2.5. Commodities

In finance, commodities are raw materials or agricultural products that can be bought and sold on the internet. You don’t trade the physical products, but a contract!

These raw materials or agricultural products must be the same to classify as commodities.

Telephones or computer chips for example are not all the same, so they are no commodities.

Gold is gold, and wheat is wheat, and can therefore be classified as commodities. Even though there may be small differences in their quality!

Commodities have four key attributes:

  1. Fungibility: 1 barrel of Brent crude oil for example;
  2. Standardization: Exchanges can trade contracts instead of physical goods;
  3. Deliverability: Futures contracts must specify delivery grade/location;
  4. Global pricing: Prices converge via arbitrage across the world;

We have sourced these four key attributes from ChatGPT.

Figure 1: Commodities / Source: ChatGPT

There are four major commodity classes:

  1. Energy, like crude oil, natural gas and gasoline;
  2. Metals, like gold, silver and iron ore;
  3. Agricultural, like wheat, corn and coffee;
  4. Livestock, like cows, pigs and fish;

There are two different types of markets in commodities, which are spot markets and futures markets.

  1. In spot markets you get instant delivery and pay the price of a commodity today;
  2. In futures markets you get delivery in the future and pay a specific price in the future;

An airline can hedge jet fuel by buying oil futures, and pay a lower total price for its fuel. A farmer can sell wheat futures to guarantee harvest income.

Every future contract defines the following:

  1. Quality of the goods;
  2. Quantity of the goods;
  3. Delivery location;
  4. Delivery date;
  5. Payment method;

It is important to understand the concepts of “contango” and “backwardation”.

Contango means that the future price is higher than the spot price, which basically means that the current supply is higher than the demand.

Backwardation means that the spot price is higher than the future price, which means that the current supply is lower than the demand.

It is also important to understand that commodities take a long time to produce, which is definitely not the case with all other investment classes. Commodities cannot be printed or grown instantly!

Commodities can experience supercycles, since the demand can grow significantly faster than the world can supply. They are also often cyclical products, which can depend on seasons.

Commodities depend solely on supply and demand (or reality) , and not on expectations, like the stock markets for example.

This is why commodities offer a great opportunity to diversify investment portfolios.

The key market participants in commodities are producers, consumers, merchants, speculators and the government.

Commodities are geopolitically sensitive because oil, energy and food are such important products. Commodities are also sourced all over the world.

In short, commodities are a unique investment class that are extremely important in the world. Yet they are little understood by people like you and me.

Commodities are a very interesting investment class for sure!

Five major global commodity exchanges are:

  1. Chicago Mercantile Exchange (CME);
  2. New York Mercantile Exchange (NYMEX);
  3. Intercontinental Exchange (ICE);
  4. London Metal Exchange (LME);
  5. Chicago Board of Trade (CBOT);