Futures Education

What are Commodities?

One thing you should thoroughly understand by now is the depth and magnitude of the futures market. The industry has grown and matured, it has broadened the scope of its offerings, and it has assumed an indispensable role in our economy. Even though many people still refer to this industry as commodities, the tides are changing as more business is transacted in non-traditional commodities than ever before.
Despite the growth in non-commodity futures, no discussion of futures would be complete without a discussion of the underlying products that define this industry: commodities. In the most basic sense, commodities are loosely defined as natural resources, chemicals and physical products you can touch, taste, smell, grow, mine, consume or deliver.
Before the advent of futures trading in the United States, much of our economy was based in agriculture or providing services to agriculture. The industrial revolution, which ushered in a new era of technological efficiencies to the world, also changed our understanding of agriculture. Through advances in science and technology, farmers were able to grow or raise more products at a faster rate with less capital. Agricultural output not only kept pace with the phenomenal growth in population, but also improved our standard of living. Improved productivity changed focus to a new breed of agricultural services focusing more on storage, transportation, and distribution. Today, our economy is just as dependent on agriculture as it was 100 years ago.
In addition to agricultural products, the commodities industry also covers two other types of products: metals and energy. The most popular contracts for commodity trading cover several broad categories: metals, energy, grains, livestock, and food and fiber. Commodities are not paper assets, they are physical products that are produced and consumed at a price based on the forces of supply and demand.
Physical commodity futures prices - more than non-physical commodity futures - are determined by basic principles of economics, namely supply, demand and inflation.

Increased Demand

Commodities are the basic building blocks of economic production and therefore an essential cog in the machine of economic growth. As we work to improve the global standard of living, the demand for commodities will grow in response to the economic growth.
Consider gold, for example. As more people increase their wealth, the demand for gold increases for many different reasons. First, it is a highly coveted luxury consumer product. But just as important as being a luxury consumer product, gold is also a component in many technological products that are used everyday by millions of people around the globe. Additionally, many countries, people and organizations use gold as a standard for storing wealth. So as the standard of living increases, so does the demand for gold.
An increase in the global standard of living affects other commodities as well. Crude oil and gasoline are in greater demand as more people buy automobiles. Rice, wheat, soybeans, corn, meats, coffee, sugar, and cocoa are in greater demand as people want to improve their diets and taste the sweeter things in life.

Decreased Supply

For years, commodity prices were relatively low (prior to 2000); however, as countries around the world adopt more market-based economies, the demand for commodities is growing. The added demand increases prices, thus calling out more supply (giving people a greater incentive to produce commodities). Unfortunately, it often takes years to increase the supply of some commodities. Commodities that must be taken out of the ground (oil and metals) have the longest lead times.
In the short run, the supply isn't keeping up with the added demand. Some people view this more as an increase in demand rather than a decrease in supply, but you could say the supply is going down relative to the demand. The effect is the same as a shortage of commodities (relative to demand) and the bottom line is that prices are going up.

Inflation

During the first stage of inflation, commodity price increases are caused by an expansion of the money supply and credit. During the second stage, people begin to anticipate future declines in their currency's purchasing power, and the currency's price (relative to commodities) begins to drop faster than the supply expansion would suggest. As existing money buys less, more money is needed to buy the same quantity of commodities. More money is then printed (and easier credit is extended) to meet the ever-expanding anticipatory "need"/demand for it, reducing the currency's price and pushing commodity prices higher still.
As more countries move toward market economies, billions of new people will join the marketplace for commodities. This unprecedented demand for commodities is creating shortages while the markets' rationing tool (price) is doing its job by supplying goods to consumers who are willing and able to pay the (higher) market price. Until the supply of commodities can catch up with the added demand, commodity prices will continue to rise.
The convergence of increased demand, short supplies, and global inflation is bringing the world record commodity prices and the trends will likely continue. There will be shocks that cause hyper increase or decrease to prices but it is unlikely to affect the long-term trend of increasing commodity prices.

Contango

In a previous module, you learned that futures can trade at a premium or discount to the cash markets. In our discussion of commodities this concept takes on a deeper importance.
In general, the commodities market compensates an individual for the cost of purchasing a commodity today, storing it, and delivering it in the future.
As a result, you would ordinarily expect to see higher prices on futures with longer expirations - the commodity has to be stored longer, so you would pay a higher premium for storage costs. This is called contango. Contango occurs when the cost of longer-term contracts is greater than the cost of shorter-term contracts.
When it comes to physical commodity futures it is important to understand the factors that influence contango. The most important determinant of the price differential between two contracts with different expirations is the cost of storing the commodity over that particular length of time. As a result, markets which fully compensate an individual for carry charges–interest rates, insurance, and storage–are known as full contango markets, or full carrying charge markets.
In normal market conditions, when there is an adequate supply of the commodity, the price should be equal to the present spot (cash) prices plus contango. As you have learned previously, the contango structure of the futures market is kept intact by the ability of metals dealers and financial institutions to bring carrying charges back into line through arbitrage. If carrying charges are greater than prevailing interest rates, dealers will buy physical metal and sell futures. Conversely, if carrying charges are below prevailing interest rates, dealers will sell the physical product and buy futures.
The net effect of arbitrage in the physical commodities market is to keep carrying charges in line with interest rates. As interest rates increase commodity prices will drop. When interest rates decrease commodity prices will increase.

Backwardation

The opposite of contango is backwardation, a market condition where the nearby month trades at a higher price relative to the outer months. Such a price relationship usually indicates a tightness of supply. The copper market, for instance, has been in backwardation more often than not since the 1950s.
Whether a market is in contango or backwardation, over time, as the contract approaches expiration, the futures price and cash prices will trade closer and closer to even, a process known as convergence.
The relationship between the cash market, the futures market and interest rates play an important role in the price and trend of the commodities market. It is important to understand these relationships as you make longer-term investments, especially hedges. It is also important in shorter-term trades and speculation as factors that affect the cash market or interest rates will greatly influence the shorter-term price trends.
Now that we have a basic understanding of the relationship between the cash market, interest rates and the futures market, let's go into more depth on the different types of products that constitute the commodities market. These will be broken down into three categories: Metals, Energy and Agriculture.

Fact and Figures Data Sources:

Hog data was collected from the: USDA National Agricultural Statistic Service, Meat Animals Production, Disposition and Income Report. (2005)
Cattle data was collected from the: USDA National Agricultural Statistics Service, Meat Animals Production, Disposition and Income Report. (2007)
Corn production data was collected from: USDA Foreign Agriculture Service, Grain: World Markets and Trade Report. (2006)
Platinum, Gold, and Silver data: USGS, Mineral Industry Survey (2006)
Aluminum data: The Aluminum Association, Aluminum Statistical Review (2007)