An economic instrument used in trades, which is replaceable with different goods of the same type.

Author: Christopher Haynes
Christopher Haynes
Christopher Haynes
Asset Management | Investment Banking

Chris currently works as an investment associate with Ascension Ventures, a strategic healthcare venture fund that invests on behalf of thirteen of the nation's leading health systems with $88 billion in combined operating revenue. Previously, Chris served as an investment analyst with New Holland Capital, a hedge fund-of-funds asset management firm with $20 billion under management, and as an investment banking analyst in SunTrust Robinson Humphrey's Financial Sponsor Group.

Chris graduated Magna Cum Laude from the University of Florida with a Bachelor of Arts in Economics and earned a Master of Finance (MSF) from the Olin School of Business at Washington University in St. Louis.

Reviewed By: Elliot Meade
Elliot Meade
Elliot Meade
Private Equity | Investment Banking

Elliot currently works as a Private Equity Associate at Greenridge Investment Partners, a middle market fund based in Austin, TX. He was previously an Analyst in Piper Jaffray's Leveraged Finance group, working across all industry verticals on LBOs, acquisition financings, refinancings, and recapitalizations. Prior to Piper Jaffray, he spent 2 years at Citi in the Leveraged Finance Credit Portfolio group focused on origination and ongoing credit monitoring of outstanding loans and was also a member of the Columbia recruiting committee for the Investment Banking Division for incoming summer and full-time analysts.

Elliot has a Bachelor of Arts in Business Management from Columbia University.

Last Updated:December 13, 2023

What are Commodities?

A commodity is an economic instrument used in trade that is replaceable with different goods of the same type. 

They are usually used as inputs within the manufacturing of different goods or services. They are the basis of the economy, as natural products are functional for manufacturing food, energy, and clothing.

Key Takeaways

  • A commodity is an economic instrument used in trades, and they are mass-produced and standardized; 
  • It is possible to distinguish them between soft and hard ones or agricultural, energy and metal; 
  • They are based on quality and quantity, meaning their pricing is the same regardless of the producer; 
  • The high level of volatility of such markets makes them appealing for daily trading operations; 
  • The commodity market is based on derivative securities, including futures and forward contracts. Buyers and dealers trade between each without the need for physical goods.
  • The price can be determined by the supply-demand law, which is manipulated by the following factors: seasonality, weather, macroeconomics, new players and competitors, politics; 
  • A percentage of commodities allocated on the portfolio is suggested as these products are not correlated with stock markets or indexes, allowing the possibility to use them to hedge inflation.

Types of Commodities

Most of them are raw materials, primary resources, agricultural or mining products, such as iron ore, sugar, or grains like rice and wheat. They can also be mass-produced unspecialized products such as chemicals and computer memory. 

When goods are traded on the market, they additionally have to meet minimum quality standards, as a low-quality commodity might be worth way less than its exchange price. 

It is possible to classify them in two different ways. Firstly, there is a difference between hard and soft ones; the first is extracted or mined (petrol, metals, ore), and the second is agricultural products (sugar, coffee, soybeans). 

  • Soft commodities are those kinds of goods that belong to the agricultural sector and are grown, such as coffee, orange juice, tobacco, sugar, and meat
  • Hard commodities are those kinds of goods that are mined or extracted. This category contains materials such as gold, silver, oil, and copper

Some basic examples consist of wheat, silver, beef, crude oil, copper, and gas. In addition, the variety of such products has been increased to include other financial instruments. Technological development has helped in the process of adding new types of goods traded within an exchange. Moreover, the other way to determine them is based on their nature, and in this case, it is possible to distinguish three groups: agricultural, energy, and metal.

Dividing them into three categories based on their nature: 

  • Agricultural, generally sources of food, this category includes corn, coffee, soybeans, and sugar
  • Energy, in this group, it is possible to find materials such as gasoline, crude oil, or natural gas
  • Metal products are used in various industries, such as jewelry and engineering, such as copper, silver, and gold

How are Commodities Traded?

These products can be acquired and traded on specific markets as a form of an asset class. There also are derivatives markets in which it is possible to acquire contracts on such goods (e.g., forwards, futures, and options). 

The current market is based on derivative securities, which include futures and forward contracts. Buyers and dealers operate effortlessly and in significant volumes without needing to trade the physical commodity. Many buyers and dealers make a profit on the underlying asset's price fluctuation, hedge the risk, and protect their portfolio from inflation. 

Some investors believe allocating a percentage of their portfolios to commodities is crucial. This is because these products are not correlated with stock markets or indexes. Hence, it is possible to use them to hedge inflation.  

The bargaining process is usually made through futures contracts on exchanges that standardize the amount and minimum quality of the commodity being traded. The main characteristic is that there might be very little diversity in that product, whether or not it comes from the same producer. They are essentially identical. A bag of coffee is the same, regardless of the manufacturer. 

Two varieties of investors exchange commodity futures

  1. The first are buyers and manufacturers of such goods; they use commodity futures contracts for hedging purposes
  2. The second one is commodities traders

These buyers operate in the commodity markets for the only purpose of making profits from the price volatility of these products. 

There is a high level of volatility in such markets, which makes them very appealing to daily traders. Commodities are very different from regular equities in terms of market trends, and this is why they can be used to diversify a portfolio. They are traded on exchanges like the London Metal Exchange (LME) or the New York Mercantile Exchange (NYMEX), the same way ordinary equity is. 

What Determines a Commodity Price?

The price is determined by the supply and demand law. This is because these goods are tangible assets, and their prices behave identically. 

Several occasions can lead to an increase or a decrease in the price of a commodity; if a specific event impacts the supply or the demand of an item, its price will surely change. 

For example, throughout the last few years, it was possible to see a change in the price of crude oil. During the Covid-19 pandemic, its price fell as the demand drastically decreased. On the other hand, during the war between Russia and Ukraine, its price increased because the supply decreased and the demand stayed the same. 

Furthermore, other factors determine the price of a commodity. Among these, it is possible to distinguish: 

  1. Seasonality: Agricultural goods are the ones that are impacted more by this factor, as seasonal cycles can modify the total production. In this situation, if the harvest is forecasted to be positive, prices are likely to increase, and later, when the market has a lot of supply, they will decrease.
  2. Weather: In case of a significant change in weather conditions or natural disasters, prices can vary due to many factors. The harvest might be forecasted negatively, as unusual temperatures can drastically impact it. Also, supply chains can be affected by it and cause a low supply on the market following an increase in prices. 
  3. Macroeconomics: Depending on the economic status of a country, prices can rise or fall. In a booming economy, where the demand for such products increases, it is possible to see a rise in prices; on the other hand, the need for these goods will decrease in a declining economy.  
  4. New players and competitors: As new companies, as well as new technologies, enter the commodity market, prices can be impacted severely. For example, the introduction of similar alternatives or cheaper ways to produce a specific good can lead to a decrease in its price. 
  5. Politics: Political decisions on exports and imports, such as import duties, can strongly affect the trade of certain goods, resulting in higher prices.

Commodities vs. Stocks

Stocks and Commodities are among the most traded financial products on the market.

However, several factors make stocks different from them: 

  • How their price is based, while goods price depends on supply and demand, stock price depends on the financial status of the company

  • Ownership, an investor who buys a stock owns a share of the company. Instead, with commodities, investors do not purchase the underlying asset but the contract

  • The trading strategy for stocks is more common to apply long-term strategies if an investor believes in a company's future. Commodities are more likely to be used in daily trading strategies, as their market is quite volatile

  • The commodity market is closed only during the weekends, and it is possible to trade them at any time of the day; it is not the same for stock markets, which have specific opening hours every day (ex., The NYSE opens at 9:30 am and closes at 4 pm)

Researched and authored by Alessandro Davì | LinkedIn

Reviewed and Edited by Aditya Salunke I LinkedIn

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