What are commodities?

Chapter 1: Intro

Commodities are incredibly important – and yet very few people know how they work.

They matter because commodities affect so many aspects of our lives: they’re in the food we eat, the metals used in so many of the products we own, and the energy we consume. At some stage in their preparation and delivery, all these things can be reduced back to commodities – which are bought and sold wholesale on the world’s commodity markets.

When we think about defining commodities, it’s useful to picture four broad categories:

1. Soft commodities include agricultural products, such as cocoa, coffee, corn, cotton, soybeans, rice, sugar and wheat.
2. Livestock – also considered a soft commodity – includes both live animals and animal meat products.
3. Hard commodities are mined and manufactured metals, such as aluminium, cobalt, copper, gold, lead, tin, nickel, platinum and silver.
4. Energy comes in the form of crude oil, heating oil and aviation fuel.

Chapter 2: Understanding commodity markets

Commodities markets play a particularly important role in commodities distribution because they are platforms where producers and brokers from all over the world buy and sell.

If they didn’t exist, it would be a lot more difficult for, say, a Chilean copper producer to sell to a Chinese manufacturer – or for a US farmer to sell his wheat to a buyer in Europe and so on.

The main three global commodities markets are:

• the CME Group (formed from the merger of the Chicago Mercantile Exchange and the Chicago Board of Trade);
• the Intercontinental Exchange; and
• the London Metal Exchange.

Chapter 3: Spot, forwards, options and futures

The importance of these markets is not only that commodities are bought and sold there on a ‘spot’ on an immediate purchase and payment basis.

There are also ‘forward contracts’ enabling products to be bought and sold at a fixed price for delivery at a particular future time. 

And there are also ‘options’ and ‘futures’. An option gives a party an option to buy or sell at a future time but not the obligation to do so. Futures are similar but they require parties to deliver a commodity or pay for it.

It is easy to see that options and futures are like bets on the future price of a commodity on which they are constructed. As a result, they can be used for hedging of ‘real’ trades. For example, an airline might buy a forward contract or choose an option or a future to lock in the future price of its fuel. 

But these commodities derivatives are also opportunities to speculate – buying or selling in the belief that price changes will be profitable. If you can hedge your bet using an option or a future, so much the better (or safer).

Chapter 4: Investing in commodities

Private investors can gain exposure to the commodities markets by investing in funds that, in turn, invest in commodities. An increasingly popular form of commodity investment are stock market listed exchange traded funds (ETFs). 

You can buy and sell shares in ETFs, which are backed by physical commodities, just like any shares. The charges levied by the managers of ETFs are lower compared to other investment funds, and the process of buying into them or selling out is much quicker and easier.

You can also invest by buying and selling derivatives, such as options and futures, where a broker or trading platform can supply ‘leverage’. This means that you can borrow money to speculate on the future price of commodities.