A commodity is a type of investment that is fundamentally different from stocks and bonds because it is a physical—not financial—asset. There are various types of commodities including metals, energy, and agricultural products. Investors make bets on a commodity’s future prices based on the supply and demand of the commodity, and not the profit of a company.
Commodities allow investors to diversify their portfolios, giving them exposure to physical goods in addition to financial assets, such as stocks and bonds. The Wall Street Journal reported that commodities posted the biggest quarterly increase in more than 30 years during the first quarter of 2022, with Russia’s invasion of Ukraine shaking up markets and pushing up prices for many commodities. By comparison, during the first quarter of 2022, the broad S&P 500 stock index fell 4.6%.
What is a commodity?
A commodity is a basic or raw material that comes from a natural resource that can be bought or sold. Commodities are generally the same from place to place—copper is copper and arabica coffee is arabica coffee regardless of where it comes from or where it’s sold—unlike finished products like cars or smartphones.
Types of commodities
Commodities are generally divided into three categories: metals, agricultural goods, and energy.
- Metals. Also known as hard commodities, they include gold, silver, copper, and zinc.
- Agricultural commodities. These include crops like wheat, corn, soybeans, coffee, and cotton as well as animal products like pork and beef. Some call these crops soft commodities, although others in the commodities field only refer to tropical commodities like cocoa, sugar, cotton, coffee, and orange juice as “softs.”
- Energy. Crude oil, natural gas, electricity, and coal are commonly traded energy commodities.
What affects the price of a commodity?
Commodity prices are driven by supply and demand, which in turn are affected by factors like war, weather, and changes in the way people live. When bad weather causes less of a crop to be grown, for example, supply drops, and the price and value of food commodities rise. Or, when growing conditions are excellent, supply increases, which pushes down the price of food commodities.
Commodity trading is global, and a pandemic or war in one part of the world can strain the supply chain and disrupt production of food and natural resources, affecting commodity prices worldwide. During uncertain times or times of high inflation, the value of gold, which is considered a traditional store of wealth, typically rises. Commodities are also often connected, so a price change in one may affect another.
Examples of factors affecting commodity prices
- Consumers react to price changes. A rise in the price of a commodity may impact demand for it. For example, consumers may respond to rising beef prices by switching to cheaper priced pork or other protein, or purchasing habits may change drastically during recessions or periods of high unemployment as consumers cut back on travel and try to make their money go further at the supermarket.
- Shifting trends. Orange juice, which decades ago was marketed as a health food, declined in popularity as consumers started to be aware of the large amounts of sugar in it. Frozen concentrated orange juice trading fell as well—only to rebound a bit during the pandemic as people ate breakfast at home more. An insect-borne disease called citrus greening hasn’t helped supply, either.
- Global events. During the COVID-19 pandemic, crude-oil futures dropped sharply due to an economic slowdown and the expectation that lockdowns would limit travel. On April 20, 2020, the West Texas Intermediate crude-oil contract for delivery in May, which traded on the Chicago Mercantile Exchange (CME), sank nearly $56 to settle at negative $37.63, the first negative close in history.
How does commodity trading work?
Most commodity trading is done through futures contracts, which are agreements to buy and sell commodities for future delivery. The price is set when the contract is initiated. Investors may also buy options, which gives them the right to buy or sell a commodity at a specific price during a set period of time, no matter what the price of that commodity is. Or, they may buy on the spot market, which is an exchange for the immediate delivery of—and payment for—the commodity.
Investors are usually more active in futures markets, in part because trading futures doesn’t involve interacting with the physical good. They can roll over contracts to the next futures contract if they want to hold their position.
Types of commodity futures market conditions
There are two types of futures markets conditions an investor might encounter for a given commodity regarding the basis, or difference between spot and futures prices:
- Contango. This is when basis is negative—the futures price is higher than the spot price–, and can happen due based on the cost of carry–storage, financing transportation, and insurance expenses
- Backwardation. This occurs when basis is positive—the spot price is higher than the futures price–and can happen when there’s a benefit to holding the physical commodity.
Trading commodities on a commodities exchange
Commodity futures trading happens on commodities exchanges. Three of the best known U.S. commodity exchanges are the Chicago Mercantile Exchange Group (CME), the New York Mercantile Exchange (NYMEX) (acquired by CME in 2008), and the Chicago Board of Trade (CBOT) (also bought out by CME in 2007). Intercontinental Exchange of Atlanta also handles a lot of commodities trading in the United States. The Commodity Futures Trading Commission (CFTC) regulates commodity futures trading in the United States.
Outside the U.S. some of the biggest and best-known exchanges are the London Metals Exchange, Brazil’s B3, and China’s Zhengzhou Commodity Exchange.
During a trading session, exchanges may set a maximum price increase or decrease known as limit up or limit down, respectively–unlike the stock market where trading is halted only under extraordinary circumstances. Similar to stocks, most trading happens electronically, but some buying and selling still happens in trading pits, where traders gather to call out their orders.
Similar to exchange-traded funds (ETFs), there are exchange-traded commodities (ETCs) that let traders buy and sell commodities without owning them. These commodity funds can consist of one or many commodities.
4 types of commodity traders
The four types of commodity traders are producers, industrial end-users, traders, and speculators.
- Producers. Producers are the farmers, miners, oil and gas companies, and others that grow or extract natural resources that become traded commodities. These producers can use futures contracts to hedge against volatile prices.
- Industrial end-users. These processors include factories, clothing makers, construction companies, and food manufacturers. They turn commodities into finished products and are sensitive to rising prices, so can also use futures contracts as hedges.
- Traders. Traders don’t produce commodities or use them to make goods, but do act as so-called go-betweens for producers and end-users. They buy excess inventory from producers and sell to industrial end-users when producers can’t, and thus provide liquidity.
- Speculators. These investors bet on commodity price movement, and also provide liquidity by buying and selling. Unlike traders, they don’t act as agents for producers or processors.
The bottom line
Commodities are useful, basic products derived from natural resources that are the same no matter where they come from. Investing in commodities gives investors exposure to the supply-and-demand driven market for some of the basic or raw materials that will become processed and prepared food products, building materials, hi-tech electronics, copper for wires, gold for jewelry and electronics, corn for food and biofuel—plus, energy commodities like oil, natural gas, coal, and electricity that power this activity.
In the commodities market, investors can buy futures, options, and even participate in the spot market where physical commodities are bought and sold. They can also use exchange-traded commodities and funds to get commodity exposure without actually owning the physical product.
Commodity investing is also one way to diversify a portfolio. Prices of commodities don’t necessarily move the same way as stocks and bonds—they may move inversely, or they may not move much at all.
