A Beginner's Guide to Commodities

To understand the commodity market, we first have to understand commodities. 

Commodities are raw materials that are used to manufacture consumer products, and they are often split up into two categories - hard and soft. Hard commodities often refer to natural resources, such as oil, gold, rubber, and coal, which all need to be mined or extracted. In contrast, soft commodities are those that are produced by us - in particular agricultural products such as wheat, corn, coffee, and sugar. An important feature of a commodity is that there is little to no differentiation in that good, regardless of the producer. For example, a bucket of coffee beans is the same regardless of if producer A produces it, or if producer B produces it - and it goes the same with all the other commodities, like oil. These commodities can be bought and sold on special exchanges as financial assets. The commodities are traded on special platforms - in the UK, key platforms for trading commodities include the London Metal Exchange (LME) for base metals, ICE Futures Europe for energy products like Brent crude oil and natural gas, and the London Bullion Market Association (LBMA) for precious metals such as gold and silver.

The next step to have a thorough understanding the commodity market is to understand the players - the two types of commodity traders. 

The first type of commodity traders are the buyers and sellers of commodities. The sales of commodities are often carried out through futures contracts. Futures contracts are standardised legal agreements to buy or sell a specific commodity at a predetermined price at a specified time in the future. These contracts are often used for two purposes by traders. The first of which is hedging - These traders make or take delivery of the actual commodity when the futures contract expires. 

For example, an airline company concerned about rising jet fuel costs can hedge against the risk of increasing prices. The airline knows it will need 1 million gallons of jet fuel in six months when the current price is £2.50 per gallon. To protect against potential price hikes, the airline enters into futures contracts to buy jet fuel at £2.60 per gallon for delivery in six months. If the price rises to £3.00 per gallon, the airline saves £0.40 per gallon by buying at the contracted price. If the price falls to £2.20 per gallon, the airline still pays £2.60 per gallon but benefits from price certainty. 

The second type of commodity trader is the speculator. These traders operate in the commodities markets solely to profit from price volatility. They have no intention of producing or receiving the physical commodity when the futures contract matures. Many futures markets are highly liquid with significant daily price fluctuations, which appeal to intraday traders. Index futures are essential for managing risk in portfolios managed by brokerages and portfolio managers. Moreover, commodities often move independently of stocks and bonds, providing valuable diversification opportunities for investors, which is why commodities are so sought after as a type of investment. 

Now that we know the players, we need to know how commodity prices are determined. The answer to that is very simple and as always in economics, it is supply and demand. For instance, geopolitical tensions (which we are seeing in the Middle East and in Europe) in major oil-producing regions can disrupt supply chains, leading to spikes in oil prices. Additionally, technological advancements in renewable energy could reduce demand for fossil fuels like coal and natural gas, impacting their market dynamics. Furthermore, changes in government policies, such as subsidies for renewable energy or carbon taxes, can also influence commodity prices and investor sentiment in the energy sector.

Adding to that, 3 main factors affect the commodity market - inflation, currency exchanges, and supply & demand. 

• Inflation: Commodity prices often rise during periods of inflation because commodities are seen as a hedge against currency depreciation. When inflation erodes the purchasing power of money, investors turn to commodities like gold, oil, and agricultural products, which have intrinsic value and can preserve wealth. 

• Supply and Demand Dynamics: The fundamental principle of supply and demand plays a crucial role in commodity markets. For example, adverse weather conditions (such as droughts or floods) can reduce agricultural yields, leading to lower supply and higher prices. On the other hand, shifts in global consumption patterns or economic growth can increase demand for commodities like oil or industrial metals, affecting prices accordingly. 

• Currency Exchange Rates: Exchange rate movements influence commodity prices, especially for commodities traded globally. A weaker domestic currency makes exports cheaper and can boost demand for commodities from that country, pushing prices higher. Conversely, a stronger currency can make exports more expensive and potentially lower commodity prices.

In summary, commodities, including oil and agricultural products, are traded on UK exchanges like the London Metal Exchange and ICE Futures Europe. They are categorized into hard (natural resources) and soft (agricultural) commodities. Prices are influenced by inflation, supply and demand dynamics, and currency exchange rates. Traders in the market are typically hedgers, who manage price risks through futures contracts, or speculators, who seek to profit from price volatility. Understanding these factors helps investors make informed decisions in the commodity market.