Commodity market facilitates an exchange of physical goods among residents in a country. Individuals aiming to diversify their portfolio can undertake investments in both perishable and non-perishable products, thereby not only mitigating the risk factor, but also providing a hedge against inflation rates in an economy.
Types of Commodities in the market
Available for trading are categorised into the following classes, based on their inherent nature:
- Hard commodities
- Precious metals: Gold, platinum, copper, silver, etc.
- Energy: Crude oil, Natural gas, gasoline, etc.
- Soft commodities:
- Agriculture: Soybeans, wheat, rice, coffee, corn, salt, etc.
- Livestock and meat: Live cattle, pork, feeder cattle, etc.
As of 2019, some examples of commodities in the market that were most commonly traded in major commodity exchanges in India included crude oil and silver. While crude oil acts as one of the most important energy sources required for virtually every industry, silver is one of the most precious metals other than gold with a steady demand.
As crude oil is not domestically available in abundance, almost 82% of it is imported from OPEC and Middle Eastern countries. Similarly, silver is traded in extensive quantities from countries such as Mexico, Peru, etc.
History and Origin of Commodity market
The world’s first commodities arose from agriculture practices (crop production and raising livestock). Archaeological discoveries indicate that agriculture developed around 10,000 BC, as humans began settlements and farming. An agricultural revolution started around 8,500 BC, which led to trading commodities between settlements. As trading developed, producers and dealers looked for ways to preserve the price of their products. Factors such as weather, conflict, and supply and demand wreaked havoc on pricing. In addition, as supplies became more plentiful, storage was necessary; merchants sought ways to raise money while their product sat until being sold. This is how futures agreements began. According to Bruce Babcock, a noted commodity authority, the first recorded commodity futures trades occurred in 17th century Japan, though there is some evidence that rice may have been traded as far back as 6,000 years ago in China. (Babcock, 2009)
In the US during the early 1800s, agricultural commodities – notably grains – were brought from Midwest farmlands to Chicago for storage until being shipped out to the east coast. Because agricultural products are perishable, the quality of the stored items would usually deteriorate over time. While stored, the purchase prices would occasionally change so the first contract for a future price was created. This forward contract allowed a buyer to pay for the commodity prior to taking delivery of it.
As more farmers and merchants began delivering their wares to Chicago, the first American exchange was set up in 1848. It was called the Chicago Board of Trade (CBOT). This group of brokers established a more efficient, standardized method of exchanging goods and payment by creating futures contracts. Instead of managing numerous customized contracts between interested parties, they streamlined the process of buying and selling future delivery for a present price by generating contracts that were identical in terms of quality of the asset, delivery time and terms.
For over 100 years, agricultural products remained the primary class of futures trading. The CBOT added soybeans in 1936. In the 1940s, exchanges included trading for cotton and lard. Livestock was added to the trading “block” during the 1950s. Contracts for precious metals like silver started trading during the 1960s. By the 1970s, when global currencies were no longer tied to gold prices, currency values fluctuated based on supply and demand, and financial futures became a tradable “commodity”. Suddenly you could trade prices instead of goods. This opened up a new era – one where a cash settlement is used instead of the traditional “delivery” of goods. Throughout the 80s and 90s, stock market index benchmarks like the S&P 500 and government debt instruments were added to the list of tradable futures.
During the 20th century, exchanges opened up all over the United States. Cities such as Milwaukee, New York, St. Louis, Kansas City, Minneapolis, San Francisco, Memphis, New Orleans and others hosted trading, but Chicago remained the most influential location for commodities futures trading.
In the early 21st century the advent of the online trading systems led to heightened interest in commodities and futures. From the comfort of home or office, buyers and sellers can place orders through electronic trading systems and online brokerage houses. Easier access and increased information sharing led many to pursue careers in futures trading.
These new steps brought thousands of more participants into the trading arena. Commodities and futures trading became a hedge to protect their financial interests against losses in other investment areas, such as stocks and bonds. Individuals and investment companies poured millions of dollars into the commodities and futures markets. This influx of new third-party traders now has a significant impact on the prices of commodity-based goods. Their interest is not necessarily securing the price of goods they will take control of; rather they use speculation about buying and selling behaviors to predict a futures contract’s value. These new players seek to make profit through price movement.
Prices Determined in Commodities Exchange
The prices of commodity markets are heavily dependent on the market demand and supply of commodities, both domestically and from foreign sources. Speculative news also affects the commodity prices heavily, as socio-economic conditions deeply influence the productive capacity of respective companies.
The factors affecting commodity prices in an economy are discussed below:
Market demand and supply
Market demand and consequent supply of goods traded on a commodity exchange heavily influence the market price. A rising demand (for any reason) can cause prices to rise in the short run, as supply cannot be increased immediately to compensate for the higher demand in the market. Generally, such a rise in demand can be attributed to a pessimistic performance outlook towards the stock market, thereby causing investors to shift towards relatively safer investment avenues.
Global indicators play a crucial role in determining the prices of commodities available internally in a country. For example, any turmoil in the Middle Eastern countries can affect the prices at which crude oil is exported, thereby affecting the prices at which it is traded domestically.
A significant example can be cited in this respect when a supply shock was experienced by all major countries in the world triggered by Iraq-Kuwait tensions in the 1990s.
Any condition affecting the total production of stipulated goods traded in an exchange can cause price changes accordingly. For example, a rise in the cost of production can drive up the prices at which a product is sold in the market, consequently affecting the equilibrium rate.
Also, the performance of the stock and bond market has an effect on the prices of commodities, as a negative viewpoint regarding their performances tends to divert investors towards commodity market securities. Individuals often trade in commodity derivatives to compensate for stock market risks, or to safeguard their portfolio from stock market downturns.
Demand for derivative investing in commodities online can arise from speculative investors, who aim to realise profits through market price fluctuations. Speculators often make predictions regarding the direction of movement of prices and aim to close the contract before the expiration date to realise capital gains on total gains.
Individuals unwilling to take physical delivery of the goods can opt for cash settlement contracts, whereby upon completion of the tenure of the futures contract, the difference between the price in spot trading and price stated in the futures contract has to be paid.
Depending upon the market assumptions, individuals can assume either a short or a long position in a futures contract. Investors expecting the price to drop in the future can undertake a short position (sell the security at a fixed price on a stipulated date) to realise profits through a fall in the market price. On the other hand, if individuals expect the price of a commodity future contract to rise in the future, they can opt to go long (buy the security at a fixed price on a stipulated date) so as to sell the same at higher prices in the future.
Nonetheless, a futures contract tends to merge with the spot price at which a commodity is trading at a future date, as prices adjust automatically at the expected level.
Any unforeseen fluctuations in the stock market can cause investors to shift towards commodity trade, as chances of severe fluctuations in prices of certain commodities such as precious metals are low. Hence, commodity market investments are secure in nature and act as a hedge against inflation for risk-averse individuals.