What is Commodity Market?
The commodity market is a physical or a virtual market place where market participants meet and buy or sell positions on commodity products like oil, gold, copper, silver, wheat, barley. Though started with Agri commodities initially, commodity markets today trade in all types of commodities like base metals – gold, silver, copper, infrastructure like oil, electricity, and even weather forecasts. There are about 50 major commodity exchanges worldwide which trade in more than 100 commodities.
Types of Commodity Market
The commodity market can be categorized under two major categories based on the type of commodityCommodityA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units.. These two categories are:
#1 – Hard Commodities
Hard commodities consist of the commodities that are required by the manufacturing industries. These should be mined and are manually extracted from the land or the ocean. They have limited reserves and are affected the most by the geopolitical and economic conditions. Possible examples of such types of commodities are Gold, Oil, silver, rubber, copper, etc. The major part of the pricing is because of the process that is carried out to extract them.
#2 – Soft Commodities
Soft commodities constitute the commodities that are mainly Agri related or livestock. Unlike hard commodities, they are not mined or extracted but are produced through proper procedures. They have virtually unlimited reserves and are not affected by geopolitical conditions but by the weather or by natural occurrences. Possible examples of such commodities are corn, wheat, barley, sugar, pork, coffee, tea, etc.
Example of How Commodity Market Works
If the price of a traded commodity fluctuates, the price of the corresponding future contracts changes in sync. Consider the case of crude oil whose prices are decided ideally by demand and supply. Middle East countries, which are the major oil-producing nations, tried to control the prices of crude oil by controlling the supply. However, in a practical world, oil prices are affected by other factors, too- geopolitical consideration being the major one.
For example, in the 2008 economic crisis, the global growth was down, and hence the prices of oil futures should have crashed big time. However, that was hardly the case, and oil futures were at a lifetime high of $ 145 per barrel. This was mainly because the investors across the world were taking out their money from equity and buying commodities and futures contracts. This flow of increased money led to a surge in the oil and gold futures.
Advantages of Investing in a Commodity Market
- Hedging Mechanism: The biggest advantage of investing in the commodity market is for the producers, importers, and exporters as it provides them with a mechanism to hedge the price fluctuations. For example, a farmer can protect itself from the price fluctuations in the wheat by selling its futures contract with an expiry date three months down the line. A retailer, on the other, can protect itself by buying a futures contract.
- Fewer Manipulations: Compared to the financial market, commodity marker deals in proper tangible products that are raw materials for the manufacturing industries. Hence the commodity markets are governed by demand and supply and are less prone to manipulations compared to financial markets.
- Risky: Commodities investments are very risky as the geopolitical factors play an important role in their pricing. For example, any suspicion of a political crisis in the middle east leads to a sudden spike in crude oil prices. Because of such a systematic riskA Systematic RiskSystematic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an “undiversifiable risk” or “market risk” or even “volatility risk”., commodity markets are very prone to operational failures and need to be regularly monitored to avoid any unfavorable circumstances.
- Leverage: Unlike financial markets, commodity markets thrive on low margin requirements and high leverage. Though it helps in better potential profit, high leverage ratiosLeverage RatiosDebt-to-equity, debt-to-capital, debt-to-assets, and debt-to-EBITDA are examples of leverage ratios that are used to determine how much debt a company has taken out against its assets or equity. in times of economic recessionEconomic RecessionEconomic recession is when economic activity is stagnant, and there is contraction in the business cycle, over-supply of goods compared to its demand, and a higher unemployment rate resulting in lower household savings and lower expense, inflation, higher interest rate and economic crisis due to higher fiscal deficit. or unexpected volatile movements can lead to increased losses.
- The commodity market is much older than the financial money marketMoney MarketThe money market is a market where institutions and traders trade short-term and open-ended funds. It enables borrowers to readily meet finance requirements through any financial asset that can be readily converted into money, providing an organization with a high level of liquidity and transferability. and has evolved over time. In fact, the very first trading known to mankind was barter trading, where commodities like food grains would be traded between farmers and the consumers. The earliest known full functional commodity market was set up in Amsterdam in early 16th
- The pricing of commodities traded in the commodity market is quite complex and depends on their individual characteristics. For example, for goods like wheat, barley, there is a storage cost involved in addition to the forces of demand and supply. The storage cost is required as these commodities require proper storage mechanisms to save them during transportation or from natural calamities.
- There are certain criteria’s that a commodity must possess to be fit for trading in the commodity exchanges. These characteristics are homogeneity, price fluctuations, open supply, and durability.
- The commodity market, though, differs from money markets in terms of the underlying instrument; the underlying concepts of trading are pretty much the same. The concept of spot price, future price, expiry, strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market. are pretty much the same.
- The commodity market, though, in general, trade-in generic commodities like coffee or wheat, but with time it has evolved to include certain differentiated products too. These differentiated products are a generic commodity but with certain peculiar characteristics. Example of high octane gasoline for which a generic commodity would be gasoline.
- Commodities are highly volatile assets compared to financial assets. They are governed not only by geopolitical tensions, economic expansions, recessions but also by natural forces like floods or calamity.
- The major commodity exchanges across the world are the London Metal Exchange, Dubai mercantile exchange, Chicago Board of Trade, Multicommodity exchange, etc.
Commodities trading and hence commodity market can be traced to the times when human civilizations started to evolve. They are just another class of assets, just like equity or bonds. The difference lies in the origins as they are more tangible. The similarity lies in the fact that both have their complexed, evolved derivativesDerivativesDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. which act as hedging mechanisms for hedgers and quick money for speculators. The commodity market provides a medium for these different participants to come together and play a role in the eventual pricing of these commodities.
This has been a guide to What is the Commodity Market and its Meaning. Here we discuss how commodity markets work along with its types, an example, advantages, and disadvantages. You can learn more about excel modeling from the following articles –