Commodities Markets - The Trading of "Stuff"

Commodities Markets - The Trading of "Stuff"

A former colleague was fond of saying, “there are five different places you can put your money: stocks, bonds, real estate, cash, and commodities.” We’ve covered the first two in previous blog entries, we’re (hopefully) familiar with the middle two, and we’ll cover the final one now.

Commodities can most simply be defined as “stuff.” Stuff that can be mined (like gold, iron, aluminum, and copper), stuff that can be grown and harvested (like coffee, soybeans, and wheat), and stuff that can be raised (like beef cattle, sheep, and pigs) are all considered commodities. Although we all are used to buying commodities in small batches (a few gallons of gasoline, a pound of coffee, a gold necklace), the commodities market trades in significantly larger quantities. Thousands of barrels of oil and tons of coffee beans routinely change hands every day. 

There are two different commodities markets: the spot market and the futures market. The spot market is for exchanging goods in real-time, much like stocks. For example, if you purchased a barrel of oil today at the current market rate, you would be making a trade in the spot market. However, most commodities are traded on the futures market, with contracts (called futures or forward contracts) dictating the exact price, quantity, and transaction date that the trade will take place.

Futures contracts originated with farmers who were concerned about substantial price swings between seed-planting date and harvest date. Imagine if you, as a farmer, were expecting to earn $100 per bushel of wheat, but because of a particularly good harvest, wheat was available in greater-than-expected quantity and the market price was only $50 per bushel. Your profit margins (or potential to profit at all) could vanish. Imagine now you’re a bread maker and wheat is your largest input. Let’s say you’re expecting to pay $50 per bushel, but because of a lousy harvest and low supply the price is actually $100 per bushel. Your profits could be at risk as well. Using a futures contract, the farmer and bread maker could agree on a price of $75 per bushel, locking in profit margins for both supplier and buyer.

As you would expect, however, the futures market is no longer just for farmers and bread makers. Keen investors recognized that money could be made speculating on futures contracts, buying contracts when prices of a particular good are expected to be high and selling contracts when prices are expected to be low. As the transaction date approaches, these investors can quickly exchange their contracts with another party and earn a profit. Or at least, that’s how it’s supposed to work.

Commodity futures are a risky market for the average investor, simply because the price of most commodities can fluctuate based on countless unexpected factors. Weather can dictate a good or bad harvest, geopolitical strife can make mining difficult, and most of the world’s oil supply is in the hands of the OPEC cartel. That being said, commodities can be appropriate as (a small) part of a diversified portfolio. For investors who are interested, it is wise to use an actively-managed commodities mutual fund helmed by a seasoned manager or team that can identify and exploit opportunities as they arise.  

Submitted by Ben Sadtler

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