An Overview Of Commodities Trading

By Marv Dumon AAA

Commodities markets, both historically and in modern times, have had tremendous economic impact on nations and people. The impact of commodity markets throughout history is still not fully known, but it has been suggested that rice futures may have been traded in China as long ago as 6,000 years. Shortages on critical commodities have sparked wars throughout history (such as in World War II, when Japan ventured into foreign lands to secure oil and rubber), while oversupply can have a devastating impact on a region by devaluing the prices of core commodities.

Energy commodities such as crude are closely watched by countries, corporations and consumers alike. The average Western consumer can become significantly impacted by high crude prices. Alternatively, oil-producing countries in the Middle East (that are largely dependent on petrodollars as their source of income) can become adversely affected by low crude prices. Unusual disruptions caused by weather or natural disasters can not only be an impetus for price volatility, but can also cause regional food shortages. Read on to find out about the role that various commodities play in the global economy and how investors can turn economic events into opportunities.

Commodities 101
The four categories of trading commodities include:

  • Energy (including crude oil, heating oil, natural gas and gasoline)
  • Metals (including gold, silver, platinum and copper)
  • Livestock and Meat (including lean hogs, pork bellies, live cattle and feeder cattle)
  • Agricultural (including corn, soybeans, wheat, rice, cocoa, coffee, cotton and sugar)

Ancient civilizations traded a wide array of commodities, including livestock, seashells, spices and gold. Although the quality of product, date of delivery and transportation methods were often unreliable, commodity trading was an essential business. The might of empires can be viewed as somewhat proportionate to their ability to create and manage complex trading systems and facilitate commodity trades, as these served as the wheels of commerce, economic development and taxation for the kingdom's treasuries. Reputation and reliability were critical underpinnings to secure the trust of ancient investors, traders and suppliers.

Investment Characteristics
Commodity trading in the exchanges can require agreed-upon standards so that trades can be executed (without visual inspection). You don't want to buy 100 units of cattle only to find out that the cattle are sick, or discover that the sugar purchased is of inferior or unacceptable quality.

There are other ways in which trading and investing in commodities can be very different from investing in traditional securities such as stocks and bonds. Global economic development, technological advances and market demands for commodities influence the prices of staples such as oil, aluminum, copper, sugar and corn. For instance, the emergence of China and India as significant economic players has contributed to the declining availability of industrial metals, such as steel, for the rest of the world.

Basic economic principles typically follow the commodities markets: lower supply equals higher prices. For instance, investors can follow livestock patterns and statistics. Major disruptions in supply, such as widespread health scares and diseases, can lead to investing plays, given that the long-term demand for livestock is generally stable and predictable.

The Gold Standard
There is some call for caution, as investing directly in specific commodities can be a risky proposition, if not downright speculative without the requisite diligence and rationale involved. Some plays are more popular and sensible in nature. Volatile or bearish markets typically find scared investors scrambling to transfer money to precious metals such as gold, which has historically been viewed as a reliable, dependable metal with conveyable value. Investors losing money in the stock market can create nice returns by trading precious metals. Precious metals can also be used as a hedge against high inflation or periods of currency devaluation.

Energizing the Market
Energy plays are also common for commodities. Global economic developments and reduced oil outputs from wells around the world can lead to upward surges in oil prices, as investors weigh and assess limited oil supplies with ever-increasing energy demands. However, optimistic outlooks regarding the price of oil should be tempered with certain considerations. Economic downturns, production changes by the Organization of the Petroleum Exporting Countries (OPEC) and emerging technological advances (such as wind, solar and biofuel) that aim to supplant (or complement) crude oil as an energy purveyor should also be considered.

Risky Business
Commodities can quickly become risky investment propositions because they can be affected by eventualities that are difficult, if not impossible, to predict. These include unusual weather patterns, natural disasters, epidemics and man-made disasters. For example, grains have a very active trading market and can be volatile during summer months or periods of weather transitions. Therefore, it may be a good idea to not allocate more than 10% of a portfolio to commodities (unless genuine insights indicate specific trends or events).

Exchanges
With commodities playing a major and critical role in the global economic markets and affecting the lives of most people on the planet, there are multitudes of commodity and futures exchanges around the world. Each exchange carries a few commodities or specializes in a single commodity. For instance, the U.S. Futures Exchange is an important exchange that only carries energy commodities.

The most popular exchanges include the CME Group, which resulted after the Chicago Mercantile Exchange and Chicago Board of Trade merged in 2006, Intercontinental Exchange, Kansas City Board of Trade and the London Metal Exchange.

Futures and Hedging
Futures, forward contracts and hedging are a prevalent practice with commodities. The airline sector is an example of a large industry that must secure massive amounts of fuel at stable prices for planning purposes. Because of this need, airline companies engage in hedging and purchase fuel at fixed rates (for a period of time) to avoid the market volatility of crude and gasoline, which would make their financial statements more volatile and riskier for investors. Farming cooperatives also utilize this mechanism. Without futures and hedging, volatility in commodities could cause bankruptcies for businesses that require predictability in managing their expenses. Thus, commodity exchanges are used by manufacturers and service providers as part of their budgeting process – and the ability to normalize expenses through the use of forward contracts reduces a lot of cash flow-related headaches.

The Bottom Line
Investing in commodities can quickly degenerate into gambling or speculation when a trader makes uninformed decisions. However, by using commodity futures or hedging, investors and business planners can secure insurance against volatile prices. Population growth, combined with limited agricultural supply, can provide opportunities to ride agricultural price increases. Demands for industrial metals can also lead to opportunities to make money by betting on future price increases. When markets are unusually volatile or bearish, commodities can also increase in price and become a (temporary) place to park cash.

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