What is a commodity?

Looking for a commodity definition? A commodity is a basic good or primary good that one can group under standard headings before they are then traded. Commodities are mostly used as part of the production of finished goods and services and fall into categories such as oils, minerals and agricultural produce. Each commodity is interchangeable, which is why any attempts to set up a gemstone commodity market have failed since each gemstone is different from the other.

Where have you heard about commodities?

As commodities form part of a finished good or service, they can quickly impact everything else along the supply chain. For example, if there is a shortage of a commodity, production is affected and thus the end price of the product or service is too. For this reason, the media often reports on when supply of commodities has risen or fallen as it usually means everyday products rise or fall in price. For example, a bad crop or flooding may cause the price of potatoes to rise, or political developments causing oil to become more expensive would generally cause a hike in petrol prices.

What you need to know about commodities…

There are many different types of commodities, but the basic idea is that each type of the commodity is the same regardless of its producer. For example, a portion of grain from one producer will likely not differ from another portion of grain from another producer.

Types of commodities

Commodities can be soft or hard, with energy forming a subcategory under hard commodities. All types of commodities are found in the futures market and are regularly traded by investors looking to make a profit.

Soft commodities: this generally refers to commodities that are grown – for example, coffee, corn, sugar, cocoa, wheat, livestock and agricultural goods are all classed as soft commodities. The production of these commodities relies a lot on the weather so any unseasonable weather or a strong storm season can have a huge affect on the production of these commodities. As a result, the prices of soft commodities are often unpredictable making soft commodities a volatile type of commodity. This is particularly true for crops as they can be only produced in specific regions around the world where temperature, soil quality and humidity are deemed ideal. If these conditions differ in any way, it can have a detrimental affect on crop production.

Hard commodities: this generally means mined commodities, referring to assets including energy goods (such as oil and natural goods) and metals (such as copper, silver, gold, aluminium and steel). When commodities make the headlines, it’s usually centred on hard commodities as their production and supply often relate to economic health, whether that be on a local, regional or global basis. Countries where a large amount of hard commoditiesare produced (Peru, for example, which produces high quantities of gold) rely a lot on exports and as a result currency is often tied to its value.

Energy commodities: these are a subcategory within hard commodities, referring to assets such as oil, coil and natural gas. Since the world has a strong appetite (and arguably a growing appetite) for energy, energy commodities are a popular choice of investment for traders looking to make large profits. The most commonly traded type of energy commodity is crude oil, with over 87 million barrels traded every single day. Other major types of energy commodities include natural gas, which is used for everything from heating houses to cooking meals, and coal, which makes up 20% of the world’s total energy consumption. Uranium, electricity, solar power, ethanol and wind power are other types of energy commodities.

How you can invest in commodities

Those looking to invest in commodities should be aware that commodities are usually traded in large volumes electronically. As a result, it is not always a wise idea for beginner traders to invest in commodities directly. Instead, beginner traders looking to invest in commodities are sometimes recommended to invest indirectly via companies working in the production of commodities – a silver mining company, for example. This less-risky approach would be considered a better starting point as it does not present the problem/dilemmas of minimum buy quantities and physical storage of the commodity.

Another indirect way to invest in commoditiesis via a fund or investment trust, which offers diversification within your portfolio, with funds investing in different types of commodities and thus spreading the risk. Commodity funds can be true commodity funds (where they have direct holdings in commodities); commodity funds that hold futures (similar to a mutual fund strategy); natural resource funds (which invest in companies that engage in business relating to commodities); and combination funds (which invest in both actual commodities and commodity futures).

Trading commodities with CFDs (contracts for difference) is a popular way to speculate on the financial markets. CFD brokers quote prices on many global commodity markets including gold, copper, oil and wheat. If you choose to trade commodities using CFDs, you’ll have both the advantages and the disadvantages of trading on margin. But you’ll always get a cash settlement rather than a physical delivery – and that’s an important issue to consider.

Those choosing toinvest in commodities physically will encounter the issue of storage. Although there are several firms that now offer safe asset storage, direct investors in commodities will incur the additional costs of storage and insurance, as well as the costs associated with buying and selling. In order for the investor to ensure they buy commodities at a good price, they will also have to invest in large quantities of the commodity.

Summing up, when starting out in commodity investing, it is best to either invest in an investment fund or trust or buy shares in associated companies. It is also recommended that traders keep in mind that commodities are volatile and that they look at the rest of their portfolio as many oil and gas companies make up a large portion of the FTSE 100.

Commodities buyers and producers

The trading of commodities is usually carried out via futures contracts on exchanges, with a minimum commodity quantity of quality usually specified. Buyers and producers of commodities are one of the two types traders of commodity futures, usually trading for hedging purposes and making or taking delivery of the physical commodity once the contract expires.

Commodities speculators

The other main type of trader trading in commodity futures is the commodity speculator, who trades in commodities with the intention to make a profit from extreme market volatility. Being a speculator often involves a large quantity of research and the constant analysis of technical and fundamental factors affecting the market. Speculators do not intend to ever make or take delivery of the actual commodity when the contract expires, but instead takes a long or short financial position with the aim to make money. So long as they play by the rules and regulations within the market, commodity speculators bring liquidity to the market, helping the market to operate efficiently for everyone involved.

Exchanges

As mentioned above, commodities are traded on exchanges with each exchange specialising in a certain type of commodity – for example, the Chicago Board of Trade (CBOT) trades in corn, silver, wheat, oats, rice, soybeans, ethanol and gold and the Intercontinental Exchange (ICE) trades in natural gas, electricity and crude oil. The largest physical commodity exchange is the New York Mercantile Exchange (NYMEX), which trades in a wide range of different products, with the Commodity Exchange Inc operating as a division within the NYMEX.

Find out more about commodities…

Our online glossary contains a wide range of different definitions relating to financial terms, and in particular commodities and commodity trading. Further explore commodities by reading our definitions of fossil fuel, exchange and trade.