Commodities

What drives commodity markets?

The commodity markets help to ensure some stability in price, especially through futures contracts. These allow suppliers to lock in the price they’ll receive for their produce at a future date; so the price is also fixed for the buyer.

The commodity prices quoted in the market, therefore, are often the futures price for each commodity; the fixed price at which a commodity will be traded at a specified point in time. Below are some key factors affecting these prices:

 

Supply and demand

Let’s take oil as an example. If the supply of oil becomes more plentiful but demand remains level, the price of each barrel will decrease. If more people are using oil but producers don’t have the capacity to match this demand, the price of each barrel will increase.

Economic and political factors

Although commodities are normally traded on futures prices, economic events that happen now will affect the levels of these prices. For example, political unrest in the Middle East often causes the futures price of oil to fluctuate due to uncertainties on the supply side.

Weather

Agricultural commodities such as wheat or coffee will be heavily influenced by the weather, as it controls the harvest. A poor harvest will result in low supply, causing rising prices.

The dollar

Commodities are normally priced in dollars, and generally move inversely to that currency. A rising dollar is anti-inflationary, so it applies downward pressure on commodity prices. Similarly, a falling dollar will usually apply upward pressure on commodity prices.

 

Inflation and commodity prices

Commodities can be used as a natural hedge against inflation. If rapid inflation seems imminent, you may see commodity prices rising very quickly – they may even provide the first sign of inflation. This is because people will be moving money out of investments that don’t offer a hedge against inflation and into the commodity markets, to protect their assets.

Trading commodities

You can invest in commodities in different ways.

 

The spot market

Buying on the spot, or cash, market for commodities, means paying the commodity’s producer for immediate delivery of the physical product. The spot price is the current market price listed. Due to the large quantities traded, and the global range of these trades, set standards are implemented and independently verified so that traders can exchange without the need for a visual inspection.

Futures contracts

This is an agreement to exchange a specific quantity of a commodity at a fixed date in the future, at a price agreed today. The price will be a ‘forward price’, taking into account foreseeable fluctuations such as the cost of carry.

Futures contracts are traded through a futures exchange. Each contract is an agreement between two parties to exchange a given quantity of a commodity, at a specific date in the future, at a price defined today. Effectively, it follows the ‘buy now, pay and collect later’ principle.

On the supply side, by trading commodities through forward contracts, suppliers are able to lock in the price of their commodity before they can deliver it to the consumer. This also fixes the future price for consumers, which helps to maintain price stability in the markets.

 
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Delivery date

As commodities are physical goods, they will eventually need to be delivered (at least theoretically) to fulfil their use. Commodities futures contracts therefore tend to have two or more delivery dates per year, though the vast majority of trades will have closed in advance of the delivery date.

Corn for example, has delivery dates in March, May, July, September and December each year.

Commodity price indices

A commodity price index is a weighted average of commodity prices, grouped to represent a broad class of asset or a more specific subset. Depending on the index, the prices of the constituent commodities may be spot or futures prices. Some examples of commodity indices include:

The Continuous Commodity Index (CCI) comprises 17 commodity futures which are continuously rebalanced to maintain an equal balance of 5.88% each. This gives a benchmark of performance for commodities as an investment.

The S&P GSCI (formerly the Goldman Sachs Commodity Index) acts as a benchmark for investment in the commodity markets, and its constituents are drawn from all commodity sectors. This index is available to those invested in the Chicago Mercantile Exchange.

The Merrill Lynch Commodity Index (MLCX) contains commodities that are selected by liquidity and then weighted according to the importance of each commodity in the global economy.

To find out more about the purpose of indices and how they can be traded through derivative products, please visit our indices section.