What are Commodities?

TL;DR

• Raw materials which can be consumed (like food) or used to create other products, and traded in financial markets
• Spot commodities and derivative commodities markets
• Hard commodities and soft commodities

What are commodities?

Commodities are raw materials such as copper or coffee, that can be bought and sold. These commodities can be traded on the commodity market: a place where buyers and sellers of raw materials come together to transact. These people come together to ensure present production through current orders or future orders for later consumption. The commodity market can be split into 2: spot orders that involve immediate delivery or derivative orders that involve future delivery. Investors can get directly involved in the commodities market through a range of investment vehicles.

There are 2 categories of commodities: hard and soft. Hard commodities refer to natural resources that are extracted from our planet, like coal or gold. On the other hand, soft commodities are usually products used in our food (agricultural or livestock) like corn or chicken. Since prices of commodities move opposite to stock prices, investors rely on commodities for diversification and hedging their portfolio against inflation risk. For example, the value of the dollar is dependent on monetary policy and fiscal policy but precious metals like gold derive their value from different factors, isolating them from inflation.

Types of Commodity Markets

Commodities either trade in the spot or derivatives markets. The spot market is where buyers and sellers trade physical commodities and these will be delivered to the respective party immediately.

Derivatives markets involve derivative securities: forwards, futures and options. Forwards and futures are contracts to transact at a future date with a predetermined price. Forwards and future contracts are the same except forwards can be customized and traded over the counter. On the other hand, futures are standardized and only traded on exchanges, guaranteeing the transaction with a clearinghouse.

Benefits and drawbacks

Investing in commodities provides exposure to growth opportunities with good potential returns. For example, this year, lumber saw its price rise as high as 370% as homeowners used money saved up from the COVID pandemic for home renovations. As mentioned earlier, commodity prices also have a low correlation with stocks and therefore great to diversify one’s portfolio - reducing their risk. Essentially, this hedges an investor’s portfolio against inflation.

On the other hand, while prices can drastically rise, prices can dramatically fall too. It is said that investing in commodities is twice as volatile as investing in stocks. At the start of the COVID pandemic, when lockdowns began and demand for oil vanished, oil producers had no one to sell their supply to. As a result, production continued, storage filled up but nothing was being sold. No one wanted to buy oil when the future was so uncertain. As a result, in April 2020, oil prices went negative, forcing sellers to pay people to take oil. Lastly, unlike stocks that generate income in capital or dividend gains, commodities do not provide investors with any income.