What is a commodity?
Commodities are a crucial part of everyday life, whether it’s related to food, energy or metals. Whilst changes to the price of oil can impact how much you pay to fill your car or travel by airplane and changes to food can impact the price of your weekly shop, commodities can also be a useful diversification tool when investing.
A commodity is traditionally a raw material or agricultural product that can be bought and sold, such as coffee, oil, or copper.
Whilst the quality of a given commodity may differ slightly between providers, there is generally uniformity across providers. Commodities are generally unchanged materials that are used in the production of other goods. As long as they meet certain quality and authenticity criteria, a commodity can be traded at the market rate.
This is unlike a differentiated product, which is considered to be unique or different from its competitors in some way.
Hard and soft commodities
Whilst there are many different types of commodities, they are generally split into two broad categories: hard and soft.
A hard commodity is a raw natural material that can be extracted from the earth, be it through mining or some other method.
For instance, crude oil is a hard commodity as it can be taken from the natural environment without having to be created by people. Whilst it goes through set processes before it can be sold, it’s essentially traded as it is found.
Hard commodities usually have a fairly stable price. This is because they can be stored for a long time without this having a large impact on their value and their industries have a high level of control over how much they produce. This control of supply can help influence the price of the commodity. The market performance of hard commodities like copper is used as an economic barometer. In a growing economy, businesses and governments invest in big projects to keep to increasing demand from consumers. This increase in demand, pushes up the price of hard commodities to be used in construction and infrastructure, for example.
Energy commodities can either be used as fuel or in the manufacturing of fuels and sources of energy. High quantities are produced and traded as their use is widespread and varied. There are different types of energy commodities, including:
- Crude oil
- Brent oil
- Natural gas
- Heating Oil
A wide variety of raw metals are hard commodities. Precious metals like gold are valuable as they are seen as a safe haven during uncertainty. Non-precious metals are vital for many forms of industry. Again, there are many different types of metal, including:
Some of the oldest commodities to have been actively traded, soft commodities are grown or produced, not extracted from the ground. Also known as tropical commodities or food and fibre commodities, this group includes sugar, cotton, rice and wheat.
Soybean is another example of a much-traded soft commodity. To have large quantities of it, it must first be planted, cultivated, grown and harvested.
Unlike hard commodities, the price of a soft commodity is far more volatile. This is largely down to its limited shelf life – it is produced to be consumed over a shorter time frame.
Oil can be kept in storage for much longer than crops, for example, so its value does not depreciate due to time. However, supply and demand characteristics can influence the price heavily, so the longer you hold onto oil, the less you can forecast how supply and demand will impact the price.
Crops and foodstuff will rot or become inedible if kept for too long. It is far harder to keep the supply and demand equilibrium for soft commodities; crops can fail due to bad weather or exceed expectations, while livestock can be killed by disease.
Soft commodities play a large part in the futures market – a legal contract to buy or sell a particular commodity or asset at a set price and a specific time in the future.
There is no definitive list of what classifies as a soft commodity, so alternative classifications have arisen. Which commodities go into these categories can vary. It’s more important that investors understand the underlying commodity they are investing in, rather than the category.
- Coffee beans
- grains and oilseeds
- Orange juice
Commodities are traded on exchanges, just as many other types of financial products are. Different exchanges specialise in trading different types of commodity: for instance, you might trade Brent Crude on the Intercontinental Exchange, while you could trade copper on the London Metal Exchange.
Trading commodities directly
The most common way in which commodities are traded is through futures. A futures contract obligates the holder of the commodity to sell it at a predetermined price at some point in – you guessed it – the future. This method of trading allows traders to invest in commodities without ever physically holding them.
Buying futures is also crucial to companies whose business models depend on using large amounts of a commodity. By agreeing the price in advance, it gives companies the chance to buy more when the price is low, and more time to adjust to future price rises.
Trading commodities indirectly
Another way of trading commodities, but without investing in them directly, is through buying and selling shares in companies that deal in commodities.
Alternatively, traders can invest in Exchange-Traded Funds (ETFs) which specialise in commodities. An ETF is a passively-managed investment fund that is designed to closely track a basket of investments, or an index. A commodities ETF makes investing in ETFs more accessible to normal investors by being low-cost, easy to trade on an exchange and transparent.