Introduction to Commodities Investing

Ever since the beginning of history, humans have been using commodities. This has created a necessity to trade commodities. However, as financial markets advances, trading commodities became a business unto itself.

The modern world provides a plethora of options when it comes to commodities investing. Commercial users of the products can use these financial markets to hedge their exposure to such commodities. However, at the same time traders and speculators can also make a fortune if they are able to accurately predict the movement of these commodities.

In this article, we will begin with the basics. We will first understand what commodities markets are how one should approach them.

What are Commodities ?

The most basic definition of commodities would be that commodities are natural resources which are used as raw materials to create a better world.

Characteristics of Commodities

• Fungible: The foremost characteristic of commodities is the fact that they are fungible. This means that one unit of any commodity can be substituted for another unit of the same commodity without any loss of value. For instance 1 kg of wheat can be exchanged for another 1 kg of wheat without too much loss in value. If the units are not fungible, it cannot be called a commodity.

• Tradable: It is also essential that commodities must be tradable. Some commodities are directly listed on the exchanges and hence become tradable. Consider the case of brent or nymex crude oil. It can be purchased and sold at an exchange and is therefore highly tradable. On the other hand, consider a commodity such as plutonium. These are not directly listed on an exchange and are therefore not directly tradable. Therefore, even though they are technically commodities we will not include them in our discussion.

• Deliverable: Since commodities are being traded, they also need to be deliverable. Commodities like oil and food grains can be delivered to the buyer. Hence, they are considered to be commodities.

• Liquid: The most essential feature that makes any commodity tradable is liquidity. Liquidity means several people are buying into and out of these commodities at any given point of time. Therefore, there is always an active market for these commodities and prices are being quoted. Any person can virtually buy or sell an unlimited amount of these commodities at a very short notice. Liquidity ensures the presence of an active secondary market which is a pre-requisite for any type of financial trading to happen.

The Common Types of Commodities

• Energy: Energy is a basic requirement for human survival. Whether it is in the form of electricity, fossil fuels or renewable natural resources, energy is simply indispensible! Also humans have created infrastructure to enable the delivery of energy over vast geographical landscapes in almost no time. Energy products like oil, natural gas and electricity have been some of the most highly traded commodities in the past century. So much so that a shortage of these commodities have lead countries to declare war on other nations. It does not seem like the world’s unquenchable thirst for energy is about to end anytime soon.

• Metals: Metals like gold and silver have been used for centuries as money. Metals have also been used extensively for industrial and commercial purposes. Have a look around yourself and it will be difficult to find a room or even an open space where no metal has been used. Some of the richest people in the world have also made their fortunes on metals like steel. Andrew Carnegie and Laxmi Niwas Mittal would be notable examples in this regard. Metals have a highly liquid market which is global in nature providing investors with lot of opportunities to trade and exploit the arbitrage opportunities as and when they arise.

• Agricultural Produce: Agricultural produce is also a highly traded commodity. Companies hedge their future exposure to agricultural produce at commodities markets. However, agricultural produce is largely sold in the futures market. Agricultural commodities also have a limitation in the sense that they cannot be stored for very long. They have a limited shelf life. However, commodities markets over the world as so advanced that even the most perishable commodities are traded and sold without any hassles.

Complexity in Commodities Trading

Commodities’ trading is incredibly complex. This is because most of the time it involves trading in derivative instruments which by definition are quite complex. However, the commodities market also interfaces with equity and other markets. This happens when companies like Exxon (having a significant exposure to commodities like oil) are listed on the stock exchanges.

People buying their stock are virtually betting on the underlying commodity. Hence complex strategies are possible wherein a person goes short on the oil commodity while going long on Exxon stock. This means that the investor is betting that Exxon will outperform the oil and natural gas sector in general. Inter market arbitrage a strategy are quite commonly used and cross trading is indeed the norm. We will cover some of these strategies in great detail in the next few articles.