Commodities are products derived from primary economic activity such as agriculture, mining, drilling, etc. rather than manufactured products or services. Like stocks, commodities are traded on the markets too with the intention of discovering a commodity’s true price, managing price risk or speculating for profit. In fact, commodity trading dates back thousands of years, predating even stock trading. Amsterdam stock exchange often cited as the world’s first stock exchange began life as a marketplace for trading in commodities. In the earliest days of commodity trading, traders would come to the market physically carrying their commodities for trade.
Today commodity trading has become very advanced with trading in sophisticated financial instruments such as futures, options, derivatives, swaps, etc. The most commonly traded commodities the world over are crude oil, gold, silver, copper, natural gas, corn, soybean, etc. The Chicago Mercantile Exchange (CME) in the US is the world’s largest commodity exchange handling close to 3 billion contracts annually. The London Metal Exchange (LME) is the world’s largest commodity market in base and other metals. In India, there are six commodity exchanges with the Multi Commodity Exchange (MCX), National Commodity and Derivative Exchange (NCDEX), National Multi Commodity Exchange (NMCE), and Indian Commodity Exchange (ICX) being the most prominent. Commodity Trading in India occurs on these exchanges and is regulated by the Securities and Exchange Board of India (SEBI).
Participants in Commodities Market
Before one tries to understand how commodity prices are determined, it is important to get an overview of who participates in commodities trading, since it is these actors and their actions that drive the prices of commodities up or down. There are typically two types of participants in commodity markets – hedgers and speculators. The first type of commodity traders or hedgers is usually manufacturers or industries that usually require large quantities of raw materials and thus have a pressing need to secure these at stable prices.
For instance, the construction industry typically requires large quantities of steel, and in order to hedge themselves from price fluctuations they might enter into futures contracts, in effect ensuring that future demands for the raw material will be met at the same price. This predictability of prices is much valued by industries as it helps them to better plan their operations. The second type of participants in the commodities markets are speculators who have no real need for the underlying commodity but only wish to make profits from the fluctuations in prices of commodities. They may buy commodities when prices are relatively low and sell them when they go up without ever taking physical delivery of the underlying commodity.
How are Prices of Commodities Determined?
With the above basic knowledge of commodities markets and their participants, we now turn to understand how prices of commodities are determined. Like stocks, prices of commodities vary constantly owing to a variety of factors.
Demand and Supply
Like everything else, the prices of commodities are determined by the principle of demand and supply. Buy and sell orders are placed on commodity exchanges by traders. When buyers for a particular commodity outnumber sellers, prices increase and when sellers outnumber buyers, prices go down. Demand and supply of commodities in turn are influenced by a number of factors.
For instance, during extreme cold weather, the demand for heating may increase leading in turn to an increase in demand for fuel such as natural gas. Or, as is common knowledge in India, during Diwali and other festival seasons, the demand for bullion goes up driving prices northwards. Sometimes when there is a bumper harvest of certain agricultural commodities such as potatoes, there is a glut in the commodities market with the supply of potatoes exceeding demand and consequently, their prices go down drastically.
Macroeconomic and Geopolitical Factors
Commodities tend to be sensitive to geopolitical factors and the larger economic picture. For instance, political or economic instability in one or more Organization of Petroleum Exporting Countries (OPEC) countries may affect the prices of crude oil owing to the fact that the bulk of the world’s oil production comes from these nations.
Similarly, copper, an important commodity required especially in the electrical industry is concentrated disproportionately in Chile, a small Latin American nation that accounts for over 30% of the world’s copper production. A sudden increase in copper production by Chile could cause a glut in global copper supplies and lead to a decrease in copper prices on the commodities market.
As explained earlier, speculators are participants who enter commodities markets with the primary aim of profiting from price variations without having any need for taking physical possession of the underlying commodity. Sustained, coordinated action by speculators in the markets can also affect prices. For instance, if a lot of people feel that the future outlook of a particular commodity is very promising, they may start buying up that commodity in large numbers thereby raising the price of the underlying commodity. Speculators in commodities markets may be individuals or they may be institutional investors indulging in high-end algorithmic trading to make profits off price movements of commodities.
Commodities trading can be a useful way of diversifying one’s portfolio provided one understands the risks involved and has good knowledge of what moves the market and how. The movement of commodity prices is similar to that of equities in some ways, for instance, it responds to variation in demand and supply in a manner similar to the stock market.
At the same time, there are several factors to which commodity prices are far more sensitive and responsive than stocks such as geopolitics, weather, macroeconomic factors, etc. Various online platforms available for commodities trading in India today provide easy and transparent access to the commodities markets. It is imperative that one does thorough research into every aspect of the market before investing one’s hard-earned money. For while commodities trading may promise potentially high returns, these also come with higher risks.