What are Commodities?

The commodities market is a market that trades in raw materials rather than manufactured products. There are two broad classifications of commodities – Soft and Hard. Soft commodities are agricultural products such as wheat, coffee, cocoa and sugar. Hard commodities are mined, such as gold, silver and oil etc. There are about 50 different commodities in total traded on financial markets around the world.

How are Commodities Traded

Commodities are traded either physically where the seller delivers the physical commodity to the buyer or financially where buyers and sellers trade contracts and either make or lose on the outcome of these contracts. Financial commodity transactions increasingly outnumber physical trades in which goods are delivered. Futures contracts which are financial derivatives of the physical commodity are the most common, and oldest method of trading commodities and can be purchased directly off trading platforms.

What drives commodity markets?

The commodity markets help to ensure some stability in price of raw materials, especially through futures contracts. These allow suppliers to lock in the price they’ll receive for their produce at a future date; so the price is also fixed for the buyer. Consequently, the future uncertainty of price is removed from the market keeping a lid on runaway commodity inflation.

There are however other external factors at play that can effect commodity prices mainly supply and demand of the physical commodity, economic and political factors such as wars or the threat of war can have a big effect on the price of oil, and weather can have a significant impact on agriculture or soft commodities as a poor harvest will reduce the level of supply. Finally, as most commodities are priced in US dollars the value of the dollar can have in inverse effect on the price of the commodity. This is because the value of the item being used to purchase the commodity increases relative to the value of the commodity being purchased.

Who Trades Commodities

Commodities are generally used as a hedge or for speculation but are not suitable for capital growth or income investments. There are four groups who trade commodities:

• Producers: This group produces the raw materials and use commodities futures to hedge against a poor harvest or fall in commodity prices
• Speculators: This group are simply trying to find anomalies or opportunities in the market to make a return in a relatively short time frame
• Hedgers: These are general investors who have a balanced portfolio of which commodities make up a component
• Financial Institutions: Market makers or brokers who hold positions on their own book or on behalf of clients

What is the best way to trade Commodities?

By far the most straight forward method of trading commodities is to buy a commodities ETF. These give convenient access to energy, metals, agriculture, industrials and livestock markets allowing you place and liquidate a position in a broad basket of commodities that are actively traded in a liquid market, and are suitable for diversifying your portfolio.

Contango and backwardation as a buying or selling signal

Now for the technical stuff….
There are two prices in commodities the futures price and the spot (current) price. The expectation is that the futures price and spot price converge the closer you get to the contract end date so prior to that date the futures price is either above or below the spot price. Contango is when the futures price is higher than the spot price and Backwardation is when it is lower than the spot price.

In normal market conditions, you would expect commodity futures to be trading in contango. This is because the forward price includes fees for holding the position, so it should be theoretically higher the longer into the future it runs. For some commodities, however, geopolitical factors tend to play a much more important role in whether the curve is in contango or backwardation.

The shape of the futures curve is important to commodity hedgers and speculators, as it gives an impression of the state of the commodity in the market both now and in the coming months. A state of backwardation, for example, can suggest a shortage in supply which hikes the current price up, or an expected plentiful supply in the coming months likely to bring the future price down.

For example, if crude oil futures markets are in contango, this suggests that the current supply is plentiful. Conversely, if prices were in backwardation it could suggest an immediate shortage. Interpretation of these markets can be used as signals for buying or selling positions however should not be taken in isolation.

Baggot Investment Partners – Commodities Service

If you are interested in adding commodities to your portfolio or use these raw materials in your business and want to hedge against raw material inflation please contact us at Baggot Investment Partners and we will be happy to advise you.