In some respects, commodity trading is the purest form of investing. There’s no derivation, no abstraction, no three levels of removal from the underlying asset. There’s just something tangible and utile – a foodstuff, a fuel – and a huge market with multiple players. That last point is important: the more buyers and sellers of a commodity there are, the more likely it is that its market price can be unswayed by manipulation. Commodity pricing is as close as the real world gets to the classical economic concept of a good’s demand and supply curves intersecting at a particular price and quantity.
Take cocoa, which as of March 2015 sells at around $2864 per ton or $1.30 a pound. The price of this raw constituent of chocolate production fluctuates more than you might think, ranging from under $750 to more than quintuple that in the last 15 years. Demand for cocoa varies, to the point that an unexplained global hankering for chocolate last summer caused prices to rise to all-time highs.
But it is changes in supply, not demand, that dictate most price movements. At least with regard to this particular commodity. And supply is contingent on various ecological factors, ones beyond the control of the people who raise cocoa for a living. Temperatures need to be around 70º to 90º, with rainfall heavy but not too heavy (no more than 100” annually.) Not to turn this into a primer on cocoa cultivation, but there is one rigid set of conditions for optimal growing. Moving a single criterion off balance can result in lower supply and thus higher prices.
Cocoa is produced far from the world’s financial centers, primarily in the Ivory Coast and Ghana, by lots of small-scale family farmers. Having many suppliers offering a uniform product means that each individual supplier wields little influence on price. Contrast that with another commodity—gold.
At $1150 an ounce, the price of gold has fallen more than a third off its 2011 zenith. And as recently as 2000, you could buy an ounce for $250. This despite annual gold production averaging 2500 tons during that period, and varying only 10% or so in either direction. If gold production is so uniform from year-to-year, why would there be such vast swings in price?
The direct answer is that gold is in demand because it is much more than a visually appealing component of jewelry. Unlike cocoa, cattle, and pork bellies, gold lasts forever. Small and compact, it can be and is used as a currency itself. When currency traders are apprehensive about taking too long a position in dollars or pounds sterling or euros, gold remains a reliable store of value. It is a lot easier for central banks to print fiat money all they want (and thus reduce each unit’s value) than for the world’s gold supply to magically increase.
So supply and demand set prices. Who knew? More importantly, what to do with all this newfound information? The average investor only consumes commodities, as opposed to speculating in them. What advantage is there in knowing the factors behind the market price of cotton or soybeans?
That’s not a rhetorical question. If you contrast the current price of a commodity with that of a futures contract for that same commodity, you will save yourself the trouble of needing to learn anything about annual precipitation in West Africa and/or a central banks’ monetary policy. Instead, the minutiae of market forces can be distilled into this one thing that a smart investor can capitalize upon—futures.
Let’s use yet another commodity as an example. As of this writing in March of 2015, wheat costs $5.07 a bushel. Futures contracts coming due in September sell for $5.19. That means that speculators are offering wheat farmers (well, wheat brokers) a slight premium for a few months hence. Both parties to the transaction, speculators and farmers alike, think that the price of wheat will rise between now and then. Speculators hope it will rise beyond $5.19, farmers that it will stop somewhere short of that number, but either way we are expecting wheat prices to increase.
It continues. Futures coming due in December sell for $5.32, and move up to $5.44 for the following quarter. The reasons are unimportant. It doesn’t matter whether consumers in China and India are adopting Westernized diets heavy on wheat, or whether new cultivars are increasing crop yields. All an investor needs to know is that prices are expected to rise, and continue to rise. In fact, you can even start with the futures prices, then work backwards and compare them to the relatively discounted current prices to notice what direction prices are trending in.
The Bottom Line
Karl Marx thought that the amount of labor involved in creating a good determined its value. Karl Marx was, to put it kindly, full of garbage. Cocoa farmers didn’t work five times harder when their product sold for $3750 a ton than when it sold for $750. A smart investor knows this, and by extension knows that the only way to earn money in the commodities market is to anticipate price movements. Which isn’t easy to do, which is why most people stick with mutual funds and exchange-traded funds (ETFs). But for the curious investor who wants to expand her horizons, commodities can be a lucrative if volatile addition to her portfolio.