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Unlike brand name products, commodities are goods that have a universal price around the world. Gold, for example, has the same price per ounce in Brazil and Bombay, whereas the price of a toaster oven or even a T-shirt varies depending on the brand and the place in which it is sold. Commodities are not strictly limited to so-called ‘pure’ elements like gold. A commodity can be refined from a raw element, as oil is refined from petroleum. A commodity can also be mined directly from the Earth, such as a metal, or it can also be an agricultural product, like eggs. In some cases, a commodity can be an abstract financial tool that is universal, such as the fluctuations in interest rates.
Introduction 2
Chapter I. Commodity and Commodities exchanges 3
1 Definition of Commodity 3
2 Investing in Commodity Indexes 5
3 How Commodity Exchanges Work 7
4 What are Futures and Options? (Using technical analysis) 8
Chapter II. Dinamics of Prices and Fundamentals 10
1 Crude Oil 10
2 Selected Food Commodities 11
Conclusion 14
Bibliography 15
Table of Contents
Unlike brand name products, commodities are goods
that have a
universal price around the world. Gold, for example, has the same price
per ounce in Brazil and Bombay, whereas the price of a toaster oven
or even a T-shirt varies depending on the brand and the place in
which it is sold.
Commodities are not strictly limited to so-called ‘pure’ elements
like gold. A commodity can be refined from a raw element, as oil is
refined from petroleum. A commodity can also be mined directly
from the Earth, such as a metal, or it can also be an agricultural product,
like eggs. In some cases, a commodity can be an abstract financial
tool that is universal, such as the fluctuations in interest rates.
Because commodities can take so many different physical
forms,
the financial market classifies them as a group based on their universal
value and how they are traded. However, commodities trading
is not limited to simple exchanges. An entire set of complex
trading rules, including speculation on so-called “futures,” keeps
the
market active.
Additionally, the expansion of the category of commodities
to include more abstract objects like interest rates is a relatively
recent addition. Historically, commodities were based on ordinary,
tangible goods that could be easily visualized by the layperson. The
expansion into this new territory reflects the growth and
ambition of the increasingly globally integrated financial markets.
Because there are now more participants in the global markets,
the desire for ‘new’ financial territory has encouraged the
expansion of the commodities market.
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services.
The more specific meaning of the term commodity is applied to goods only. It is used to describe a class of goods for which there is demand, but which is supplied without qualitative differentiation across a market. A commodity has full or partial fungibility; that is, the market treats it as equivalent or nearly so no matter who produces it. Petroleum and copper are examples of such commodities. The price of copper is universal, and fluctuates daily based on global supply and demand. Items such as stereo systems, on the other hand, have many aspects of product differentiation, such as the brand, the user interface, the perceived quality etc. And, the more valuable a stereo is perceived to be, the more it will cost.
In contrast, one of the characteristics of a commodity good is that its price is determined as a function of its market as a whole. Well-established physical commodities have actively traded spot and derivative markets. Generally, these are basic resources and agricultural products such as iron ore, crude oil, coal, salt, sugar, coffee beans, soybeans, aluminium, copper, rice, wheat, gold, silver, palladium, and platinum. Soft commodities are goods that are grown, while hard commodities are the ones that are extracted through mining.
There is another important class of energy commodities which includes electricity, gas, coal and oil. Electricity has the particular characteristic that it is either impossible or uneconomical to store, hence, electricity must be consumed as soon as it is produced.
Commoditization (also called commodification) occurs as a goods or services market loses differentiation across its supply base, often by the diffusion of the intellectual capital necessary to acquire or produce it efficiently. As such, goods that formerly carried premium margins for market participants have become commodities, such as generic pharmaceuticals and silicon chips.
There is a spectrum of commodification, rather than a binary distinction of "commodity versus differentiable product". Few products have complete undifferentiability and hence fungibility; even electricity can be differentiated in the market based on its method of generation (e.g., fossil fuel, wind, solar). Many products' degree of commodification depends on the buyer's mentality and means. For example, milk, eggs, and notebook paper are considered by many customers as completely undifferentiable and fungible; lowest price is the only deciding factor in the purchasing choice. Other customers take into consideration other factors besides price, such as environmental sustainability and animal welfare. To these customers, distinctions such as organic-versus-not or cage-free-versus-not count toward differentiating brands of milk or eggs, and percentage of recycled content or forestry council certification count toward differentiating brands of notebook paper. Larger considerations can enter these equations, such as systemic socioeconomic unfairness (as poor people point out, "sure, it's easy to buy the expensive food when you've got plenty of money") and deception and authentication (e.g., a brand may greenwash its product and consumers lack practical ways to authenticate the claims).
In the original and simplified sense, commodities were things of value, of uniform quality, that were produced in large quantities by many different producers; the items from each different producer were considered equivalent. On a commodity exchange, it is the underlying standard stated in the contract that defines the commodity, not any quality inherent in a specific producer's product.
Commodities exchanges include:
Markets for trading commodities can be very efficient, particularly if the division into pools matches demand segments. These markets will quickly respond to changes in supply and demand to find an equilibrium price and quantity. In addition, investors can gain passive exposure to the commodity markets through a commodity price index.
Commodity Indexes track a variety of different commodities. Certain commodity index funds, such as the Power Shares DB Commodity Index , make money by investing in derivatives of commodities, or the likelihood that a commodity will either increase or decrease in value. When a broad based commodity index has a ‘bad day,’ this is because the futures of commodities that it chose to invest in did not perform according to expectations, which lowers the overall value of the index itself.
The Dow Jones-UBS Commodity Index reflects futures price movements only, and deals with set commodities traded on U.S. exchanges, excluding zinc, aluminum and nickel. These three metals are traded on the London Metal Exchange only. The Dow Jones-UBS Commodity Index Total Return is a measure of the Dow Jones UBS Commodity Index, and should be read as a measure of return on fully collateralized futures positions. In mathematical terms, the latter Dow Jones Commodity Index is the measure of the second derivative, while the former is the first derivative.
Investing in indexes is different from trading directly in commodities. Instead of a straight-ahead tangible investment, investing in an index requires suppositions about the likelihood of a certain price fluctuation over a set period of time. These price fluctuations and the period of time on which they may or may not occur also varies, so that each ‘investment’ is essentially a highly complex mathematical bet that nominally takes into account the actual price of the commodity as a factor, and can occasionally be categorized as being more speculative than definitive. Because commodity indexes can influence other trading activity, their actions can occasionally rouse accusations of causing inappropriate price fluctuations.
As an example: in 2009, the U.S. Senate Permanent Subcommittee on Investigation launched an investigation into commodities index investment and its impact on wheat futures versus actual wheat prices. In essence, the committee reported that exaggerated wheat futures investing had artificially raised the prices of wheat futures far beyond the actual reality of tangible wheat prices. A separate report conducted by Vanderbilt University refuted this assertion, noting that such a statement is inherently difficult to prove due to the numerous factors that influence prices, including the frequent convergence of wheat futures and wheat prices.
However, this should not necessarily dissuade investors from becoming involved in the market. An investor can pick a commodity index that has a fairly solid track record and purchase options or futures of likely overall market performance. Investing in an index will usually produce a higher rate of return for the individual investor, simply because the index has been structured to survive market ups and downs. Most investors choose an index as a quick method of diversifying their portfolio without having to spend a substantial amount of time researching individual performance of a given commodity. Additionally, investing in a commodities index is almost a surefire method of avoiding inflation, a problem that afflicts most stocks, bonds, and other traditional assets. In terms of choosing a specific index in which to invest, selecting an index that has been on the market for several years is the best way to secure an excellent return and provide an inflationary hedge.
Examples of commodity exchanges include the Chicago Board of Trade , the Chicago Mercantile Exchange , the Kuala Lumpur Futures Exchange, the London Metal Exchange , and the New York Mercantile Exchange . The United States has five of the top ten commodities exchanges in the world. Each of these exchanges was founded in order to provide greater liquidity to sellers and buyers, but the exchange in of itself does not have any value. In other words, it is a forum for trade, and while it does have certain guidelines that must be followed by its members, the exchange itself does not advocate one particular trade over another. The principal purpose of commodities exchanges is to develop these regulations, and keep the market from becoming too chaotic. Those who trade on the exchange floor must be members. All major decisions that affect the running and regulation of the exchange are generally made by a vote of the member body.
The exchange itself is divided into administration, which is operated by a paid staff, and the actual trading floor itself, which is populated by traders. The traders proceed to make bids and offers on trading cards. Bids are made by buyers, and are comprised of a specific sum for a specific quantity of a particular commodity. Offers are made by sellers, and list a price for a specific quantity of a commodity. Both bids and offers are announced in the open air of the central trading ring. When a bid and offer match, a trade is officially made and recorded by the pit recorder. This information is posted on a large board; in the modern electronic era, this information is immediately sent out to all affiliated online traders as well. All trades must be resolved before the start of the next trading day. All of the information related to the trade, including the parties involved, the price of the trade, and the time period in which the trade was made, are recorded on the card.
Most commodity exchanges work by allowing traders to exchange futures contracts, or cash forward contracts, as they were initially known. The procedure is the same for a futures contract as for a commodity. In this case, the futures bid and offer must incorporate sell dates and the price at which the trade will be made in the future. Certain commodities can only be exchanged in certain exchanges.
The top two U.S. commodities exchanges are the Chicago Board of Trade and the Chicago Mercantile Exchange, which together comprise roughly 80 percent of all U.S. trading volume. The second largest exchange in the world is the London International Financial Futures and Options Exchange , or LIFFE. Most exchanges in the U.S. are regulated by the Commodity Exchange Act of 1974.
‘Futures’ are an agreed upon sell date for a quantity of a particular commodity at a particular time. ‘Options’ are similar to a ‘futures’ contract, with the exception that a buyer is not obligated to act on the terms of the initial agreement, but still retains the right to do so if he chooses.
New investors should be aware that there are also ‘futures options’ and ‘futures contracts,’ which are two distinct entities. To use traditional terminology, futures options are essentially options, and futures contracts are essentially futures. Because this terminology can be used interchangeably, it’s a good idea to be aware how these concepts are described when first entering into the trading market.
Futures are slightly riskier than options, primarily because futures require an action, whereas options allow for more equivocation and adjustment to current market trends. Naturally, the greater risk involved, the higher the potential return, or conversely, the greater the potential loss.
It should be noted that buying options usually incurs a premium, which is the fee that the trader earns from the transaction. This premium is based on the relative riskiness of the transaction. Those transactions that will almost certainly prove to be profitable carry a correspondingly high premium; those that are likely to fail will usually have a lower premium. Options are usually classified into ‘calls’ and ‘puts.’ A call option indicates that an investor believes a particular commodity will rise in value over a set period of time. A put option, on the other hand, indicates that the investor feels that the commodity will lower in value over a set period of time. In either case, a ‘strike price’ is set at the time of the purchase of the option. The investor has the choice of closing or converting the option before the set expiration date. Many investors choose to allow their options to close, instead of converting them. They then collect the subsequent profit.
Futures, on the other hand, are less flexible. Both the buyer and the seller must provide the agreed commodity at the pre-agreed price, regardless of market changes or fluctuations. If 6,000 bushels of wheat are promised at $5 per bushel over a year period, the terms can’t change until the futures contract is fulfilled. These two positions are usually known as the ‘short’ and the ‘long’ position. The short position is held by the provider of the commodity; the long position is held by the receiver of the commodity. A futures contract is valued against the actual performance of the market, and settled in cash at the end of each trading day.
As an example, if the short position agrees to provide the wheat at $5 a bushel, but the price of wheat on the market changes to $6, the short position has just lost a dollar on each bushel of wheat compared to what he could earn on the open market, while the long position has just saved a dollar on each bushel of wheat compared to what he could buy it for on the open market. At the end of each trading day, each party will either have their account debited or credited depending on the performance of the market until the futures contract expires.
However, the bulk of futures contracts do not involve the actual delivery
of tangible items, but rather provide a means of taking a financial
position on a potential transaction. For many commodities, depending
on the position that the investor adopts and the subsequent performance
of the market, futures contracts are an excellent way of guaranteeing
a source of income.
In recent years, crude oil prices have climbed to unprecedented levels, reaching an all-time high of nearly $150 per barrel in July 2008. In the wake of the financial crisis of 2008–2009, oil prices fell below $40 per barrel at the end of 2008 (figure 1).
Figure 1
Evolution of crude oil prices, 1980–2010 ($ per barrel)
Source: UNCTADstat.
Note: The prices shown refer to an equally weighted average of Brent, Dubai and WTI crude oils.
It is often argued that the fast-growing Asian emerging economies are a major source of rising demand for crude oil. The higher energy intensity of their production compared to that of developed economies has contributed decisively to the growing demand (e.g. ECB, 2010). This demand slowed down only temporarily as a result of the recent crisis.
As Kaufmann (2011) argues, the strong surge in oil prices in recent years cannot be explained without taking into account the role of the supply side. There are two groups of producers in the oil market that differ significantly in their behaviour. Whereas the non-OPEC countries can be assumed to be price takers, with their production positively related to price and negatively related to cost, the OPEC countries form a cartel whose operations are based on strategic considerations. A shift in the supply relations between the two groups can thus be assumed to have a significant impact on the evolution of oil prices. The sudden slowdown in the growth rate of non-OPEC crude oil supply after 2004 is therefore seen as a major factor driving oil price developments (Kaufmann, 2011; ECB, 2010). It caused an unexpected increase in OPEC’s capacity utilization, lowering OPEC’s excess capacity and thus strengthening the role of the cartel as a marginal supplier.
Recent oil price increases are likely to have been accelerated by political tensions and armed conflicts in oil-producing countries, among other factors, although the effect may have been dampened to some extent by declining inventories. According to the IEA (2011), current inventories and spare capacity are still sufficiently high to constrain price increases in the near future.
Grain prices have been very volatile in the most recent years. Having peaked in 2008, they declined sharply, but started rising again in 2010. In February 2011 maize prices exceeded the level of June 2008. Due to substitution effects, price movements of the three crops analysed in this study are highly correlated (figure 2). A number of supply and demand factors contribute to rising food commodity prices. Supply growth is slowing, because agricultural land is limited and productivity growth has slowed (OECD-FAO, 2009). Supply constraints are exacerbated by the effects of climate change (such as extreme weather events), which are already felt in many regions of the world, but are expected to grow dramatically over the next decades.
Figure 2
Evolution of grain prices, 1980–2010 ($ per ton)
Source: UNCTADstat; and IMF, primary commodity price tables.
On the demand side, the rising world population and changes in emerging economies towards more protein-rich diets are major long-term factors. As incomes in emerging economies have risen sharply with accelerated economic growth, consumption patterns of the population have also changed. Between 1995 and 2005, world meat consumption rose by 15 per cent, East and Southeast Asia being the region with the highest increase at almost 50 per cent (FAO, 2009). Taking into account that the production of 1 kg of meat requires about 7 kg of grains, the impact on grain demand is substantial.
Biofuel production is another decisive demand factor. The decision by some governments to introduce blending requirements and subsidies for biofuel production is considered to play a significant role in the recent price hikes of grains. Biofuel production also affects price movements of agricultural products which are not used in the production of biofuels, because agricultural land is diverted to producing crops needed for biofuel production. As biofuels partly replace petroleum products, they strengthen the link between the oil market and markets of agricultural products used in the production of biofuels (i.e. maize, sugar, oilseeds and palm oil). High oil prices also affect agricultural commodity prices via higher production costs, especially for energy and fertilizers. This may also explain the co-movement of oil prices and some agricultural commodity prices.
In the short run, weather effects have a strong impact on price developments. Often, these are exacerbated by policy measures such as export bans or taxes. Thus, wheat prices were driven up last August by the drought in the Russian Federation and an export ban.
In contrast to grains markets, high and rising prices are not a new phenomenon in the sugar and cocoa markets, judged by historical standards (figure 3). These two soft commodities already experienced extreme price spikes in the 1970s and 1980s. Recently, the cocoa price has come under pressure due to political tensions in Côte d’Ivoire, the world’s largest cocoa producer. The sugar price has risen sharply despite production increases. Expected higher demand may be a factor (FAO, 2010).
Figure 3
Evolution of prices of selected soft commodities,
1980–2010 (US cents per pound)
Source: UNCTADstat.
The past decade has witnessed a large increase in the
prices of many commodities, despite significant falls during the
global financial crisis. These increases have raised a number of
concerns for policymakers, including the potential for rising
commodity prices to feed into broader domestic inflation pressures,
with some developing nations particularly concerned about rising
food prices. The G-20 has committed to ‘work to address
excessive commodity price volatility’, with a focus on the role
played by the growing presence of financial investors in
commodity markets. While speculators are present in commodity
markets they do not appear to have contributed significantly
to the level or volatility of prices except in the very short term.
At this stage, the available evidence suggests
that fundamental
factors are the main determinants of commodity prices.
Commodity prices are currently both high and volatile
relative
to the past few decades, consistent with the physical
supply and demand fundamentals that underpin these markets.
However, the increase in prices and volatility is not unprecedented,
having occurred during other large global supply and demand
shocks throughout the past century. There is a lack of convincing
evidence (at least to date) that financial markets have had a
materially adverse effect on commodity markets over time
periods of relevance to the economy. It is possible that speculators
have had some effect on commodity price volatility, but their
contribution would appear to be relatively small – particularly
when compared with the contribution from fundamental factors –
and short term in nature.