Commodity

What Is a Commodity?

A barrel of oil from Texas and a barrel from Oklahoma of the same grade are worth the same price. Nobody asks which company drilled it. That sameness, called fungibility, is what turns a raw material into a commodity and lets it trade on an exchange in large, anonymous volumes.

Exchanges make fungibility precise by setting contract specifications. A West Texas Intermediate crude contract calls for oil of a set sulphur content delivered at Cushing, Oklahoma. A London Good Delivery gold bar weighs about 400 troy ounces and must be at least 99.5% pure. As long as a delivery meets the specification, buyer and seller do not need to trust each other’s product.

Organised commodity trading is much older than stock indices. The Chicago Board of Trade opened in 1848 so that farmers and grain merchants could agree on prices before the harvest reached the city. That need to lock in a price ahead of delivery still drives most commodity markets.

Types of Commodities

Energy covers crude oil (WTI and Brent), natural gas, heating oil and gasoline. These are the most traded commodities by value, and their prices feed directly into transport and manufacturing costs.

Precious metals include gold, silver, platinum and palladium. Gold is bought mostly as a store of value, while silver and platinum also have large industrial uses.

Industrial metals such as copper, aluminium, nickel and zinc track factory output and construction. Copper is so tied to economic activity that traders nickname it “Dr. Copper”.

Agricultural products include grains (wheat, corn, soybeans), softs (coffee, cocoa, sugar, cotton) and livestock (cattle and hogs). Weather, disease and harvest reports move these prices more than economic data does.

How Are Commodities Traded?

With the categories in place, the next question is how a trader actually gets exposure. Physical buyers, such as refiners and jewellers, trade in the spot market, where the price is for immediate delivery. Everyone else mostly uses futures contracts, closing or rolling them before expiry so that no barrels or bushels ever arrive.

Rolling creates a cost that surprises many beginners. Suppose spot crude sits at $70 and the next month’s contract trades at $71, a market structure called contango. A fund holding futures sells the expiring contract at $70 and buys the next one at $71, so it owns about 1.4% fewer barrels for the same money.

If spot stays at $70 all year, the fund repeats that roll 12 times and loses roughly 16%, even though the oil price never moved. The reverse structure, backwardation, pays the holder instead: when later contracts are cheaper than spot, each roll buys more barrels.

Traders can also use exchange-traded funds that hold futures, shares of producers such as miners and oil companies, or a contract for difference that tracks the price. Each route carries a different mix of roll costs, company risk and financing charges.

Commodity vs. Stock

Why Are Commodities Important for Traders?

Commodities sit at the start of the price chain, so they move before the data that economists watch. A jump in oil or grain prices reaches consumer prices within months, which is why commodity rallies raise fears of inflation and higher interest rates. Supply decisions matter as much as demand, and a production cut by OPEC can move oil by several dollars in a single session.

Most commodities are priced in dollars, which links them to currency markets. When the US dollar index rises, commodities become more expensive for buyers paying in other currencies, and prices often weaken. Traders who ignore the dollar can misread a commodity move as a change in supply or demand.

Volatility is the main risk. Crude oil climbed to nearly $147 a barrel in July 2008 and fell below $35 by December, a drop of more than 75% in five months as the financial crisis crushed demand. Because commodities pay no income, a long position has nothing to cushion that kind of fall, and the roll costs of contango can deepen losses further.

Commodities also help with diversification. Their returns often move differently from stocks and bonds, especially during supply shocks, which is when a portfolio of financial assets tends to struggle most.

Key Takeaways

• A commodity is a raw material traded in standard grades, so one unit is interchangeable with another and prices reflect global supply and demand.
• The four main groups are energy, precious metals, industrial metals and agricultural products, each driven by different forces.
• Most traders gain exposure through futures, and rolling futures in contango can cost money even when the spot price stays flat.
• Commodities pay no dividends or interest, so returns come only from price changes and roll yield, minus storage and financing costs.
• Commodity prices feed into inflation, react to the US dollar and can swing by more than half within months when supply or demand shifts.