Commodity Market

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.read more. These two categories are:

Commodity Market

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Source: Commodity Market (wallstreetmojo.com)

#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

  1. 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.
  2. 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.

Disadvantages

  1. 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”.read more, commodity markets are very prone to operational failures and need to be regularly monitored to avoid any unfavorable circumstances.
  2. 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.read more 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.read more or unexpected volatile movements can lead to increased losses.

Important Points

Conclusion

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. read more 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.

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