Commodities are extremely important as they are essential factors in the production of other goods. A wide array of commodities exist, including coffee, wheat, gold, and oil. These commodities are traded constantly on commodity exchanges around the world such as the Chicago Mercantile Exchange, The London Metals Exchange, and the Intercontinental Exchange.
Types of Commodities
Since commodities are traded on exchanges, their prices are not set by a single individual or entity and many economic factors that will have an effect on the price of a commodity. However, each commodity is unique and will have a different set of catalysts that can move the price each day.
- Commodities come in many different types, including grains, energy products, and metals.
- Prices change as economic events unfold and trigger waves of buying and selling.
- Commodities trade in the cash or spot market, but also on the organized exchanges in the form of futures contracts.
- Commodities futures trade on exchanges and are used for both speculation and for hedging.
As with equity securities, a commodity's price is determined primarily by the forces of supply and demand for the commodity in the market. For example, let's look at oil. If the supply of oil increases, the price of one barrel of oil will decrease. Conversely, if the demand for oil increases, which often happens during the summer, the price of oil will increase. Gasoline and natural gas also fall into the group of energy commodities.
For other commodities, such as crops, weather plays an extremely significant role in price changes. If the weather in a certain region is going to affect the supply of a commodity, the price of that commodity will be affected directly. Examples include corn, soybeans, and wheat. Cotton, coffee, and rice fall into a different category called soft commodities.
Gold is one of the more actively traded commodities because it is used in the production process for jewelry and other goods, but is also viewed by many as a worthwhile long-term investment. Silver and copper are other examples of commodities in the metals group.
Spot vs. Futures Price
On the exchanges, commodities are traded via futures contracts. These contracts obligate the holder to buy or sell a commodity at a predetermined price on a delivery date in the future. Not all futures contracts are the same—their specifics will differ depending on the respective commodity being traded.
The market price of a commodity that is quoted in the news is often the market futures price for that respective commodity. The futures price is different than the spot price or cash price, which is the actual price of the commodity that one would pay for it today. For example, if an oil refiner buys 10,000 barrels of oil for $50 per barrel from an oil producer, $50 per barrel is the spot price. The futures price can be more or less than the spot price at any given moment.
As with other securities, many traders use commodity futures to speculate on future price movements. Traders generally do not trade the commodities themselves, as buying barrels of crude or bushels of wheat is not practical for obvious reasons. These investors analyze various events in the market and chart patterns to speculate on future supply and demand. They subsequently enter long or short futures positions depending on which direction supply and demand will move prices.
Speculators are distinct from hedgers, which are often the end users seeking to protect interests in the commodity by selling or purchasing futures contracts. For example, if a soybean farmer is concerned that prices will fall over the next six months, they can hedge their crops by selling soybean futures today. Taken together, hedgers and speculators represent much of the buying and selling interest in commodities futures, making them important parties in determining commodities prices from one day to the next.