Commodities Trading: An Overview

Commodities are an important aspect of Americans' daily lives, providing the food they eat and the energy used to propel their cars. A commodity is a basic good traded in large volumes and interchangeable with other goods of the same type. Commodities are either for immediate delivery in spot trading or for conveyance later when traded as futures. Commodity markets deal in metals (aluminum, copper, gold, lead, nickel, silver, zinc, etc.) and “soft” items (cocoa, coffee, sugar, oil, etc.).

Key Takeaways

  • Commodities are typically sorted into four broad categories: metal, energy, livestock and meat, and agricultural products.
  • For investors, commodities can be an important way to diversify their portfolios beyond traditional securities.
  • Commodities are considered risky investments because the supply and demand of these products are affected by events that are difficult to predict, such as weather, epidemics, and natural and human-made disasters.
  • There are many ways to invest in commodities, including futures contracts, options, and exchange-traded funds (ETFs).

For investors, commodities are an important way to diversify their portfolios beyond traditional securities. Because the prices of commodities tend to move in the opposite direction of stocks, some investors rely on returns from commodities during periods of market volatility.

In the past, commodities trading required significant amounts of time, money, and expertise and was limited to professional traders. Today, there are far more options for participating in the commodity markets.

A History of Commodities Trading

Trading commodities is an ancient profession with a longer history than the trade in stocks, bonds, and, according to many anthropologists, money. The rise of numerous empires can be directly linked to their ability to create complex trading systems and facilitate the exchange of commodities. This also means that the history of colonialism can only be understood in light of the history of commodities trading.

Before the beginnings of rail travel and industrial shipping in the 19th century, the cost of sending goods across continents and vast oceans meant only those items that fetched steep prices per unit, such as spices, coffee, cocoa, gold, and silver, were worth trading farther than the local markets. Two moments brought us to the present, when the most inexpensive goods on one side of the world can be found in markets on the other: the first resulted from incredible changes in transport technologies (railroads, steam engines, the first refrigerated train cars, and so forth) in the 19th century, and the second came on the heels of the introduction of huge bulk carriers and the massive harbor-based facilities after the Second World War and the Suez Canal crisis of the late 1950s. By some estimates, the shipping cost for bulk goods decreased about 90% between the 1870s and a century later. Whereas in the 1850s, one would ship only the costliest goods abroad, in recent decades, materials with any perceptible value have been loaded into containers to be sold in the global marketplace. Indeed, at this point, even garbage (metal scrap, recyclable materials, and refuse headed for landfills) is worth the relatively low cost it takes to ship it an ocean away.

As this makes clear, commodities trading is not just ancient but it's also among the most modern professions, taking on board the latest technological advances to increase global trade volume. Trading in commodities is done through an exchange, which refers both to a physical location where the trading occurs and to the legal entities formed to enforce standardized commodity contracts and related investment products.

Exchanges have gone through the consolidation found in other industries in recent years. The majority of exchanges carry a few different commodities, although some specialize in a single type. In the U.S., there is the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange, and the Intercontinental Exchange in Atlanta.

Special Characteristics of the Commodities Market

In the broadest sense, the basic principles of supply and demand drive commodities markets. Changes in supply affect demand, and low supply equates to higher prices. So, any disruptions in the supply of a commodity, such as a virus that affects cattle or a cold snap in a citrus area like Florida, can cause a spike in the generally stable and predictable demand for a commodity.

Global economic development and technological change can also have a great effect. For example, the emergence of China and India as significant manufacturers has led to a prodigious increase in demand for industrial metals, making them more difficult to get in other parts of the world.

The Types of Commodities

Commodities are broadly sorted into four categories: metal, energy, livestock and meat, and agricultural products.

Metals

Metals commodities include gold, silver, platinum, and copper. During periods of market volatility or bear markets, many investors put their money into precious metals, particularly gold, because of their status as having reliable value. Investors also do so to hedge against high inflation or currency devaluation.

In recent years, besides the traditional trade in metal as a store of value and for industrial manufacturing, the major story in these commodities has been about the tech industry's need for rare earth elements. Some, like dysprosium, erbium, europium, gadolinium, and holmium, are used in speakers, electric vehicle motors, and smartphones. Another element, gallium, is frequently found in semiconductors and LEDs, and tantalum and niobium are indispensable in producing capacitors and resistors. Without these metals, it's difficult to see how many advanced goods would have been miniaturized.

Metal commodities that play a central role in batteries, such as lithium, cobalt, and nickel, are in high demand for building renewable energy storage. As a result, considerable competition for access to these critical metals exists. For example, European, American, and Chinese companies have been sourcing some of these metals in several central African countries, including the Congo, raising ethical and political questions about who benefits from this trade, especially when mining some of these metals creates significant problems for local ecology and the people doing the extraction.

Energy

Energy commodities include crude oil, heating oil, natural gas, and gasoline. Global economic developments and reduced oil outputs from established oil wells around the world have historically led to rising oil prices, as demand for energy-related products has gone up at the same time that oil supplies have dwindled.

Investors interested in exposure to the energy sector need to understand how economic downturns, shifts in production enforced by the Organization of the Petroleum Exporting Countries, and advances in alternative energy sources—wind power, solar energy, and biofuels, for example—all have a huge effect on the market prices for energy commodities. That's not to say that the trade in oil has been going away: in 1998, daily oil production worldwide was 73.6 million barrels per day, which increased to 93.9 million barrels per day 25 years later.

Livestock and Meat

Livestock is the term for the domesticated animals raised on farms for use as food, labor, and more. The breeding and slaughtering of these animals supplies the trade in meat, milk, dairy, animal byproducts used in industrial and household goods, leather, and wool. Overall, as a commodity, livestock is valued chiefly for its meat.

The CME is the major U.S. exchange for the livestock trade, offering futures and options on the different types of them. Livestock is an essential part of the agricultural commodities market, with a far-reaching effect on the global food supply.

The most common meats traded include beef, pork, lamb, and poultry, such as chicken and turkey. The meat market is global, with trade agreements, tariffs, and international relations playing crucial roles in shaping how meat is traded. The meat supply chain involves animal rearing, slaughtering, processing, and distribution. Efficient logistics are necessary to maintain the quality and safety of meat, which can affect market prices and availability.

While some consumers have shifted toward alternative protein sources like plant-based and lab-grown meats, the U.N. says it anticipates worldwide meat protein consumption to surge about 14% by 2030 from 2020 levels. This surge is expected because of worldwide increases in income and population. The increasing demand for livestock is driven by trade in Asia and the Middle East, where local production cannot fully satisfy consumer needs. In recent years, import demand in several middle and high-income Asian nations has grown because of dietary shifts toward more animal-based products. International trade agreements have played a significant role, incorporating specific clauses for meat products to increase market access and open new trading partnerships.

By 2030, the supply of beef, pork, poultry, and sheep meat is estimated to expand by 5.9%, 13.1%, 17.8%, and 15.7% respectively. In the U.S., shifting consumer tastes, an aging demographic, and slower population growth should stabilize per capita meat consumption at about its early 2020s levels. One widely noted trend in the livestock trade is the growing preference for poultry over other sources of protein. There are several reasons for this change, two of which stand out: poultry's lower cost makes it a more affordable source of meat worldwide, and white meat is seen as a healthier option and more convenient to prepare. Poultry is expected to constitute 41% of all meat protein sources by 2030.

Meanwhile, the livestock commodities sector has faced growing calls to address sustainability and environmental concerns. Consumers are increasingly interested in knowing, e.g., the industry's carbon footprint and are looking for protein from more sustainable farming sources.

Agricultural Products

Agricultural commodities include corn, soybeans, wheat, rice, cocoa, coffee, cotton, and sugar. For investors interested in the agricultural sector, population growth—combined with limited agricultural supplies—could provide profits from rising agricultural commodity prices.

In recent decades, the agricultural sector has undergone several significant shifts related to technological advances, environmental concerns, changes in market dynamics, and policy shifts. Here are some of the key changes shaping the sector:

  • Climate change: This is crucial for any discussion of the future of this sector. Changes in weather patterns, increased incidence of extreme weather events, and shifting climatic zones have already affected crop yields, pest and disease patterns, and farming practices.
  • Consumer shifts: There have been notable changes in consumer preferences toward organic and locally sourced foods. This has influenced farming practices, the types of crops grown, and how agricultural goods are marketed and distributed.
  • Genetic modification and biotechnology: Genetically modified organisms and biotechnology have been controversial yet transformative over the past several decades. Taking advances in the biological sciences and applying them to agriculture has enabled the creation of crop varieties with improved resistance to pests, diseases, and environmental stresses. However, they have also sparked debates about their health and environmental consequences.
  • Globalization: The now-worldwide scope of agricultural trade means few farming communities in the world aren't feeding into the global market. This has led to increased competition, crop choice changes, and global supply chain shifts. Trade policies and agreements have also greatly changed market dynamics and farming practices.
  • Government policies and subsidies: Government interventions in the form of subsidies, support programs, and regulations have had significant effects on farming practices, crop choices, and the overall viability of different agricultural sectors.
  • Sustainable farming: There has been a growing emphasis on sustainable farming practices because of climate change and the ecological effects of large factory farming. This includes a shift toward organic farming, integrated pest management, and conservation agriculture, which focus on minimizing the environmental effects of farming.
  • Technological advances: The adoption of new agriculture technologies has led to massive changes in the sector. GPS systems, Internet of Things devices, drones, automated machinery, and big data analytics have greatly increased the efficiency and yields of farming practices.
  • Urbanization and other changes in land use: The expansion of urban areas and changes in land use have decreased in certain areas the amount of land available for agriculture, creating the need for methods of farming that can increase yields per acre.

What Moves Commodity Prices?

Commodity investment returns are based on different components, each of which plays a distinct role. Let's discuss some of them:

  • Changes in costs: Basic gains or losses shift based on differences in carry costs, storage, insurance, and financing.
  • Currency fluctuations: Since most commodities are priced in U.S. dollars, changes in the dollar's value can greatly affect commodity prices. A weaker dollar makes commodities cheaper in other currencies, potentially increasing demand, while a stronger dollar has the opposite effect.
  • Geopolitical and economic stability: Political events, economic policy, and instability in key regions can significantly influence commodity prices. Wars, political unrest, or economic sanctions where a commodity is produced can disrupt supply chains and affect prices.
  • Global economic trends: The overall health of the global economy greatly influences the demand for individual commodities. Economic growth typically leads to increased demand, while economic downturns do the reverse.
  • Government policies and regulations: Tariffs, subsidies, trade agreements, and environmental regulations all influence commodity prices. Policies restricting trade or production can lead to higher prices, while subsidies and incentives to certain industries can increase supply and potentially lower prices.
  • Inflation and interest rates: Investments in commodities are usually a hedge against inflation. When there's inflation, commodities typically rise along with it, providing some protection for investors who have them as part of their portfolio. Interest rate changes can also influence commodity prices by affecting the cost of holding or financing commodities.
  • Market speculation: Traders speculating on future prices can drive changes in the current prices of commodities.
  • Storage and transportation costs: The expenses related to storing and transporting commodities, especially for perishable goods, can change, significantly affecting their price.
  • Supply and demand: This is arguably the most fundamental factor. If the supply of a commodity is low relative to demand, prices rise. Conversely, if supply is high and demand is low, prices fall.
  • Technological advances: Technological gains have historically helped lower the cost of commodity production. Alternatively, they can also lead to an uptick in demand for other materials. For instance, advances in renewable energy technology should help, at some point, shift the demand for fossil fuels.
  • Weather and environmental events: The weather is a crucial influence on the production and supply of commodities, especially agricultural products and energy commodities like oil and natural gas. Droughts, floods, hurricanes, and other climatological events can disrupt supply chains and production, leading to price volatility.

Using Futures To Invest in Commodities

Futures are a prominent way to engage in the commodities market. A futures contract is a legal agreement to buy or sell a particular commodity at a predetermined price at a specified time. The buyer of a futures contract is taking on the obligation to buy and receive the underlying commodity when the futures contract expires. On the flip side, the seller is obliged to deliver the underlying commodity at the contract's expiration date. 

Futures contracts are available for every kind of commodity. Generally speaking, two types of investors engage in the futures markets for commodities: commercial or institutional users of the commodities and speculative investors.

Commercial and Institutional Purchasers of Futures

Many companies use futures contracts as part of their budgeting process and to mitigate shifts in cash flow. This is especially suitable for businesses that depend on commodities for their operations. These firms can reduce the risk of financial losses if prices fluctuate by taking positions in the commodities markets.

A good example of this is in the airline industry. Airlines require large quantities of fuel, and stable fuel prices are vital for their financial planning. To achieve some price stability, airlines hedge using futures contracts. With these contracts, airlines lock in fuel prices for a certain period. They thus protect themselves from the unpredictable swings in crude oil and gasoline prices, securing more predictable and stable operating costs.

Farming cooperatives may employ futures contracts to hedge against market volatility. Without this strategy, the unpredictability of commodity prices could pose significant financial risks, including bankruptcy, for businesses that need relatively stable prices to manage their operating expenses. For example, consider a cooperative of wheat farmers. The price of wheat can fluctuate widely because of weather conditions, global supply, and market demand. To manage this uncertainty, the cooperative could use futures contracts to lock in a selling price for their wheat crop ahead of the harvest. Doing this ensures a guaranteed price, regardless of future market fluctuations. Suppose market prices drop significantly by the time they harvest. In that case, the cooperative is protected from the lower prices because they had already secured a higher selling price through the futures contract. Either way, they gain some predictability and can budget for the future accordingly.

Speculators in Commodities Futures

Speculators in commodities tend to be sophisticated investors or traders who purchase assets for short periods and employ certain strategies to profit from price changes. Speculative investors hope to profit from changes in the price of the futures contract. These types of investors typically close out their positions before the futures contract is due. As a result, they typically never take actual delivery of the commodity itself.

If you wish to speculate on commodity prices and do not have a broker who trades futures contracts, you may have to open a new brokerage account. You will likely need to fill out a form acknowledging that you understand the risks of futures trading. Futures contracts require a different minimum deposit depending on the broker, and the value of your account will increase or decrease with the value of the contract. If the value of the contract decreases, you may be subject to a margin call and required to deposit more money into your account. Because of the high level of leverage typically involved in such contracts, small price moves in commodities can result in large returns or considerable losses; a futures account can be wiped out or doubled in a matter of minutes.

There are advantages to using futures contracts to participate in the commodities market. Analyzing particular investments is simplified because it’s a “pure play” on the underlying commodity. This means that you can focus solely on the price moves of the commodity itself without dealing with the complexities of company-specific factors that can affect stocks. In addition, futures trading can lead to significant profits. This is partly because futures contracts allow for high leverage: with a minimum deposit account, investors can control full-size contracts. This leverage means that you can take a strong position in the market even with a relatively small amount of capital.

However, while this can magnify profits, it also increases the risk of considerable losses. Therefore, futures trading requires careful risk management and is generally more suitable for experienced investors.

Futures Options

Because the markets can be very volatile, direct investment in commodity futures contracts can be very risky, especially for inexperienced investors. If a trade goes against you, you could lose your initial deposit and more before you have time to close your position.

Most futures contracts offer the ability to purchase options. Futures options can be a lower-risk way to enter the futures markets. One way of thinking about buying options is that it's like putting a deposit down on something instead of purchasing it outright. With an option, you have the right—but not the obligation—to follow through on the transaction when the contract expires. Hence, if the price of the futures contract doesn't move as you anticipated, you have limited your loss to the cost of the option.

Using Stocks To Invest in Commodities

If you’re interested in exposure to particular commodities markets, you can invest in the stocks of companies operating within them. For example, investors interested in the oil industry could put their money into oil drilling companies, refineries, tanker companies, or diversified oil companies. Those interested in the gold sector can purchase stock in mining companies, smelters, refineries, or any firm that deals with bullion.

Stocks are generally considered less prone than futures contracts to volatile price swings. Stocks are easier to buy, hold, trade, and track. Plus, you can narrow down where you put your money to this or that particular sector. This requires, of course, due diligence in researching the specific companies that interest you.

Investors can also purchase options on commodities such as natural gas options and oil companies and refineries options. Like options on futures contracts, options on commodity stocks require a smaller investment than buying stocks directly. Thus, while your risk for a stock option may be limited to the cost of the option, the price changes of a commodity may not directly mirror the price activity of a company’s stock with a related investment.

An advantage of investing in stocks to gain exposure to commodities is you can already engage in trading with your brokerage account. The information on a company’s financials is readily available, and stocks are often highly liquid. This is not always the case with other forms of investing in commodities.

There are relative disadvantages to investing in stocks to engage in the commodities market. Stocks are never a “pure play” on commodity prices. In addition, the price of a stock may be influenced by company-related factors that have nothing to do with the value of the commodities you’re trying to track.

Using ETFs and Notes To Invest in Commodities

ETFs and exchange-traded notes (ETNs) are other ways to engage in the commodities market. ETFs and ETNs trade like stocks and enable you to speculate on fluctuations in commodity prices without investing directly in futures contracts.

Commodity ETFs tend to track the price of a particular commodity or a group of them using futures contracts. Occasionally, you can invest in an ETF with the actual commodity in storage. Meanwhile, ETNs involve unsecured debt securities meant to mimic the price changes of a particular commodity or a group of them found in an index. ETNs are backed by the issuer.

You don't usually need a special brokerage account to put money into an ETF or ETN. There are also no management or redemption fees with ETFs and ETNs because they trade like stocks. However, not all commodities have ETFs or ETNs associated with them.

One downside is that a major change in the price of the commodity might not get reflected point for point in the underlying ETF or ETN. In addition, ETNs have credit risk associated with them since they are backed by the issuer.

Using Mutual and Index Funds To Invest in Commodities

While you cannot use mutual funds to invest directly in commodities, these funds might have holdings in commodity-related industries, such as energy, agriculture, or mining. Like the stocks they invest in, the mutual fund's shares are affected by factors beyond just changes in the commodity's price, including more general changes in the stock market and company-specific factors.

However, there are some commodity index mutual funds that invest in futures contracts and commodity-linked derivatives. These can provide a more direct exposure to changes in commodity prices.

By investing in mutual funds, you get the benefit of professional money management, added diversification, and liquidity. Unfortunately, some mutual funds have high management fees.

Using Commodity Pools and Managed Futures to Invest in Commodities

A commodity pool operator (CPO) is a person or limited partnership that collects funds from investors and pools these resources to put into futures contracts and options. CPOs must provide you with periodic account updates and annual financial reports. They must also keep records on all investors, transactions, and any additional pools they are operating.

Typically, CPOs employ a commodity trading advisor (CTA) to advise them on trades for the pool. CTAs contributing professional investment advice must be registered with the Commodity Futures Trading Commission (CFTC). Registration includes a thorough background check to ensure they are fit to be giving financial advice.

You might want to participate in a commodity pool for several reasons. One advantage is that you gain access to professional investment advice from the CTA, which is particularly helpful for those not well-versed in futures trading. In addition, the pooling of funds means there can be a larger capital base to invest, which can broaden the opportunities and help diversify risk. Nevertheless, if you join a closed fund, there could be a uniform contribution required. This means each investor must commit to the same level of capital.

What Is the Difference Between Hard and Soft Commodities?

Hard commodities are natural resources that must be mined or extracted. They include metals and energy commodities. Soft commodities refer to agricultural products and livestock.


The key differences include how perishable the commodity is, whether extraction or production is used, the amount of market volatility involved, and the level of sensitivity to changes in the wider economy. Hard commodities typically have a longer shelf life than soft commodities. In addition, hard commodities are mined or extracted, while soft commodities are grown or farmed and are thus more susceptible to problems in the weather, the soil, disease, and so on, which can create more price volatility. Finally, hard commodities are more closely bound to industrial demand and global economic conditions, while soft commodities are more influenced by agricultural conditions and consumer demand.

Are There Commodity ETFs?

Yes. Commodity ETFs provide investors with an easy and convenient way to gain exposure to commodity prices without directly investing in physical commodities or dealing with futures. These ETFs have different types of exposure to the commodity markets, for example, there are physical commodity, futures-based commodity, and commodity producer ETFs, as well as leveraged and inverse commodity ETFs.

What Is Backwardation?

Backwardation is a term used in the commodities futures markets to describe a specific market condition. It occurs when the prices of futures contracts are lower in months further out and in those closer in time. This situation is the opposite of contango, where future prices are higher than current prices.

What Is Contango?

Contango describes a situation when the futures prices of a commodity are higher than the spot or current market price. In a contango market, the price of a futures contract tends to rise as its delivery date approaches.

The Bottom Line

Novice and experienced traders have options for investing in the commodities markets. While commodity futures contracts are the most direct way to participate in price changes in commodities, there are other means for you to invest that have less risk but still have exposure to the specific commodities you have in mind.

In general, commodities are said to be risky because they can be affected by events that are difficult, if not impossible, to predict, such as unusual weather patterns, epidemics, and both natural and human-made disasters.

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