Commodities – What They Are and How Commodity Trading Works

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What is a commodity? In some cases, a commodity is a raw material that can be consumed directly (food, for example), and in other instances, it is used like building blocks to create other products.

As far as commodity investing is concerned, you can invest by buying quantities of, say, a precious metal (gold, for example), or you can buy and sell futures or ETPs (Exchange Traded Products) that track commodity indices. 

Commodity trading is complex and highly volatile and should only be attempted by experienced, knowledgeable investors. It’s been a popular way of investing for many years, but when and how did commodity trading start?

A Potted History of Commodity Trading

Commodity trading goes right back in time to the beginnings of civilisation. Sumer (previously Iraq) is probably the oldest known civilisation to initiate commodity trading. Between 4,500 and 4,000 BC, Sumer became the birthplace of the first futures commodity trading. 

To secure their futures, farmers relied on good weather to harvest crops. They hoped to avoid floods, plagues of locusts, or bandits stealing their cattle which would bring ruin and starvation if they had nothing to use as barter for life’s necessities. So the Sumerians developed a basic form of futures trading to offset these disasters. In effect, they created the first-ever futures commodities market.

They used clay jugs filled with clay tokens shaped like the animals or crops they owned. The tokens were used as a future promise of delivery. They not only served to quantify the commodities involved, but they were also the early form of commodity codes. The Sumerians would either buy these tokens with gold or trade their tokens for the tokens of others. It brought about the beginnings of standardisation in trading with an accepted, agreed market value.

It meant that the commodity prices of certain assets could be recognised in terms of the value of other assets, which facilitated trade and enabled them to put transaction risk into perspective.

Modern standards limited the commodity market in those early days.

The Types of Commodities Traded Today

A broad commodity def would be a substance or product that can be bought, sold, or traded. The kinds of commodities that are traded today fall into four main categories.

  • Agricultural commodities or food commodities
  • Livestock and Meat
  • Metals such as Copper or precious metals such as the Gold Commodity
  • Energy

Commodity examples such as food and meat are similar in concept but come under different categories and subcategories. Unique commodity codes are used to differentiate categories and subcategories. These commodity codes are also referred to as HS Codes, the initials “HS” being an abbreviation for “Hormoginsed System.”  

They were first introduced in 1988 for identifying import and export duties and are controlled by the WCO – the World Customs Organisation.

Investing in Commodities via Futures

In the same way that the Sumerians sought to protect their future, particularly for arable commodities, so too do today’s investors. It is referred to as investing in futures and relates to commodities that are grown rather than those that are extracted or mined. 

Investors refer to these kinds of commodities as soft commodities, and they include things like Cocoa, Coffee, Corn, Cotton, Rice, Soybeans, Sugar, and Wheat. Soft commodities also cover livestock, including things like Lean Hogs, Feeder Cattle, and Live Cattle in general.

Soft commodities have a significant role to play in the futures market. Farmers use soft commodities to lock in future prices for their crops and investors looking for profit. However, because of uncertainties like the weather, pathogens, and other natural risks, soft commodity futures tend to be more volatile than other futures.

Investing in Futures via Community Pools 

Some investors utilise something called a Community Pool to invest in commodities in the futures sector. The term “Community Pool” (also known as Managed Futures Funds) is a legal expression created by the NFA (National Futures Association). 

These types of commodities funds hold a pool of capital contributed by many investors. A Community Pool investment management team manages the pool. This type of pool employs leverage using the money borrowed from a broker to increase the ROI.

Community Pools are like Mutual Funds that use pooled money to invest in a portfolio of mixed securities and commodities, including stocks.

Commodity Index Funds and How they Work

Commodity Indexes are investment funds that track the movement of a portfolio containing various commodities. The index is used by investors who want to get into commodities but don’t want to risk the uncertainty of trading in futures. The value of these commodities funds rise and fall according to the price of the underlying products the commodities fund contains.

Investing in Oil and Gas Commodities

You can invest in oil either directly or indirectly. To go down the direct route, you invest in oil futures, oil options, or commodity ETFs (Exchange Traded Funds). The indirect route can be accessed by buying Energy Sector-based ETFs and Mutual Funds or buying Stocks in specific oil companies.

If you are interested in the Crude Oil market, NYMEX WTI (West Texas Intermediate) Crude Oil futures are considered the most liquid oil contract worldwide. WTI futures is a US fund, and Brent Crude oil is the European option drilled from beneath the floor of the North Sea. 

While WTI Crude is a blend of various oils drilled and processed in the US, and it is mainly used for refining gasoline. Brent Crude is a mixture of oils refined into diesel and gasoline. In terms of trading, WTI Crude is considered the benchmark for US crude oil, while Brent Crude is regarded as one of the benchmarks for markets in Africa, Europe, and the Middle East.

Investing in Natural Gas

Natural gas might be a cleaner form of energy but it still creates CO2. However, it produces 30% less CO2 than oil and 50% less than coal. It is, however, still controversial, primarily due to a process called fracking. 

There are several ways you can go about investing in natural gas

  • Nasdaq offers Natural Gas Futures on pan-European Natural Gas derivatives. They include EUR settled German, French, and Dutch Monthly DS Futures contracts, plus GBP settled the UK and Belgian Monthly DS Futures.
  • You can buy commodity stocks and shares in leading UK oil companies investing actively in Natural Gas. In addition, you can take shares in exploration companies engaged in fracking – companies like Igas Energy and Egdon Resources. Finally, from the international viewpoint, Liquefied Natural Gas Limited, an Australian enterprise, or NW Natural, is also listed on the New York Stock Exchange.
  • Another option is investing via Funds and Trusts like New City Energy, Ashburton Global Energy, and Pictet Clean Energy. They all offer Natural Gas investments in their portfolios. 
  • There are also several Exchange Traded Commodities and Funds through which you can get low-cost exposure to investments in Natural Gas.

As well as ETFs, there are ETNs (Exchange Traded Notes), and interestingly, something called Inverse ETNs. These are unsecured debt securities. Inverse ETNs give an opposite performance to their underlying commodity. For example, if the benchmark they track falls by 2% upon maturity, an Inverse ETN gains 2%.

Arbitrage Explained

We’ve covered most of the ways on how to invest in commodities, but there is one method we haven’t touched on, and that is something called arbitrage. It is an investing commodity strategy. However, because it involves buying and selling something simultaneously, some people don’t consider it investing. 

Nevertheless, many investors see it as a valid opportunity, especially when they arbitrage precious metals like gold. But, you have to be quick on your feet.

Basically, arbitrage refers to taking advantage of different prices in different markets. This article focuses on commodities, but anything can be arbitraged. It’s simply a case of buying a commodity or product cheaply and selling it more expensively, but the trick is doing it simultaneously. So, you have to have your wits about you and act quickly. 

Price disparity can be caused by different geographic location, as with Forex, for example. It can also be attributed to a lag in information updates with cryptocurrencies on different exchanges in different time zones.

Nowadays, professional investors use unique algorithms to exploit complex arbitrage transactions.

What are the Best Commodities to Invest In?

If we knew the answer to this question for sure, we would be rich. But unfortunately, investment always has been and always will be a risky business. Many professionals think 2022 will be a more challenging year for commodities like gold and oil, as the economic impact of the Coronavirus pandemic unfolds. 

With inflation becoming an issue in many countries worldwide, we could see gold taking a bullish position.

We could also see energy making a solid return riding on the back of healthy demand in Asia and Europe for liquefied Natural Gas.

As for commercial goods commodities, the demand will depend on consumer behaviour. But as we see countries recovering from the pandemic, providing the government can control inflation, the outlook could be bright. 

As with all investing, the risk is ever-present – especially with the more volatile commodities. As ever, investors need to be prepared to dig in for the long haul.