Commodity Explained

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Commodity

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. The quality of a given commodity may differ slightly, but it is essentially uniform across producers.

When they are traded on an exchange, commodities must also meet specified minimum standards, also known as a basis grade. They tend to change rapidly from year to year.

What’s a Commodity?

Understanding Commodities

The basic idea is that there is little differentiation between a commodity coming from one producer and the same commodity from another producer. A barrel of oil is basically the same product, regardless of the producer.

By contrast, for electronics merchandise, the quality and features of a given product may be completely different depending on the producer. Some traditional examples of commodities include the following:

  • Grains
  • Gold
  • Beef
  • Oil
  • 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 exchanged in the marketplace. For example, cell phone minutes and bandwidth.

Key Takeaways

  • A commodity is a basic good used in commerce that is interchangeable with other commodities of the same type.
  • Commodities are most often used as inputs in the production of other goods or services.
  • Investors and traders can buy and sell commodities directly in the spot (cash) market or via derivatives such as futures and options.
  • Owning commodities in a broader portfolio is encouraged as a diversifier and a hedge against inflation.

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 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 that 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 that 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.

Commodities Speculators

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 also be used effectively to diversify an investment portfolio.

Commodities as a Hedge for Inflation

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.

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What Are Commodities and How Do You Trade Them?

You can invest in everything from soybeans to cattle

If you have ever wondered what a commodity is, rest assured you are not the only one that has asked. Commodities, along with stocks, bonds, real estate, and other assets, form one of the major investment asset classes. Though they are largely not appropriate for individual investors due to their bulk nature, everyone from packaged food companies to airlines rely on them to conduct business.

Commodities are natural resources and foods that come from the earth. Some examples of these goods are wheat, cattle, soybeans, corn, oranges, various metals, coal, cotton, and oil. Commodities of the same grade are considered fungible—that is, interchangeable with other commodities of the same grade regardless of who produced or farmed it.

Commodities Explained

An example of a fungible could be high-quality copper produced by a mining company in Colorado, and a different mining company in Wyoming which also produces high-quality copper. If the copper produced by both mining companies receive the same grade or purity, it is considered fungible. As a buyer of high-quality copper, it doesn’t matter which mining company produced it as long as the same quality of copper can be received.

Who Trades Commodities and Why

The futures market is one in which suppliers and purchasers of commodities bargain for delivery and payment of the goods to be delivered on a future date. Farmers, miners, investors, speculators, consumers, and strategic users buy and sell commodities for a variety of reasons.

For some examples, a farmer in the Midwest may want to pre-sell his corn in the futures market. He’ll know he won’t be bankrupted if corn prices decline between planting and when he’s ready to deliver to market (because commodity suppliers and buyers create contracts to buy and sell the commodities).

An airline might buy fuel at a fixed rate using a futures contract in order to avoid the market volatility of crude oil and gasoline.

A company like Kraft Heinz might buy huge amounts of raw coffee for future use in the manufacturing of its Maxwell House coffee brand at today’s prices, allowing the company to monitor and measure its upcoming production costs.

How Commodities Are Traded

Most commodities, but not all, trade on what is known as a commodities exchange such as the Chicago Board of Trade (CBOT) or the New York Mercantile Exchange (NYMEX). In this way, you can buy and sell commodities similarly to stocks.

You can also buy commodities directly. For example, you might purchase Canadian gold maple leaf coins and store them somewhere safe as a hedge against inflation risk.

There are also ways to get indirect exposure to commodities by investing in stocks, mutual funds, or exchange-traded funds that work with specific products or materials. For example, if you don’t want to buy gold directly, you can buy an ETF managed by people who buy gold bullion. Or you could buy shares of a company that mines gold. Taking this approach is generally less risky and easier to understand for the average investor.

Commodity Exchanges and How They Work

Imagine you wanted to buy 30,000 bushels of corn for a cornbread company you own. While you can knock on doors and talk to farmers, it might be easier to use a commodities broker to bid for them. The NYMEX standardizes the commodity contract.

Each contract must be made up of 5,000 bushels of corn, or 127 metric tons. The contract price is quoted in cents per bushel. Listed contracts can represent physical delivery in March, May, July, September, or December.

Once the contracted delivery date is reached, delivery of the commodity is made and money exchanges hands, at the contracted price, regardless of the current price of the commodity.

Commodity Options

If you are a new investor, it might be best to stay away from commodity options until you’re more familiar with trading. Still, if you want to know what a commodity option is, the simple explanation is that it is a financial instrument based on the value of a futures contract.

This financial security is derived from the commodity it is based on. The security is then traded. Another security is created, deriving from the value of the first security derivative—then it is traded.

This is why commodities futures options can be dangerous for new investors—securities derived from securities that were derived from the underlying asset, the commodity, cause confusion.

You are gaining a sort of super-leverage (large debt to fund the investment), paying for the right or obligation to buy or sell the underlying future (the security), which itself is a right or obligation to buy or sell the underlying asset, without collecting the asset.

Commodities Trading: An Overview

Commodities, whether they are related to food, energy or metals, are an important part of everyday life. Anyone who drives a car can become significantly impacted by rising crude oil prices. The impact of a drought on the soybean supply may influence the composition of your next meal. Similarly, commodities can be an important way to diversify a portfolio beyond traditional securities – either for the long term or as a place to park cash during unusually volatile or bearish stock markets, as commodities traditionally move in opposition to stocks.

It used to be that the average investor did not allocate to commodities because doing so required significant amounts of time, money and expertise. Today, there are several routes to the commodity markets, some of which facilitate participation for those who are not even professional traders.

A History of Commodities Trading

Dealing commodities is an old profession, dating back further than trading stocks and bonds. Ancient civilizations traded a wide array of commodities, from seashells to spices. Commodity trading was an essential business. The might of empires can be viewed as somewhat proportionate to their ability to create and manage complex trading systems and facilitate commodity exchange, serving as the wheels of commerce, economic development, and taxation for a kingdom’s treasuries. Although most of the principals were people who actually created or used the physical goods in some way, there were doubtless speculators eager to bet a drachma or two on the upcoming wheat harvest, for instance.

Commodities can be an important way to diversify a portfolio beyond traditional securities – either for the long term or as a place to park cash during unusually volatile or bearish stock markets, as commodities traditionally move in opposition to stocks.

Commodities Exchanges

There are still multitudes of commodities exchanges around the world, although many have merged or gone out of business over the years. Most carry a few different commodities, though some specialize in a single group. For instance, the London Metal Exchange only carries metal commodities, as its name implies.

In the U.S., the most popular exchanges include those run by CME Group, which was formed after the Chicago Mercantile Exchange and Chicago Board of Trade merged in 2006 (the New York Mercantile Exchange is among its operations), the Intercontinental Exchange in Atlanta and the Kansas City Board of Trade.

Commodity trading in the exchanges can require standard agreements so that trades can be confidently executed without visual inspection. For example, you don’t want to buy 100 units of cattle only to find out that the cattle are sick, or discover that the sugar purchased is of inferior or unacceptable quality.

Characteristics of the Commodities Market

Basic economic principles of supply and demand typically drive the commodities markets: lower supply drives up demand, which equals higher prices, and vice versa. Major disruptions in supply, such as a widespread health scare among cattle, might lead to a spike in the generally stable and predictable demand for livestock. On the demand side, global economic development and technological advances often have a less dramatic, but important effect on prices. Case in point: The emergence of China and India as significant manufacturing players has contributed to the declining availability of industrial metals, such as steel, for the rest of the world.

Types of Investment Commodities

Today, tradable commodities fall into the following four categories:

  • Metals (such as gold, silver, platinum, and copper)
  • Energy (such as crude oil, heating oil, natural gas, and gasoline)
  • Livestock and Meat (including lean hogs, pork bellies, live cattle, and feeder cattle)
  • Agricultural (including corn, soybeans, wheat, rice, cocoa, coffee, cotton, and sugar)

Volatile or bearish stock markets typically find scared investors scrambling to transfer money to precious metals such as gold, which has historically been viewed as a reliable, dependable metal with conveyable value. Precious metals can also be used as a hedge against high inflation or periods of currency devaluation.

Energy plays are also common for commodities. Global economic developments and reduced oil outputs from wells around the world can lead to upward surges in oil prices, as investors weigh and assess limited oil supplies with ever-increasing energy demands. Economic downturns, production changes by the Organization of the Petroleum Exporting Countries (OPEC) and emerging technological advances (such as wind, solar and biofuel) that aim to supplant (or complement) crude oil as an energy purveyor should also be considered.

Grains and other agricultural products have a very active trading market. They can be extremely volatile during summer months or periods of weather transitions. Population growth, combined with limited agricultural supply, can provide opportunities to ride agricultural price increases.

Using Futures to Invest in Commodities

A popular way to invest in commodities is through a futures contract, which is an agreement to buy or sell a specific quantity of a commodity at a set price at a later time. Futures are available on every category of commodity.

Two types of investors participate in the futures markets:

  • commercial or institutional users of the commodities
  • speculators

Who Uses Futures Contracts

Manufacturers and service providers use futures as part of their budgeting process to normalize expenses and reduce cash flow-related headaches. These hedgers may use the commodity markets to take a position that will reduce the risk of financial loss due to a change in price. The airline sector is an example of a large industry that must secure massive amounts of fuel at stable prices for planning purposes. Because of this need, airline companies engage in hedging. Via futures contracts, airlines purchase fuel at fixed rates (for a period of time) to avoid the market volatility of crude oil and gasoline, which would make their financial statements more volatile and riskier for investors.

Farming cooperatives also utilize futures. Without futures and hedging, volatility in commodities could cause bankruptcies for businesses that require a relative amount of predictability in managing their expenses.

The second group is made up of speculators who hope to profit from changes in the price of the futures contract. Speculators typically close out their positions before the contract is due and never take actual delivery of the commodity (e.g., grain, oil, etc.) itself.

Requirements for Futures Trading

Investing in a commodity futures contract will require opening a brokerage account if you do not have a broker that also trades futures. Investors are also required to fill out a form acknowledging an understanding of the risks associated with futures trading.

Each commodity contract requires a different minimum deposit (dependent on the broker) and the value of your account will increase or decrease with the value of the contract. If the value of the contract decreases, you will be subject to a margin call and will be required to place more money into your account to keep the position open. Due to the huge amounts of leverage, small price movements can mean large returns or losses, and a futures account can be wiped out or doubled in a matter of minutes.

The Advantages of Futures

  • It’s a pure play on the underlying commodity
  • Leverage allows for big profits if you are on the right side of the trade
  • Minimum-deposit accounts control full-size contracts that you would normally not be able to afford
  • You can go long or short easily

The Disadvantages of Futures

  • Futures markets can be very volatile and direct investment can be very risky, especially for inexperienced investors.
  • Leverage magnifies both gains and losses
  • A trade can go against you quickly, and you could lose your initial deposit (and more) before you are able to close your position.

Most futures contracts will also have options associated with them. Buying options on futures contracts is similar to putting a deposit on something rather than purchasing it outright; you have the right, but not the obligation, to follow through on the transaction. Therefore, if the price of the contract doesn’t move in the direction you anticipated, you have limited your loss to the cost of the option.

Using Options to Invest in Commodities

Many investors use stocks of companies in industries related to a commodity in some way. For example, those wishing to make an oil play could invest in drillers, refineries, tanker companies or diversified oil companies. Those bitten by the gold bug could purchase mining companies, smelters, refineries, or generally any firm that deals with bullion.

Equities are said to be less prone to volatile price swings than futures. Plus, stocks are easy to buy, hold, trade and track, and it is possible to narrow investments to a particular sector. Of course, investors need to do some research to help ensure that a particular company is both a good investment and commodity play.

Stock options, which require a smaller investment than buying stocks directly, are another way to invest in commodities. While risk is limited to the cost of the option, it is typical that the price movement will not directly mirror the underlying stock.

Advantages of Stock Options

  • Investors usually already have a brokerage account, so trading is easier
  • Public information on a company’s financial situation is readily available
  • The stocks are often highly liquid

Disadvantages of Stock Options

  • A stock is not a pure play on commodity prices
  • Its price may be influenced by company-specific factors as well as market conditions

Using ETFs and Notes to Invest in Commodities

Exchange traded funds (ETFs) and exchange-traded notes (ETNs), which trade like stocks, allow investors to participate in commodity price fluctuations without investing directly in futures contracts.

Commodity ETFs usually track the price of a particular commodity or group of commodities that comprise an index by using futures contracts, although a few investors will back the ETF with the actual commodity held in storage. In 2020, The University of Texas/Texas A&M Investment Management Company, which oversees $21 billion in endowment and related assets, famously placed 5% of its portfolio in actual bars of gold bullion that were held in a New York bank vault as a currency play.

ETNs are unsecured debt designed to mimic the price fluctuation of a particular commodity or commodity index and are backed by the issuer. A special brokerage account is not required to invest in ETFs or ETNs.

BAL: iPath Bloomberg Cotton Subindex Total Return ETN; CAFE: iPath Pure Beta Coffee ETN; NIB: iPath Bloomberg Cocoa Subindex Total Return ETN

Advantages of ETFs and ETNs

  • There are no management or redemption fees to worry about because they trade like stocks.
  • They provide an easy way to participate in the price fluctuation of a commodity or basket of commodities.

Disadvantages of ETFs and ETNs

  • A big move in the commodity may not be reflected point-for-point by the underlying ETF or ETN.
  • Not all commodities have an ETF or ETN associated with them.
  • ETNs have credit risk associated with the issuer.

CORN: Teucrium Corn Fund; SOYB: Teucrium Soybean Fund; WEAT: Teucrium Wheat Fund

Using Mutual and Index Funds to Invest in Commodities

While mutual funds cannot invest directly in commodities, they can invest in stocks of companies involved in commodity-related industries, such as energy, agriculture or mining. Like the stocks they invest in, the fund shares may be affected by factors other than commodity prices, including stock market fluctuations and company-specific risks.

A small number of commodity index mutual funds invest in futures contracts and commodity-linked derivative investments, thus providing more direct exposure to commodity prices.

Advantages of Commodity Mutual Funds

  • Professional money management
  • Diversification
  • Liquidity

Disadvantages of Commodity Mutual Funds

  • Management fees may be high, and some of the funds may have sale charges.
  • They are not a pure play on commodity prices because most commodity mutual funds invest in stocks.

Using Commodity Pools and Managed Futures

A commodity pool operator (CPO) is a person or limited partnership that gathers money from investors, combines it into one pool and invests it in futures contracts and options. CPOs need to provide a risk disclosure document to investors, and they must distribute periodic account statements as well as annual financial reports. They are also required to keep strict records of all investors, transactions, and pools they may be running.

CPOs will employ a commodity trading advisor (CTA) to advise them with the trading decisions for the pool. CTAs must be registered with the Commodity Futures Trading Commission (CFTC) and are required to go through an FBI background check before they can provide investment advice. They usually have a system to trade futures and use it to advise commodity-pool trades.

Advantages of CTAs

  • They can provide professional advice.
  • A pooled structure provides more money for a manager to invest.
  • Closed funds require all investors to put in the same amount of money.

Disadvantages of CTAs

  • It may be difficult to evaluate past performance, and you may want to look at the CTA’s risk-adjusted return from previous investments.
  • Investors should also read CTA disclosure documents and understand the trading program, which may be susceptible to drawdowns.

The Bottom Line

There are a variety of commodity investments for novice and experienced traders to consider. Although commodity futures contracts provide the most direct way to participate in price movements, other types of investments with varying risk and investment profiles also provide sufficient opportunities for commodities exposure. Commodities can quickly become risky investment propositions because they can be affected by uncertainties that are difficult, if not impossible, to predict such as unusual weather patterns, epidemics, and disasters both natural and man-made.

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