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What is a commodity?

A commodity is a basic raw material or agricultural product that can be bought and sold on the market. Commodities include things like copper, oil and coffee.

Understanding commodities

Commodities are what’s known as interchangeable. This means they can be swapped with other commodities of the same type – coffee is simply coffee and all gold is precious regardless of its purity.

It’s possible to get different grades of the same commodity though. For example, a supermarket’s value branded coffee is likely to taste different when compared to your favourite Starbucks order. This boils down to the quality of the product – the higher the quality, the higher the price.

Commodities which are traded on an exchange must meet a certain minimum standard, called basis grade. This is in place to make sure traded commodities can be used throughout the economy. Poor quality commodities can result in supply chain issues, as well as disruption to the end user.

Commodities often act as inputs for goods and services across the global economy. Take oil for example. It’s used in the manufacture of a whole host of materials, from motor oil to deodorant, and it is estimated the world consumes around 100 million barrels a day.

What are the 4 commodities?

Commodities that are traded can broadly be split into four main categories:

  • Metal – examples include gold, silver and platinum
  • Energy – such as crude oil, natural gas and gasoline
  • Livestock and meat – things like cattle and fish
  • Agricultural – e.g. wheat, corn and coffee

What is commodity trading?

Commodity trading offers investors access to the current price and the future price of commodities.

Commodities are usually traded through a financial security called a derivative, such as forward or future contracts. These types of agreements allow buyers and sellers to trade in large amounts, without physical delivery of the commodity. The value of the contract is based on the price of the underlying asset the derivative is aiming to track – which moves up and down based on supply and demand.

Depending on the overall health and shape of the economy, commodities can be extremely volatile – where their prices swings up and down sharply. This adds risk. Furthermore, commodity trading is often focused speculating on short-term price movements, we think investors should avoid getting involved in and this and invest with a long-term view – at least 5 years.

All investments can fall as well as rise in value, so you could get back less than you invest.

What determines commodity prices?

Like most assets, the price of commodities is determined based on the law of supply and demand. If there’s more demand to buy the commodity than supply – the price will go up. The opposite is true if supply is greater.

Supply and demand for commodities can ebb and flow, which makes them one of the more volatile (prices move up and down sharply) asset types. Natural disasters, politics and other unexpected events, such as a global pandemic can upset the equilibrium between the two. This makes it difficult to predict the future for most commodity prices.

The Covid-19 pandemic was an acute example of an event impacting commodity prices. As economies around the world emerged from the pandemic, demand for goods and services rose sharply. This created extra demand, particularly for energy commodities such as oil, causing its price to rise to their highest level since the financial crisis in 2008.

It’s not always possible to quickly turn on the supply taps to meet demand either. Commodity production takes time.

For example, new crops have to be grown, new oil wells drilled or finding new mines to mine doesn’t happen overnight. This can add further demand in the short term as companies and consumers panic buy in bulk to keep their stockpiles replenishes, which elevates prices even higher.