The Commodity Markets

Ethan Bailey Commodities Leave a Comment

What is a commodity?
A “commodity” is a raw material or agricultural product such as natural gas or wheat that can be bought or sold. Each commodity has a standard quality, meaning that there is no differentiating between two commodities of the same type; however, different commodities have their own characteristics. They differ in availability, seasonality, substitutability, transportability, and costs of storage and production. When comparing oil and electricity, both are essential energy sources but differ in availability and cost of production.

What is a commodity market?
A commodity market is a marketplace for the buying, selling, and trading of these raw and produced goods. There are two types of commodity markets: physical and future. The physical market or spot market is a cash market with the immediate settlement of the transaction. The future market is a little more complicated because it deals with companies acting in the now to reserve commodities in the future. A futures contract is an agreement to buy or sell a predetermined amount of a commodity at a specific price and date. Investors use future contracts to avoid the risks associated with price fluctuations of a commodity.

The different types of commodities:

1.Energy Commodities
Energy commodities can be broken into two main groups: oil and natural gas.

Crude oil is the largest commodity market, valued at $1.7 trillion in 2015 (2.7 trillion in 2012), more than all metal markets combined. Recently, military conflicts and political instability have created a severe strain on prices, with figures 2 and 3 below demonstrating this since the 1990’s. Oil prices have steadily been rising, with a negative price shock in 2008 brought about by the Great Recession.

Not all oil is the same. It is important to distinguish between unrefined crude oil and refined products such as gasoline and lubricants. The final use of crude oil is whatever it gets refined into, the secondary commodity, but since crude oil is easily stored and cheaply transported, crude oil is the ideal commodity for international trade. Oil was the heart pumping the economic development through the 20th century. It continues to be vital to emerging markets.

There are many substitutes for oil depending on the industry, but these substitutes would entail significant investment in infrastructure and changes in land use (farming) to be viable, making the demand for oil inelastic, meaning that consumers do not respond drastically to price changes. Eventually, this may change, but the current global economy is not ready for such extreme measures as oil remains very cost-competitive.

Natural gas is considered a greener source of energy than oil since there are fewer emissions in production and usage. The market for natural gas is the second largest in the world, totaling to $1.24 trillion in 2012. Prices for natural gas are location dependent as prices have fallen in the United States, whereas they have risen in Europe.

Like oil, natural gas has varying levels of quality and must undergo a refining process. Together, the US and Russia split 40% of natural gas production, with Europe being a leading importer. This is expected to continue as natural gas becomes an even stronger source of energy for the continent. Natural gas can be problematic. Since freight costs are astronomical in comparison to the density of the gas, gas trade is dominated by pipelines.

As countries move towards a greener future, some are choosing solar, wind, hydraulic, or more commonly, a combination of all of the above energy sources. Eventually, producers of natural gas will need to change their production methods to stay competitive in global markets.

2. Raw materials and metals
Iron ore is a large commodity market at $300 billion, but iron ore is different from other commodities in that 98% of it is used for only one purpose which is the production of steel. It is easy to understand the vast importance of steel in both developed and developing countries. It is used in many of our everyday products including buildings, cars, and appliances.

Aluminum is a commodity vital in industries such as construction, infrastructure, and transport, which has caused global consumption and production to increase as of late, specifically led by Chinese demand. China produces 50% of the global production, but most is used internally.

Copper is a simple metal with diverse usability. It is commonly used in electrical products, transportation equipment, and construction. In the past, we have seen major swings in the price of copper. For example, in 2008, the price of copper was $3,000 a ton, and it increased to $10,000 a ton in 2011. The price system has stabilized as of late, but demand is mainly driven by China, so changes from China would strongly affect the price. China is now seeking new means to obtain copper through scrap refining.

3. Agriculture and soft commodities

Agricultural is an important set of commodity, not because it leads to technological advances, but because agriculture is the main source of income for developing countries and producing food cheaply allows us to put more of our resources towards development. Corn, for example, is a crop originally grown in North America which is now grown globally, but only a small percentage is used for human consumption. Some corn goes toward the production of fuels, corn syrup, and animal feed, but because corn is now produced globally, the price is less volatile and less affected by seasonality. Other crops like soy can be grown twice per year, further decreasing the potential for damaging market shocks.

That is not to say that agriculture doesn’t have its problems. Recently as of the 2010s, a drought affecting crops contributed to the Arab Spring political uprising.

Soft commodities are grown and include products such as sugar, cotton, coffee, etc., but their primary difference is that these products are generally sold for a profit rather than consumption, which is why they are called cash crops. Like other crops, adverse weather is disastrous, and storability, as well as quality, are key factors.

Why commodity markets is important?
Commodity markets can be very volatile, but prices are simply based on supply and demand. Fluctuating commodity prices can have a huge impact on the earnings of companies, the stock markets, and the world economy.  One needs to look no further than to Brazil’s currently sputtering economy.

As seen in the figure above, Brazil’s economy was supported and benefitted from strong foreign demand, particularly from China, for their export commodities, namely iron ore, soybeans and raw sugar. These activities gave Brazil an average GDP growth rate of 3.1% for decades; however, in 2011 when commodity prices fell, Brazil faced adverse effects with stalling GDP growth, causing structural weaknesses to become more conspicuous.

What are the implications of price trends?
There are two types of price trends that are of the utmost importance: price volatility and price spikes.

Brent price and volatility

 

Price volatility has existed since man began bartering for food and other goods. In the above graph, we see rapid price level in green and the percentage of annual volatility in red. This graph reveals brent oil prices from 2012 to 2017.

Price spikes are extreme volatility over short time.  The cause of these spikes in either direction can vary from natural disasters, fears in supply disruptions, drop in demand, booming production, and/or economic reports.

Summary
Commodity markets have experienced remarkable growth recently in all sectors due to increased international involvement. Furthermore, increased technological developments have created more efficient production methods, resulting in reduced costs. This is a key driver of increasing supply to meet the growing demand of emerging markets.

That is not to say all commodity markets are the same. They all differ between usability, price, substitutability, and overall purpose. It is important to make these distinctions and fully understand the implications when dealing with new markets.

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About the Author

Ethan Bailey

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Graduated with a degree in Economics from the University of North Carolina in 2017. Currently he is a Financial Communications Analyst. Experience in Data Analytics using Stata, SAS, and SQL. Written Econometric research papers on the college wage premium as well as developing countries.

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