The commodity is a basic good that is used in the manufacturing of other products and services, or as a store of value, manufactured or grown by different producers across the globe with little or no differentiation.
Types of Commodities
The following are types of commodities.
#1 – Metals
Metals are generally manufactured by processing mined ore. Steel, copper, aluminum, gold, and silver are some of the most common metallic commodities. Metals can further be classified into two categories:
- Industrial Metals – These types of metals are abundantly available and are generally used in an industrial activity like the manufacturing of a huge number of products. As they are good conductors of heat and electricity, they can be found in most of the products that we use in daily life. Copper, lead, zinc, tin, aluminum are a few most prevalent examples of industrial metals.
- Precious Metals – These types of metal are valued higher than industrial metals because they are not abundantly available and are difficult to mine and produce. They are used for both industrial purposes and store of value. Investors and traders buy and hold them for the safety of capital or for gains.
#2 – Energy
It mainly provides fuels to run motors, appliances and even space rockets. It plays an integral part in the overall functioning of the world. Commodities like oil, electricity, natural gas, gasoline, and ethanol are a few common examples.
#3 – Livestock and Meat
Livestock and meat are commodities that are bought for the purpose of slaughter and meat consumption. The most prominent example in this category is cattle and can be traded as live cattle (cattle mature enough to be slaughtered) and feeder cattle (cattle that should be fed and grown before it can be slaughtered).
#4 – Agricultural Commodities
These are produced by farmers and traded worldwide. The most common examples are rice, wheat, corn, and sugar.
Role of Commodities in Business and Economy
It plays an integral part in the overall functioning of the economy. Giant companies are involved in commodity trading across the world. Different countries specialize in producing different commodities based on the availability of natural resources in those countries. China is the world’s largest manufacturer of steel, while Chile leads in copper and Russia in aluminum. China is the world’s largest consumer of most used hard commodities due to the manufacturing boom it has seen in the past 2-3 decades.
Pricing of Commodities
Price discovery happens based on demand and supply. Supply disruptions like the closure of manufacturers or natural disasters or cartel cuts generally result in higher prices. Alternatively, an unanticipated spike in demand due to increased economic activity or for any other reason results in increased commodity prices. Similarly, price declines come on the back of higher supply or lower demand.
They are freely traded across the world in almost every country’s commodity exchanges. Major exchanges across the world are Chicago Mercantile Exchange (CME), Chicago Board of Trade (CBOT), New York Mercantile Exchange (NYMEX) and the London Metal Exchange (LME). Commodity exchanges play a pivotal role in its price discovery.
Commodity Trading and Investing
Several investors and traders including giants like Dangote and Cargill are major traders in commodity markets. The margins are quite low in commodities due to its fast-moving nature, efficient price discovery, and low entry barriersEntry BarriersBarriers to entry are the economic hurdles that a new entrant must face in order to enter a market. For example, new entrants must pay fixed costs regardless of production or sales that would not have been incurred if the participant had not been a new entrant..
Traders and investors can also take exposure through the spot market (cash) or through derivatives marketDerivatives MarketThe derivatives market is that financial market which facilitates hedgers, margin traders, arbitrageurs and speculators in trading the futures and options that track the performance of their underlying assets. trading in futures and options. 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. are generally used for hedging purposes and the actual delivery takes place for trades that are entered by manufacturers. These players hedge their price exposure through derivative contractsDerivative ContractsDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based..
Another breed of traders is called speculators who just buy or sell contracts in anticipation of the higher or lower prices in the future. Its price speculation is widely practiced and speculators hardly take or deliver physical commodities.
Regulations in the Commodity Market
There are no regulations when two parties join hands privately to trade commodities, however, if the trades happen through exchanges, those trades are governed by regulatory agencies like the Commodity Futures Trading Commission (CFTC) in the United States and Markets in Financial Instruments Directive (MiFID) in Europe.
The regulatory agencies try to limit the speculative activity to avoid unnecessary formation of bubbles led by the vested interests of the few players.
Commodities go through cycles every once in a while when their prices increase significantly (generally in an economic bull run), reach unsustainable levels, and then decline subsequently to remain in a slump for some time. It is possible for all commodities (especially metals) to display this behavior at the same time, but there could also instances of individual commodities seeing a cycle at different times.
Some of the advantages are as follows:
- It plays a pivotal role in the overall functioning of the economy. Nearly everything that we use or eat today uses commodities.
- These are a hedge against inflation; their price tends to increase at the rate of inflationRate Of InflationThe rate of inflation formula helps understand how much the price of goods and services in an economy has increased in a year. It is calculated by dividing the difference between two Consumer Price Indexes(CPI) by previous CPI and multiplying it by 100..
- This sector is a huge job creator and employs millions of people across the globe.
Some of the disadvantages are as follows:
- The most pressing problem that it causes is pollution. Coal is said to be the most polluting commodity.
- Mining ore sometimes comes at the cost of decimating forests and wildlife.
- The working conditions of people in commodity manufacturing/handling in the developing world are said not to be up to the mark.
- These are prone to speculation which leads to the formation of bubbles and subsequent bursts, which also hurts the genuine players in the market as well.
Commodities have been around for centuries and the world has evolved significantly. The market has also evolved, and with the trade and commerce commodities travel easily from one part of the world for use in other parts of the world. Agencies across the world are trying to figure out how we can use less of some polluting commodities and replace them with not so polluting material for environmental sustainability.
There is no doubt that commodities have played an important part in shaping humanity and economies and they will continue to do so in the future.
This has been a guide to what is a commodity and its definition. Here we discuss the cycle and pricing of commodities along with its types and regulations. We also discuss the advantages and disadvantages. You can learn more about investment banking from the following articles –