Commodities are basic raw materials, primary products and food-stuffs that are homogeneous and generally traded on a free market. Commodity contracts may represent cash transactions for immediate delivery or, more commonly, forward contracts for delivery at a specified time in the future. The bulk of such contracts are bought and sold on a commodities exchange by dealers and commodity brokers and traders. Their homogeneity, coupled with fast communications and an efficient system of quality grading and control, means that they can be traded without an actual transfer of the goods. This allows enormous scope for hedging and speculative activityas traders buy and sell rights of ownership in spot and futures markets.
The prices of commodities are determined by the forces of demand and supply. And because of the nature of the conditions of demand and supply for commodities, their prices tend to swing more violently than prices of manufactured goods. A small but persistent surplus of, say, tin, over demand can cause a dramatic slump in prices; likewise, disastrous weather conditions and a poor harvest can drive up a crop price.
Commodities are primarily of interest to industrial users. Oil is the one with the most widespread potential impact since almost all businesses have energy requirements. But there are many other examples. Cocoa prices, for example, are critical to chocolate makers, while certain metal prices will affect such companies as producers of cars, ships and other manufactured goods, as well as the construction industry.
Companies whose profitability is partly dependent on the cost of their raw materials will naturally seek protection from potential surges in primary commodity prices. It is this need to hedge that gives rise to the futures markets.
For investors, commodities offer the potential for exceptionally high returns but with an equally high degree of risk. In addition, investing in physical commodities is rarely possible given the problem and costs of storage. Indeed relatively few investors participate in even the commodities futures markets except through managed funds which diversify risk across a variety of commodities, or by investing in companies in the oil, gold mining and other extractive and exploratory industries.
As indicated, futures markets are chiefly used by consumers of physical commodities to avoid the risks of adverse price movements during the periods between contracting purchases and receiving deliveries. This hedging involves the opening of parallel but opposite futures contracts when physical orders are made, so that real profits or losses made by the time the commodity is delivered will be cancelled out by losses or profits on the futures markets.
The futures markets are basically paper markets, not to be confused with forward physical prices, which are simply quotations for physical material for delivery some time in the future. Speculators take on the risk consuers wish to avoid in the hope of accruing the potential profits that the consumer has relinquished.
Traded options appear in a number of commodity futures contracts. Options
confer on holders the right, but not the obligation, to trade at a predetermined
price, the striking price, within a pre-set time-span. For this, they pay a
non-returnable premium. Since the premium is the only money the investor can
lose, options represent a relatively low-risk way of speculating in commodities.