To put it simply, commodities are basic goods (raw materials or agricultural products) interchangeable, or fungible, with others of the same type, used as inputs in the production of other goods and services. The quality may differ slightly but is fundamentally uniform across all producers. These alongside stocks, bonds and reals
estate are among the major investment classes.
There are four main categories of commodities traded: metal, energy, livestock and meat, and agricultural. Some traditional examples include oil, natural gas, gold, coffee
and cotton.
FUTURES CONTRACTS
Commodities are traded on a futures market. Commodities and futures work similarly to the way stocks and equities do when investors talk about stock market. Futures are standardized contracts among buyers and sellers regarding an asset – such as a commodity, currency, or stock- that is bound to be bought or sold for a specific price, on a specific date in the future (the expiration date). They can be sold or bought repeatedly until the expiration date, at which point they will fulfil with cash or physical delivery of the goods at the price in the contract. Owing commodities is often seen as an opportunity to diversify portfolios beyond traditional securities and a hedge against inflation.
VOLATILITY
Provided that futures contracts rely on an agreed-upon price that stands until the expiration date regardless of the current price at the time of delivery, commodities futures trade on exchanges are a way for suppliers (producers) to hedge against changes in the market prices of the goods, as well as a way for speculators to profit
from these fluctuations, given the volatility characteristic of commodities’ trade.
Commodities are more volatile than other assets due many reasons, among them:
- Liquidity (or trading volume), as many commodities that trade on the futures exchanges offer less liquidity than other mainstream assets. In spite of gold and oil being the most liquidly traded commodities, the potential for adverse events to occur that can still affect extraction causes the market to be highly volatile at times.
- Supply and Demand, heavy influencers in commodities’ prices.
- Mother Nature, since volatility is related to the risk associated with unpredictability of certain factors such as weather, epidemics, and disasters. This is probably the most important reason as the production, extraction and farming rely heavily on natural conditions.
Notice that, when talking about commodities’ liquidity, oil is unsurprisingly mentioned as a top traded commodity due to the global demand and intense energy consumption resulting from rapidly industrializing economies. However, the market volatility becomes evident when in this year’s Spring oil prices collapsed amid Covid-19 pandemic and economic slowdown.
HEDGE AND SPECULATION
Volatility can be both a trader’s paradise or an investor’s nightmare as traders seek profit and investors look for steady earnings.
Manufacturers and service providers that rely on commodities for their production process participate in commodities markets in order to reduce their risk of financial loss due to a change in price.
The Airline sector can be taken as an example as a large industry that must secure massive amounts of fuel at stable prices for planning purposes. This leads to the engagement in hedging with futures contracts, allowing airline companies to purchase fuel at fixed rates for a specified period of time. The same goes for farming cooperatives that require a relative level of price predictability so that operating expenses can be managed efficiently. These are situations that reflect the search for stability in the price structure, risk mitigation and avoiding unpleasant surprises.
On the other side of the spectrum, we have speculators whose ultimate goal is to profit from the volatile price movements. They buy a contract at a certain price, wait for the price to go up before selling the contract to an end-user. There is never actually the intention to take delivery of the commodity itself as they do not rely on the goods to maintain business operations, typically closing out their positions before the futures contract is due.
CONCLUSION
The aim of this article is to present very lightly, in an easy and understandable way, some of the basic principles and mechanisms of commodity trading, futures contracts and everything around the topic from volatility to hedging and speculation which correspond to the different purposes of participants in the markets. Furthermore, as consumers of commodities, staple goods, it is important to understand how volatility of such goods can impact our daily lives, namely when changing prices lead to an immediate change in our living expenses, and how, on the other hand, demand plays a huge role on market prices. However, this is just scratching the surface. When it comes to commodities, there is more to it.
This article was published in our September 2020 Newsletter
Taíssa Santos, BSc in Management