What are Commodities
Overview
In this module, we will define commodities while also expanding on the types of commodities that are traded.
Defining Commodities
We can classify most financial instruments and securities as being part of a general class of intangible financial assets. Financial assets for the most part, are created on exchanges, in the boardrooms, at corporations or in the dealing rooms of banks.
There is only one category which covers tradable assets created by Mother Nature herself. This category is generally referred to as the Commodities sector.
In general the global financial markets for commodities are quite liquid, in other words there are a whole host of price makers showing prices on a variety of contracts and dates. This enables easy access for all market participants in order to hedge against or speculate on future price movements of the underlying commodities.
This is important given that the actual underlying commodities form an integral part in almost everything we consume, see and touch. Let’s consider a few examples:
The cereal you eat in the morning. The coffee you drink on the way to work. The stuff used to build and run the car you drive, the gold jewelry, the meat and bread you eat, to name a few of the obvious ones.
Unlike financial assets, a commodity can be summed up as the actual raw material used in production (manufacturing), as well as the products produced from farming activities (such as coffee, orange juice and meat).
Types of Commodities
It is quite common for Commodities to be referred to as either “soft” or “hard”, within which there is a further sub-classification along the following lines:
• Agriculture (Produce, Livestock and Lumber)
• Energy
• Metals (Precious Metals & Base/Industrial Metals)
Soft Commodities
To oversimplify a bit, the soft commodity market (also known as softs) in general refers to things related to “farming”. In other words, if it can be grown (wheat) or fed (cattle) then this will be the category in which to find that commodity.
Soft commodities form the basis of all basic food groups. In fact, their use even extends past what we consume directly, but often interlinked with each other. As an example, a price change in grain prices could lead to a price change in cattle prices as many are grain fed.
Price action in the soft commodity market also tends to be a lot more volatile than what is observed in the hard commodities market. The reason being many of the various factors influencing crop yields and quality are all out of the control of the producer for the most part. As such, very little can be done if there is no rain and as a result no crop.
Soft Commodities
What is interesting though is that commodities have a “convenience charge” attached to it, proving to provide a benefit for those who already own the underlying security. It is not uncommon for the same commodity to have varying prices within a region.
In other words, if there is a drought in the one area of the country, maize will have to be transported from the area where it is available to the area where it is required. This transport cost has absolutely nothing to do with the underlying supply and demand of the maize, but as one can clearly derive, forms an integral part of the price of maize if it needs to be transported for a sizable distance that exists between the silo and the miller.
Soft commodities are by far the most sensitive group when you consider all that can go wrong. It can spoil if not used in time, pests can destroy an otherwise healthy crop, and the weather (temperature) can influence the size and quality of the crop. All things that cannot really be controlled or prevented.
The most commonly traded soft commodities are the following:
Agriculture:
• Maize (Corn) • Soybeans • Wheat • Milk • Cocoa • Cotton • Sugar
Livestock:
• Hogs • Cattle
Hard Commodities
A hard commodity is the term used to reference the various metals. Within metals there is a general classification between precious and base metals.
Base metals are relatively common and consumed in almost everything that is produced in a factory. In addition, many of the base metals are by-products from the mining activities of other metals, so for the most part fairly common.
Precious metals on the other hand represent those metals which are a little trickier to acquire, and quite often have limited deposits scattered all around the globe. But as a category, one can already comfortably assume that the factors that drive metals are far more “reasonable” than those influencing the softs market, resulting in less volatile prices.
Metals can’t really spoil, and nor can the weather change the amount of iron ore available in a particular piece of ground. There is no rush to “harvest” metals as the “crop” won’t disappear when the season is over.
Sometimes, events occur which may have some common impact; an example would be severe flooding. It is not uncommon to hear of mines that are so severely flooded that production has to halt for months until the various shafts can be mined again.
Hard Commodities
Hard commodity prices however can also be influenced by something that has very little to do with the availability of the resource. These price fluctuations could also just be momentary or in fact turn out to be structural changes, all of which takes careful consideration of the overall cause and impact of the influencing factor or events.
Labour unrests could make it difficult for a mine to continue operations for a while, but this could be short lived and business as usual may continue a week or so later. So too can port congestions or transport issues be a short-term concern influencing prices.
On the contrary, political instability in a geographic region where most of a particular commodity is sourced from may prevent production or export for a long while. An example of the latter is the conflict in the Middle East and the impact this has on global crude prices.
The most commonly traded metals markets globally are the following:
Precious Metals:
• Gold • Platinum • Palladium • Silver
Industrial Metals:
• Copper • Lead • Zinc • Aluminium
Energy Commodities
The energy markets are equally popular and liquid. Though one can debate their relative “softness” or “hardness” the point being that this group of commodities are all fundamentally important as part of a vital component of production, consumption and commerce. Oil affects prices of practically everything you can see and touch right before you.
The use of energy spans all sectors. Raw materials have to be mined by machinery. Raw materials have to be transported from the mines to the factory, humans have to be transported to the factory to go make the goods. Finished goods have to be transported from the factory to the stores selling them. Humans have to transport the finished goods from the stores to their homes, and so the cycle continues.
The major energy futures markets are the following:
Energy:
• Crude Oil • Brent Crude • Ethanol • Natural Gas • Heating Oil
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