds, and real estate, they moved some of it into the commodities market, which pushed up the prices of commodities, and further depressed stock prices because the profits of many companies are diminished when commodity prices are higher. This was the primary reason why oil prices increased 150% during the spring and summer of 2008, and naturally this increases costs for most companies, since virtually every depends on oil to some extent.
The disadvantages of investing in commodities are price volatility and limited profit potential.
The commodities market is volatile because supply and demand are dependent on many factors that cannot be controlled or predicted, such as the weather, the time it takes to find new sources and to bring it to market, or geopolitical factors.
Leverage and speculation exacerbate the volatility of commodities. Because most commodities are bought or sold using futures contracts, traders can use very high leverage ratios, as high as 10:1, in their trades, which causes many traders to become nervous and trade accordingly if there is any news that may cause prices to rise or drop significantly. Hence, a forecast of a colder than normal winter may cause the price of frozen orange juice to shoot up, or the threat of another war in Nigeria or the Middle East may cause oil prices to spike, or the threat of hurricanes that can limit oil refining can cause the price of gasoline to spike, which happened after Hurricane Katrina damaged oil refineries in the Gulf of Mexico. During the spring and summer of 2008 crude oil went from under $100 per barrel to almost $150 per barrel due mostly to speculation (and the summer driving season, of course).
There are also geopolitical risks with many commodities. Events in countries of major suppliers of commodities can cause the prices of commodities to gyrate wildly from day-to-day, such as happens to oil prices whenever there is civil conflict in Nigeria that may threaten the supply of oil. A major geopolitical risk for companies that extract natural resources is the threat of nationalization or major increases in taxes. For instance, in 2006, Bolivia nationalized the natural gas industry, and expelled the foreigners of companies that were extracting and processing their natural gas.
Another major risk is currency risk, where the value of the currency used to buy the commodity can decline with respect to the currencies of the major suppliers of that commodity. For instance, when the value of the United States dollar declines against major currencies, the price of oil increases.
Profiting from Commodity Trading
The main method of making money by investing in commodities is by buying low and selling high, not necessarily in that order, but within a short time. This is because the prices of commodities continually cycles up and down—prices do not trend upward or downward indefinitely. Higher prices increases the supply and lowers the demand of all commodities, and vice versa—hence, the upper and lower limits to commodity prices is strictly limited. So you cannot use a buy-and-hold strategy to make significant amounts of money like you would in buying the stock of a growing company.
For this reason, it is not usually profitable to buy the commodity itself, unless you actually intend to take delivery and use it for your business. You can buy gold, for instance, and hold it indefinitely, and while the price may climb for a while, it is sure to fall back again, although it will trend upward with inflation. Furthermore, actually holding the commodity makes it more difficult to sell it for profit.
An investment in commodities does not pay interest or dividends, unless you invest in a commodity company that pays dividends, but then the value of your investment will depend more on the profitability of the company than the commodity, which can be affected by the effectiveness of its management, its proficiency in conducting its business, and its ability to minimize expenses. The company can also be subjected to extensive geopolitical and currency risks if it operates in multiple countries, especially third-world countries, as many commodity companies do.
Trading and market timing are necessary to make significant profits from commodities, and the best financial instrument for trading commodities is futures. Futures contracts are standardized forward contracts traded on several organized exchanges that stipulate the amount of the commodity, delivery price, and delivery date. The futures contract expires on the delivery date.
A trader that opens a position by selling a futures contract is said to be short and obligates the seller to provide delivery of the commodity, while a trader that opens a position by buying a contract is considered long and obligates the contract buyer to take delivery according to the terms of the contract.
Most speculators close out their positions before the expiration of the contract by offsetting their contract with another contract with the same terms—the short seller buys back the contract before the delivery date, and the long buyer sells the contract. Offsetting the contract before the delivery date relieves the trader of making or taking delivery of the commodity. Profits are made by closing the position at a higher price than its opening price.
So to profit from trading, you must be able to forecast the market for the commodity to some degree, since you will have to buy low and sell high before the contract expires, which is harder to do than investing in undervalued companies or companies with high growth potential using a buy-and-hold strategy.
Hence, to be successful, intimate knowledge of both the commodity and its market is necessary. Success also requires constant monitoring of any news that may affect the supply and demand of the commodity, since the price depends on both the supply and demand.