What is a commodity and how does it work?
Updated: August 28, 2024
There are certain things we depend on in life – clothes to cover our backs, gas to fuel our vehicles and bread to put on the table. These are all commodities that we use everyday that drive the global economy. Commodities have long been a popular and profitable way to invest since 1848 when commodity trading began at the Chicago Board of Trade¹. But what is a commodity and how does it work? This is what you need to know before you invest.
What is a commodity?
A commodity is a raw material used to manufacture goods that can be sold and traded for consumer use. It’s not a finished product but rather a material used to create one. Commodities are the same, regardless of where they are produced, and are usually mass-produced according to standardized procedures to ensure quality and volume. Since all commodities are the same, they are also easily interchangeable.
Commodities have been around since the 1800s² when farmers sold wheat and corn via local markets. Today, modernized systems have standardized the commodity market. Therefore, investors can purchase and trade commodities at a set value, regardless of its manufacturer.
Examples of commodities
Commodities are classified as either a hard or soft commodity.
Hard commodities
A hard commodity is a natural product that is extracted from the earth. This includes petroleum, ore and silver.
- Energy commodities: An energy commodity includes those materials extracted from the ground, including energy sources like crude oil, ethanol, gasoline and uranium. Energies also include renewable energy, such as wind or solar power.
- Ore commodities: Precious metals mined from the ground are considered hard commodities, such as gold, silver and platinum. Also included are industrial metals, such as aluminum, nickel, lead and copper.
Soft commodities
A soft commodity is one that is grown, such as wheat, soybeans and lumber. This also includes those products that cannot be stored long-term, such as sugar, cotton and coffee.
- Commodities for human use: These commodities include those for human consumption like sugar, cocoa and coffee. They also encompass some non-edible items, such as lumber and clothing.
- Agricultural commodities: Agricultural commodities include livestock or animals that can be raised, such as cattle and hogs. It also includes products made from animals, such as leather and gelatin.
Examples of hard vs soft commodities
| Hard commodities | Soft commodities |
|---|---|
| Crude oil | Livestock |
| Ethanol | Cotton |
| Coal | Sugar |
| Gold | Cocoa |
| Silver | Soybeans |
| Palladium | Lumber |
| Aluminum | Leather |
How do commodities work?
There are three basic principles for how commodities work: buyers and producers, supply and demand and commodity speculators. When answering the question of what is a commodity, it’s important to understand all three.
Buyers and producers
Commodities heavily rely upon the relationship between producer and consumer. A producer is the manufacturer that produces the product, such as a farmer or rancher. There is typically a middleman, a processor, who takes the raw goods and alters them for sale. Those goods are then purchased in bulk by a retailer who then sells the products to the consumer at a marked-up price.
Therefore, producers work with two buyers: the retailer and the consumer.
Supply and demand
The value of commodities is greatly based on supply and demand³. Producers aim to sell a product at a certain price and quantity, but that price ultimately depends on a consumer’s willingness to purchase the product at that cost. The more popular a product is, the more consumers are willing to pay, and the value increases with the extra demand.
Commodity speculators
Commodities are popular among investors because they benefit from price fluctuations. When demand is high, so are purchase prices. That increase in price can result in gains for commodities traders who buy shares when prices are low and sell when prices are high.
Speculators take many forms, whether they are individual commodities traders, portfolio managers and hedge firms and trading firms.
How to invest in commodities
There are several options available when you want to invest in commodities. Brokers are a popular choice. Choose the right broker that suits your needs.
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Direct investment
You can purchase a commodity yourself through a direct dealer. This eliminates any markup from a third party, and you can often sell back to the same dealer, greatly simplifying the process. One popular commodity for direct investment is gold, which can be easily purchased by a coin dealer and sold at any time.
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Exchange-Traded Funds (ETFs) and mutual funds
ETFs and mutual funds can offer less risk because traders gain wide exposure to different commodities while minimizing risk. They are often purchased through an investment fund, which means traders can benefit from professional guidance. This makes them ideal for beginners to investing.
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Futures Contracts
More advanced investors may look to a futures contract for their investments. This is a commodity derivative managed from a brokerage account. These are typically used by larger companies instead of individuals because a certain amount of capital, or margin, is required. A margin call may later be required, which is when you are required to deposit more capital in order to maintain your holding.
Commodity stocks
There is also the option to purchase direct stock from the manufacturer itself. These stock prices are heavily based on demand and can take many forms, such as oil stocks, metal stocks or energy stocks.
Most commodities are exchanged via ICE Futures US and the CME Group, which together control four major exchanges. These include the Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange (NYMEX) and the Commodity Exchange, Inc. (COMEX).
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Who sets the price of commodities?
Because they are essential products that are used every day, commodities form the basis of the global economy. They are traded, bought and sold in financial markets. Manufacturers are able to set a value for their goods and enter into contracts with investors for that price. Should the price increase, investors receive a higher value for their investment, but they are also left vulnerable to losses should prices plummet.
The price of commodities depends on several factors:
- World economy: Global conflicts can easily affect the price of commodities such as oil or grain. The World Bank reports that unexpected economic shocks can be attributed to several fluctuations in the price of commodities dating back to 1996⁴.
- Natural disasters: Weather-related disasters, such as hurricanes or typhoons⁵, can also cause great price instability among commodities, especially for those materials destroyed during the storm.
- Political events: Elections and other major political events⁶ can also influence demand, thus affecting the price of commodities. For example, duties on imports and exports can fluctuate, impacting the overall price of the product.
- Competition: Competition among suppliers can also affect the price of commodities. Newer technologies can create a lower overhead and lead to faster processing, thus bringing the overall price down⁷.
- Season: Changes in season⁸ can also affect availability and demand, such as those commodities in harvesting.
Why invest in commodities?
There are many reasons why you should invest in commodities:
- To take advantage of market highs
- To reduce investment volatility
- To take short-term positions
- To join the market as a speculator
- To diversify your portfolio
Because commodities generally balance out high inflation, they are considered a safer and more reliable way to begin investing, as long as you choose the right investments at the right time. A licensed financial advisor can help you choose the right options for your portfolio.
Commodity risks
Investing in commodities can be an extremely lucrative venture when done correctly. However, it is not without risk⁹, as the commodities market is extremely volatile, and prices can easily fluctuate. Decreases in consumer demand economic recessions can easily lead to losses if positions are not sold in time. While this draws speculators, it is not ideal for newer traders who may lack the experience to accurately time the market.
Commodities vs stocks
Commodities are very different from stocks in several ways.
| Feature | Commodity | Stocks |
|---|---|---|
| High volatility | ✓ | 𝒙 |
| Leverage | 𝒙 | ✓ |
| Pays dividends | 𝒙 | ✓ |
| Short-term investment | ✓ | 𝒙 |
| 24/7 trading | ✓ | 𝒙 |
Commodities pros and cons
There are several advantages to commodities, but they are not perfect and should be approached with caution. After all, even products with a high demand can incur losses. There is no way to predict the future, and sudden or catastrophic events like extreme weather or a change in political leadership can easily impact the price of commodities, changing the value of your investment. However, if you time the market just right, it could result in major profits generated from short-term trading.
Pros
-
Can bring short-term gains
-
Protection against inflation
-
Adds to portfolio diversification
Cons
-
Can be very volatile
-
Dependent on macroeconomic events
-
No regular dividends
FAQs
Lena Muhtadi Borrelli brings over 20 years of experience in the finance industry. She began her career at Morgan Stanley before transitioning over to media. As a finance writer, she has served as an authority for several respected outlets, including Forbes, TIME, Newsweek, Bankrate, Investopedia, Insurance.com, and InvestorPlace. No matter what she is writing, Lena has a unique ability to simplify complex topics, making finance more approachable and relatable to the average reader. When she is not writing or scanning the news for the latest headlines, she is happiest spending time in the Florida sunshine with her husband and two pups.
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