What is a commodity?

A commodity is a raw material or primary agricultural product used to produce other goods. Unlike branded products, commodities are standardized, which means their quality and characteristics are largely the same regardless of where they’re produced. For example, while different wines vary greatly by brand, soybeans are essentially the same whether they are in Brazil or in China (although specific grades or quality may vary).

To be defined as a commodity, products must also be:

• Widely traded in the international markets, meaning a broad range of producers and buyers exist
• Non-perishable or relatively easy to store.

Commodities are traded on commodity exchanges with well-known international prices determined by supply and demand dynamics. Producers, manufacturers, and investors use these exchanges to buy and sell commodities or their derivatives – such as futures and options – to hedge against price volatility or speculate on price movements..

How are commodities classified?

Commodities can be classified in different ways. Some common classifications include:

• By origin:
  • Agricultural: Soybeans, corn, sugar, cotton, biofuels
  • Mineral: Oil, natural gas, ores
  • Industrial: Petrochemicals
• By use:
  • Food: Soybeans, corn, sugar
  • Metals: Ores, steel, aluminum
  • Energy: Oil, gasoline, biofuels
  • Fibres: Cotton lint, synthetic fibers

Agricultural commodities can also be further divided into:

• Grains commodities: Soybeans, corn, wheat
• Protein commodities: Meat, milk, and their derivatives
• Soft commodities: Sugar, cocoa, coffee, orange juice, and cotton.

Metals are commonly divided into:

• Base metals: Steel, aluminum (widely used in industry)
• Precious metals: Gold, silver, platinum (used for jewelry, specific industrial purposes, and as a store of value).

How do commodity futures contracts work in B2B trading?

In B2B trading, commodity futures contracts are agreements to buy or sell a standardized quantity of a commodity at a predetermined price on a future date. These contracts are traded on exchanges like the Chicago Board of Trade (CBOT), which standardizes the terms (e.g. one wheat contract is for 5,000 bushels) and defines acceptable grades of wheat.

Businesses use futures contracts primarily for hedging. For example, a food manufacturer might purchase wheat futures to lock in a stable price for raw materials. On the other hand, a wheat farmer can sell futures to secure a guaranteed price for their crop before harvest. These contracts help promote predictable pricing for both buyers and producers of commodities.

After expiry, futures contracts can either be cash-settled or physical delivery of the commodity can take place.

How are commodity prices determined in financial markets?

Being standardized products with many buyers and sellers, commodity prices are primarily determined by the relationship between aggregate supply and demand. Companies in the commodity sector must accept the prices determined by the market, and have little or no ability to negotiate alternative rates.

Because commodity markets are global, prices are determined internationally with limited influence from the politics of individual countries. Even in the oil market, where a group of major exporters coordinates actions to influence prices, their power is significantly constrained by external factors.

That said, commodity prices can be highly volatile. For example, agricultural commodities experience price volatility caused by weather and the planting/harvest cycle:

• Harvest cycles: The supply of agricultural commodities typically peaks during the harvest, although demand exists year-round. To meet demand during non-harvest months, supply must rely on stored inventories. If production falls short of expectations, or demand exceeds forecasts, there can be shortages – leading to price spikes.
• Weather dependency: Agricultural production is highly influenced by weather conditions, which can cause dramatic price fluctuations.

For mineral commodities, production is less seasonal and weather has less impact on supply. However, reserve scarcity and logistical issues can create supply-demand imbalances and lead to significant price changes.

Energy commodities, like oil and natural gas, also experience price fluctuations related to weather, especially due to heating and cooling demand in countries with extreme climates.

Additionally, almost all commodity markets are affected by geopolitical risks and the global economic outlook:

• Geopolitical risks: These disproportionately impact commodity markets due to the concentration of production and exports in a few countries or regions, which aren’t always politically stable.
• Global economic conditions: These influence commodity prices through demand for raw materials and the effect of exchange rates on producers and consumers.

How do businesses hedge risks using commodity futures contracts?

Commodity futures contracts are used by businesses to hedge risks associated with commodity price fluctuations. These contracts allow companies to lock in a predetermined price for buying or selling a specific commodity at a future date, helping protect them from adverse price movements.

As mentioned earlier, companies that buy or sell commodities have little control over their prices, which are determined by the market. Because of this, price fluctuations can significantly impact the profitability of businesses that rely on these products. Futures contracts provide a way to protect against this price volatility.

How do futures contracts work?

Futures contracts are agreements to buy or sell a specific asset at a predetermined price and date in the future. These contracts have a fixed expiration date, and investors can choose to settle the contract by receiving the physical delivery of the underlying asset or offsetting the contract with an opposite transaction before the expiration date.

Businesses that rely on commodities use these contracts as part of commodity risk solutions. Here’s how they can help:

• Price stabilization: Futures contracts provide a way for businesses to mitigate the risk of sudden price spikes or drops.
• Cost predictability: Companies can use futures to forecast costs more accurately and set long-term budgets without unexpected price changes.
• Revenue protection for producers: Producers, like farmers, can use futures to secure a selling price for their products before harvest.

To illustrate how commodities futures work in practice, consider this example:

StoneX Sodas is a beverage company that relies on aluminum cans to package its drinks. The company produces millions of units each year, so even a small increase in aluminum prices can significantly affect profit margins.

To protect itself from unpredictable price swings, StoneX Sodas enters into an aluminum futures contract with a supplier. They agree to purchase a specific quantity of aluminum at a fixed price to be delivered in six months. This locks in their production costs, allowing StoneX to plan its budget and pricing strategies without worrying about market volatility.

If aluminum prices increase due to supply chain disruptions or geopolitical events, StoneX benefits from the lower agreed-upon price. If aluminum prices drop, StoneX still honors the contract, but the stability gained from hedging outweighs the risk of missing out on lower costs. It also means the company can maintain consistent pricing for its products.

What industries rely heavily on commodities for their operations?

Industries that rely heavily on commodities include energy, agriculture, manufacturing, transportation, construction, and electronics. These industries depend on raw materials for production. For example, the energy industry relies heavily on oil and natural gas, while construction depends on metals like steel and aluminum.

What is the Commodity Futures Trading Commission (CFTC) and its role?

The Commodity Futures Trading Commission (CFTC) is a federal agency that regulates the derivatives markets, including futures, swaps, and options, in the U.S. Its primary role is to ensure these markets operate fairly, transparently, and free from fraud, manipulation, and abusive trade practices.

What are the differences between hard commodities and soft commodities?

There are two categories of commodities: hard commodities and soft commodities. The primary difference between these two commodities is their origin: hard commodities are extracted or mined, while soft commodities are grown or cultivated.

Soft commodities

Soft commodities include agricultural products such as coffee, orange juice, sugar, livestock, cotton, canola, and cocoa. These goods are mostly used in the food, beverage, and textile industries.

Prices of soft commodities are highly influenced by external factors like:

• Weather conditions: Droughts, floods, or frost can disrupt production
• Pests and disease: Crop infestations can lead to shortages
• Soil health and farming practices: This can affect yields
• Geopolitical issues: Trade restrictions or political instability can impact supply chains.

Because they are more reliant on external factors, soft commodities tend to be more volatile than hard commodities. Price fluctuations in softs can have a direct and immediate effect on consumer goods, such as increased food prices during poor harvest seasons.

Hard commodities

Hard commodities include natural resources like gold, silver, copper, crude oil, coal, and natural gas. These materials are extracted through mining or drilling and are vital to industries such as construction, electronics, energy, and manufacturing.

Unlike soft commodities, the production of hard commodities is less dependent on weather or other environmental conditions. This makes their supply relatively more stable. However, their prices are still influenced by:

• Market demand: Industrial growth often increases demand for metals and energy resources
• Geopolitical risks: Sanctions or conflicts in resource-rich regions can affect supply
• Global economic trends: Hard commodities often serve as economic indicators, with prices rising or falling based on global economic health.

This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.