What Is a Commodity?
A commodity is a raw material that is bought and sold but is interchangeable with other materials of the same type -- such as oranges or lumber.
Companies that produce these goods sell them to the companies that will use them. And oftentimes, they’re also traded on an exchange -- the products will need to adhere to a basis grade, or minimum standards.
Commodity Product Examples
Commodities rarely differ between producers, unlike manufactured merchandise such as electronics. This means commodities of the same grade are interchangeable or fungible with each other.
If a company purchases raw materials from different producers, the quality should be the same (assuming they're the same grade).
The following are examples of commodities:
- Stock animals (such as cattle)
- Fossil fuels (such as coal)
- Precious metals (such as silver)
How Does a Commodity Work?
Commodity suppliers and buyers trade on a futures market. Both parties negotiate an agreement for payment of goods and a predetermined date when the commodity will be delivered.
A contract is drawn up, which outlines the price and future delivery date for the goods. On the agreed-upon date, both the money and commodity are exchanged.
Typically, commodities trade on an exchange such as the New York Mercantile Exchange (NYMEX). These markets allow commodities to be traded, much like investors would with stocks. Those who trade commodities include producers of raw materials (like farmers and miners), investors, and companies who use commodities as part of their business.
There are also individual buyers of commodities, though they’re less common. Usually, these individuals invest in precious metals. For instance, this person would purchase a large amount of gold bouillon and store them at a secure facility.
Instead, individual investors tend to invest in commodities pools, known as exchange-trade products (ETPs) or grouped together as mutual funds. Unlike traditional exchange traded funds or mutual funds, investors don’t own a share of the assets. Instead, investors purchase the right to trade an asset for a small window of time.
How are Commodity Prices Determined?
Prices for commodities are determined by supply and demand. More specifically, commodity prices tend to go up when investors predict inflation. That’s because commodities are usually seen as a way to hedge inflation.
For instance, a strong economy may lead to an increased demand for lumber. If there isn’t enough supply to keep up with demand, the price for lumber will go up. The opposite can happen if there is too much lumber, but not enough demand for it.
Why do Commodity Prices Move Up and Down?
Commodity prices move up and down because of changes in the market. A basic rule of thumb is that commodity prices will go down if there is decreased demand or an abundance of supply. Commodity prices will go up when there is increased demand or a decrease in supply.
Who Regulates the Commodity Market?
The Commodity Futures Trading Commission (CFTC) regulates the commodity futures and options market. This independent U.S. federal agency was established in 1974 due to the Commodity Futures Trading Commission Act in the same year. The goal of the CFTC is to protect investors against fraud and manipulative trade practices, as well as promote efficient and competitive futures markets.
Commodity Market Examples
A common example of trading commodities is when a farmer wants to sell their wheat. The farmer wants to ensure that they’ll be able to turn a profit, especially if wheat prices drop by the time the crop is harvested. Therefore, a commodities contract is drawn up so that the farmer will be able to sell to the buyer at a price they both agree to.
Another example would be businesses that want to ensure that their production costs are somewhat predictable. It can draw up a futures contract with a tea producer at current prices. That way, the company can prevent rising prices from eating into its profits.
Understanding Types of Commodities
There are three main categories of commodities -- agriculture, energy, and metals. Commodities that fall under the agriculture category include foodstuffs like sugar, grains, livestock, and raw materials such as cotton. Energy commodities include natural gas and crude oil, whereas metals include mined materials such as gold and silver.
Each of these categories of commodities are traded through futures contracts and are used to achieve different goals depending on the type of investor or buyer.
Commodity Buyers and Producers
This type of trader uses commodities futures contracts to reduce risk, known as hedging. Traders will fulfill their end of the contract once the futures contract expires. For instance, a farmer can sell their future harvest to hedge against losses if the price of their crop goes down by the time harvest season comes.
Commodity speculators trade in the futures market in order to profit from volatility. These types of traders don’t intend on delivering the goods or purchase them once the contract date comes around. For instance, intraday traders can buy and sell futures and turn a profit. Some brokerages and portfolio managers also purchase index futures to diversify their portfolios.
Commodities as Hedge Funds
Investors tend to purchase commodities to hedge against inflation. That’s because prices tend to go up when there’s accelerated inflation. In other words, when the demand for certain goods rises, so does the price. Purchasing these types of assets now can protect investors against the decreased buying power of their funds.