Commodities

What is a Commodity?

Commodities are a fungible good/service that are often used as inputs for the production of other goods/services. To put more simply, commodities of the same type and similar quality are of equal monetary value, much like how two $100 bills are of the same value (i.e. 1kg of gold has the same monetary value regardless of the location or company in which it was extracted from).

Commodities were traditionally seen as a direct product of agriculture or mining (see below). Recently, this definition has expanded to include financial products such as foreign currencies and indexes. Technological advancements have also led to new types of commodities being traded such as cell phone minutes and bandwidth.

Commodities are usually purchased and sold through futures contracts that have the quantity and quality of the product standardised. Unlike currency, commodities have practical uses such as being used as an input in a production line. Hence there are two general parties who trade certain commodities: those who need to use it, and traders.

There are two main strategies involved in trading commodities. The first is to hedge against price fluctuations of the commodity that may occur in the future. Essentially, the buyer will pay today’s market price for the futures contract. At the expiration of the contract, the commodity is delivered. The second is to speculate on the direction of price movements of the underlying commodity. These traders don’t deliver or receive the commodity and only aim to profit off the volatile price movements of the commodities. They close their positions by purchasing a contract opposite to their original open position.

Categorising Commodities

Commodities are split into two types: hard and soft commodities.

Hard Commodities

Hard commodities are metals or energy resources, mined or extracted from natural resources. They form the basis of the economic health of a country, and global demand for such resources can be monitored to gauge the future stability of an economy. It is because the supply and demand for the products are largely predictable due to its fixed nature.

Hard commodities can be further subdivided into:

Metals: Metal commodities include gold, platinum, silver and copper. These commodities are typically popular for their reliable status during periods of high volatility or high inflation and currency depreciation.
Energy: Energy commodities include crude oil, natural gas and gasoline. These tend to be volatile as economic conditions, shifts in production enforced by the Organization of Petroleum Exporting Countries (OPEC) and technological advances in renewable energy sources have a large impact on energy prices.

Soft Commodities

Soft commodities consist of products that must be grown and cared for. Soft commodities can include livestock and meat as well as corn, soybeans, rice, coffee and other agricultural products.

They are more volatile as their price-setting mechanism relies on multiple external factors. Weather-related or seasonal transitions heavily impact prices and population growth combined with dwindling supply typically provide opportunities for profit. The production of such goods depends largely on the environmental conditions of a country. It is one reason why agrarian economies suffer more due to events such as climate change.

Case Study

Despite its limited industrial viability, gold remains a highly popular commodity that is often seen as a global store of value and medium of exchange. This precious metal cannot be counterfeited or produced in bulk and is generally used as jewelry, technology or simply stored in gold reserves. It has always stood out against other precious metals as it is primarily driven by investment and a store of value; in fact, many governments hold onto large gold reserves, with the US having the largest gold reserve of 4583 tons at a market value of $240 million.

Many countries continue to hold massive amounts of gold reserves simply as an insurance against economic catastrophes or hyperinflation (i.e. gold is viewed as a hedge against inflation). While fiat money (e.g. the AUD or US dollar) generally serves as a good currency, its value is controlled by economic variables that the central banks have control over, meaning it can be unstable, especially in economically difficult times. In comparison, gold is stable for its limited supply and is inversely related to the dollar value, thereby gaining value (in terms of fiat currency) as the value of the currency falls.

In uncertain times like COVID-19, gold is an asset that is highly sought after and unsurprisingly, its prices and stock values are on the rise. With large stimulus packages being released across many large economies, including Australia, the inflation of currency has made gold an attractive investment. Gold can be invested in through purchasing physical gold, gold futures, investing in gold ETFs (exchange-traded funds) or investing in gold-mining companies