The Basics Of Commodities

Commodities are all around us. They’re well-known, tangible products that are often consumed on a daily basis. Popular commodity products include wheat, sugar, cotton, cocoa, crude oil, and gold. Generally speaking, commodities are highly abundant and accessible products to people in both developed and developing countries around the world.

A large number of commodities are traded in the futures market, which is a central exchange where buyers and sellers enter into contracts. A futures contract is simply an agreement to buy or sell a commodity at a particular price on a stipulated future date. Futures are highly leveraged products, requiring relatively small investments to potentially generate relatively high returns or you can risk more than the amount you invested.

It’s important to note that not all securities that trade on the futures market are commodities. Additional futures securities include stock index futures, foreign currencies, and bonds.

Types of Commodities

Commodities can be organized into three key areas: agricultural, metals, and energy. Below is a list of some individual commodity products that fall under each category:

Agricultural: Cocoa, Coffee, Corn, Cattle, Lumber, Oats, Orange Juice, Sugar, Wheat

Metals: Copper, Gold Palladium, Platinum, Silver

Energy: Brent Crude, Gasoline, Heating Oil, Light Sweet Crude, Natural Gas

Despite the fact that the above commodity products are physical in nature, there are distinct differences in each category. For example, looking at the agricultural group, you can see that each listed commodity is perishable. This is not the case with the metals group. However, metals like gold carry significantly higher storage costs due to the added security required to guard it. There are a number of characteristics that make each commodity unique, but what’s more important is understanding why price changes occur in these commodities.
Influences on Commodity Price.

Commodity prices are typically driven by supply and demand. Generally speaking, when there is an ample supply of a commodity, its price tends to be low. Prices may also be pushed to lower levels when demand is soft. The opposite is also true. When supply is tight and or demand is strong, commodity prices are often pushed higher.

There are many components that could influence both the supply and demand of a commodity. In the metals market, for example, the price of gold and silver may be driven higher by fear and uncertainty in the global economy, whereas economic certainty and growth often lead to lower prices. Conversely, price changes in agriculture commodities are heavily influenced by weather conditions. Too much or too little water may create flood or drought conditions, which can drastically affect crops. In addition, extreme weather conditions such as hurricanes and earthquakes can significantly impact commodity yields. Lastly, all categories of commodities are subject to price swings that occur from political and governmental restrictions on commodity imports and exports.

Let’s look at an example. Figure 1 is a chart of the United States Commodity Index and the S&P 500® Index from late 2010 to recent months. The relative performance of this commodity index, which holds a basket of various commodities, has significantly underperformed the stock market. This divergence in price performance may possibly indicate that over the past several years the commodity market has a growing excess of supply that is exceeding its demand.

Figure 1: A five-year weekly comparison chart of the S&P 500 and the United States Commodity Index. Image source: paperMoney® platform. The example used is for illustrative purposes only. Not a recommendation of any security or strategy. Past performance does not guarantee future results.

Conclusion

The commodity market offers investors the opportunity to trade products that they’re familiar with. This market is substantial, providing a lot of commodities to choose from in the agriculture, metals, and energy categories. Keep in mind, there are a lot of factors that investors need to take into account prior to trading commodities. Understanding the underlying catalysts to movement on a given commodity is key to understanding its future price changes.

Going forward, this will be a key point we’ll address as we investigate individual commodity products.

Investools does not provide financial advice and is not in the business of transacting trades.

Trading securities can involve high risk and the loss of any funds invested. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon, or risk tolerance.

The risk of trading futures can be substantial. The valuation of futures may fluctuate, and as a result, investors may lose more than their original investment. Investors must consider whether futures are a suitable investment for their own personal financial situation before trading. Past performance is not indicative of future results.