As commodities are growing in popularity for investment allocation, I found this to be a good opportunity to introduce commodities and futures.
One could argue commodities have been around since the beginning of civilization. People have produced, paid or bartered for commodities to use for either production or to consume. Some of the uses of commodities include food, energy, construction, manufacturing, and clothing.
According to the Merriam-Webster dictionary, commodities are defined as: 1) an economic good. 2) A product of mining or agriculture. 3) An article of commerce especially when delivered for shipment. 4) A mass produced un-specialized product. [i]
In today’s global markets both large and small firms will trade and hedge commodities as part of their daily business as either a producer or end-user of the commodity. For example a chocolate candy producing firm will need to purchase cocoa, sugar and of course energy to fuel their factories. If they do business in foreign countries they may need to buy and sell foreign currencies for hedging or delivery purposes.
To manage their price risk, a commodity producer, such as a farmer may sell a futures contract to lock-in their selling price. An end-user, such as a coffee chain may buy a futures contract to lock-in their purchasing price. Keep in mind commodity markets tend to be mean-reverting markets as they spike or decline from an average price and then revert back towards that average price overtime. This is often due to shocks in the system such as increased demand, reduction of supply, weather concerns, disruption of distribution channels or possibly political or regional events. If a commodity becomes too expensive, the market participants’ behavioral mechanism will appear as they seek less expensive substitutes. This is known in economics as the substitution effect and one of the differences to note between commodity and equity trading.
Commodities are traded in two common locations: either the spot/cash market usually reserved for industry or sometimes known as “commercials” such as producers, distributors and end-users as the actual physical commodity is traded. Or the products trade on an exchange such as one of the futures exchanges found around the world. The futures exchanges are often utilized by both commercials and speculators. An exchange offers commercials the opportunity for immediate offset of their commodity risk by speculators offering liquidity to take on the risk. If a commercial has a loss from hedging, it often means they profited in the underlying cash market, because they are holding the opposite direction in the cash market. One can think of the loss on the hedge as a premium on an insurance policy.
Commodity exchanges often seek commodity products to list on their exchange that tend to have price volatility and/ or seasonality. Why list a product that has little or no volatility? This would imply no or little risk. Futures are founded on the basic concepts of price discovery from supply, demand and the movement of pricing.
A listed contract offers standardization of grade, size and delivery point as a method of risk management for both the producers of the commodity as well as the end-user of the commodity. As the exchange’s clearinghouse takes the opposite side of each trade, it reduces the potential for default risk of the commodity contract.
In America, many commodity exchanges appeared around the country in the 1800s. However, one can point to the Chicago Board of Trade (CBOT) in 1848 as the beginning of commodity exchanges in America as a method for commodity producers and end-users to hedge their commodity risk. It is also considered to be the oldest existing commodity exchange in the world. Many historians point to the Dojima Rice Exchange in late 17th century Japan as the first commodity futures (forward) exchange. The exchange operated for over 230 years ending just before World War II. [ii]
Prior to the CBOT there was a lot of price volatility in agricultural markets. Farmers would bring harvested crops to the Chicago markets. If they couldn’t sell the crops they were stuck with it and some farmers were known to dump the unsold crops into Lake Michigan. It was this price volatility that prompted the need to hedge agricultural markets and the introduction of the CBOT. In 1898 the Chicago Butter and Egg board was founded and renamed the Chicago Mercantile Exchange in 1919.[iii]
Some of the commodity markets include: Energy markets: Natural Gas, WTI (West Texas Intermediate) Crude Oil, Brent Oil •Grains: Corn, Wheat, oats and the soybean complex of soybeans, soybean oil and soybean meal •Softs: Coffee, Cocoa, Sugar, Orange Juice (as noted in the movie “Trading Places” they traded: Frozen Concentrated Orange Juice) •Livestock: Live Cattle, Feeder cattle •Metals: Gold, Silver and copper. By the early 1970s, futures exchanges began trading financial futures as they were perceived as commoditized products beginning with currency futures and later bond futures and stock index futures.
Moving forward since the recent financial crisis, commodities have taken on a new importance as a non-correlated asset class for an investor’s portfolio. As many emerging nations gain wealth, the demand for many commodities continues to gain importance on the world economic stage.
[i] Shore, M. (2011) DePaul University 798 Managed Futures Lecture notes
[ii] West, M.,”Private Ordering at the World’s First Futures Exchange”, Michigan Law Review, Vol. 98, No. 8, Symposium: Empirical Research in Commercial Transactions (Aug., 2000), pp. 2574-2615
Published by The Michigan Law Review Association
[iii] Shore, M. (2011) “Why Are Congressional Agricultural Committees Given Oversight of the MF Global Hearings?”
Copyright ©2013 Mark Shore. Contact the author for permission for republication at email@example.com
Past performance is not necessarily indicative of future results. There is risk of loss when investing in futures and options. Futures can be a volatile and risky investment; only use appropriate risk capital; this investment is not for everyone. The opinions expressed are solely those of the author and are only for educational purposes. Please talk to your financial advisor before making any investment decisions.