Introducing the financial markets

Lesson 9 of 10

What are commodities?

Commodities are physical assets. Unlike equities, indices or currencies they are raw materials mined, farmed or extracted from the earth. Some examples include:

To be officially tradable, a commodity must be entirely interchangeable with another commodity of the same type, no matter where it was produced, mined or farmed.

For example, to a commodity trader, gold is gold. It doesn't matter where it was extracted. An ounce of gold mined in Australia is worth exactly the same amount as an ounce of gold mined in China, the USA or Tanzania.

The same can be said of other commodities such as natural gas, cotton and copper, so long as they meet certain minimum quality or purity standards.

Economists call this being fungible and it means large quantities of commodities can be traded relatively quickly and easily on an exchange. This is because every trader can be confident they are buying/selling equivalent assets without needing to inspect them, or find out where or how they were produced.

Question

Which of the following can be classed as commodities? Please select all answers that apply:
  • Oats
  • Tin
  • Plastic
  • Sugar

Correct

Incorrect

Oats, tin and sugar are all fungible commodities, but plastic is not. There are hundreds of different types of plastic all manufactured to different specifications.
Reveal answer

Types of commodity

Commodities are often placed into two groups:

Soft commodities

These are agricultural commodities, farmed rather than mined or extracted. Softs tend to be very volatile in the short term, as they're susceptible to seasonal growing cycles, weather and spoilage which can suddenly and dramatically affect prices.

Hard commodities

These are generally mined from the ground, or taken from other natural resources. Hard commodities are typically easier to handle and transport than softs, and are more easily integrated into the industrial process.

You may also see commodities classified according to their ecological sector:

  • Energy (oil and gas)
  • Metal (gold, silver, copper, lead, etc)
  • Agriculture (wheat, coffee, livestock, etc)

Question

Is the following a hard or soft commodity?

Orange Juice
  • a Hard
  • b Soft

Correct

Incorrect

Orange Juice is a soft commodity.
Reveal answer

Question

Is the following a hard or soft commodity?

Brent Crude Oil
  • a Hard
  • b Soft

Correct

Incorrect

Brent Crude Oil is a hard commodity.
Reveal answer

Question

Is the following a hard or soft commodity?

Palladium
  • a Hard
  • b Soft

Correct

Incorrect

Palladium is a hard commodity.
Reveal answer

Question

Is the following a hard or soft commodity?

Soybeans
  • a Hard
  • b Soft

Correct

Incorrect

Soybeans are soft commodities.
Reveal answer

How are they traded?

There are two main ways to trade commodities:

The spot market

The spot market is where financial assets are sold for cash and exchanged right there and then. So, if you need immediate delivery of a commodity, you'd head to the spot market.

For example, say you ran a business that built industrial pipes. You recently got an order for a large amount of copper piping, but there's none left in the warehouse. You need the copper immediately, so your best bet is to go to the spot market and buy some.

Similarly, if you owned a mining company and had some copper you wanted to get off your hands straight away, you'd try and sell it on the spot market.

Due to the large quantities of commodities traded - and global nature of these trades - set standards are used by the spot market so traders can buy and sell commodities quickly without the need for a visual inspection.

The futures market

The futures market is a place where buyers and sellers agree to exchange a specific quantity of an asset at a fixed date in the future, at a price agreed today.

The assets in question are not physically traded on the exchange, so the participants buy and sell futures contracts instead. This enables traders to speculate on the price of commodities without having to own them at any point, because the contracts can be sold or closed before the actual delivery date.

Which is particularly useful if, for example, you want to trade on the price of cattle, but don't want several herds of live cows delivered to your door in a few months' time...

While futures contracts are often used by individuals and companies looking to exchange physical commodities at a later date, they are predominantly used for speculation and hedging.

It's also worth noting that the price of futures contracts tends to be different from buying or selling an identical amount of that same commodity on the spot market. That's because the seller needs to take into account future risks and charges, such as the cost to hold the commodity and then transport it to the buyer. Hence futures contracts are valued using forward prices, rather than spot prices.

Who trades commodity futures?

There are four main types of commodity futures trader.

Producers

These are companies/individuals that produce or extract commodities and enter into a futures contract to offset the risk of future price movements. If, for example, you are a coffee farmer and agree to sell your yield for a specific price on a specific date, you will have a guaranteed income on that date even if coffee prices plummet in the meantime.

Speculators

These are traders looking solely to profit on commodity price movements. They generally have no interest in owning the physical commodity itself.

Hedgers

These are mid- or long-term investors who hold commodities in their portfolio to provide protection against downward movements in other securities. Commodities tend to move in an opposite direction (or at least an unconnected direction) to certain stocks and bonds.
In the event of a stock market crash, for example, investors holding commodities may not suffer as badly as those with exclusively share-based portfolios. Gold in particular is seen as a 'safe haven' and receives significant investment when equities are unstable.

Brokers

These are firms or individuals who buy and sell commodity contracts on behalf of their clients.

Lesson summary

  • Commodities are physical assets that are mined, farmed or extracted from the earth
  • They can be soft commodities (agricultural) or hard commodities (energy and metals)
  • They are traded on either the spot or futures market
  • The spot market is generally for buyers and sellers of the physical commodity, while the futures market tends to be dominated by speculators and hedgers
Lesson complete