Commodities Defined

Commodities play vital roles in the economy and are important to the success of many businesses. Commodities such as oil, aluminum and wheat comprise the raw materials for most of the products we use every day. Because commodities are so important — and because their prices can fluctuate considerably — commodity trading is a vast worldwide financial activity. Some businesses trade in commodities and commodities futures to reduce price risks for essential products and supplies, while others invest purely for portfolio diversification or to gain from market movements. Here’s what you need to know about the types of commodities, how commodity trading works, the factors that affect commodity prices and the pros and cons of investing in commodities.

What Is a Commodity?

Commodities are raw materials and other basic goods that are treated as interchangeable with others of the same kind. Commodities are essential to every economy, and they are used in the manufacture of most products. Examples of commodities include oil, gold, corn, cotton and beef.

Commodities are usually mass produced by multiple suppliers and more or less uniform in quality. As a result, a commodity sells for the same price no matter who produced it. That’s critical for companies that buy or sell commodities. It also means that standard quantities of commodities can be traded on financial exchanges, with the price fluctuating based on supply and demand.

Hard vs. soft commodities. Commodities are often divided into hard and soft. Hard commodities are mined or extracted. They include oil, gas, steel and copper. Soft commodities are agricultural products and livestock. Examples are corn, soybeans, sugar and pork.

Key Takeaways

• Commodities are essential raw materials and other basic goods that are considered uniform in quality and therefore interchangeable.
• Examples of commodities include oil, natural gas, metals such as steel and gold, and agricultural products including corn, wheat and sugar.
• Commodities and their financial derivatives such as futures contracts and options are widely traded on exchanges worldwide.
• Futures contracts reduce risk for businesses that produce or use commodities by guaranteeing the price of a commodity at a specific point in the future.
• Traders and businesses also invest in commodities to speculate on price movements and diversify investment portfolios.

Commodities Explained

Commodities are fundamental to every economy. Most businesses rely on commodities, either directly or indirectly, because they are used in an enormous number of different products. Corn, for example, is incorporated into processed foods and also used to make industrial alcohol, recyclable plastics and hundreds of other non-food products. Oil is refined to make gasoline and is also the basis of plastics, fertilizer and the asphalt that paves our roads.

Commodities are used so widely that they affect the cost of just about everything we consume — from food to transportation, clothing, building supplies and household products. Changes in commodity prices therefore are a big factor in driving inflation. Commodity prices can fluctuate wildly and extremely rapidly, based on supply and demand — both of which are influenced by many different factors, from economic growth and politics to weather and supply-chain snarls.

Because commodity prices fluctuate so much, many businesses that sell or buy commodities enter into futures contracts. These contracts lock in a future price for a specific quantity of a commodity. These futures contracts and other financial derivatives such as options account for a large part of the enormous worldwide commodities trading market.

Businesses use futures contracts to reduce price risks, allowing them to plan with greater confidence. Wheat farmers who have invested their capital in growing crops run the risk of losing money if prices drop before they can harvest and sell their wheat. By contracting in advance to sell their wheat for a fixed price, they reduce that risk. Food manufacturers who buy those wheat futures contracts can plan their future production knowing that they’ll be able to get indispensable raw materials at a fixed price.

How Are Commodities Traded?

Commodities are bought and sold on financial exchanges, a bit like stocks and bonds. Large commodities exchanges include the Chicago Mercantile Exchange (CME), New York Mercantile Exchange (NYMEX) and London Metal Exchange (LME). Buyers and sellers can trade commodities at the current price, known as the spot price. But much of the trading is in futures contracts and options, which are contracts to buy or sell a commodity at a predetermined price at a specific time in the future.

The rules governing commodity trading in the U.S. are determined by the Commodity Exchange Act of 1936. The Act requires all futures trading to be conducted on regulated exchanges. The Commodity Futures Trading Commission (CTFC), a government agency created as a result of the Act, regulates commodities trading activity. The regulated exchanges define standard contract terms, including the quantity and required quality of each commodity as well as delivery dates and delivery locations.

How Does Commodities Trading Work?

While some businesses trade commodities to secure guaranteed prices for critical materials, commodities trading has also evolved into a major worldwide financial market. Investors buy and sell commodities futures, betting that they will make money as prices rise or fall. In this type of trading, the physical commodities don’t change hands.

Here’s how commodity futures trading works for these investors. A buyer and seller agree to a contract based on a future price and a specified date. For example, the buyer might agree to buy 100 tons of nickel at $30,000 per ton one month from today. The buyer is betting that the market price of nickel, called the spot price, will rise during that time. The seller is betting that the price will fall. When the month is up, the buyer closes out the futures contract by entering into another contract to sell 100 tons of nickel at the spot price. If the price has risen, the buyer makes money. If it has fallen, the buyer is out of pocket. The opposite is true for the seller, who loses money if the price rises and cashes in if the price falls.

Commodity futures trading can be risky, for two reasons. One reason is that that commodities prices can be hard to predict, because they’re influenced by many factors. The other is that commodities futures often trade on margin, which means that traders only need to come up with a percentage of the total contract value when they initially agree to the contract. As a result, a buyer could multiply their initial stake if the spot price rises above the contract price; but it also means they could lose their entire investment or even more if the price falls.

To reduce risk, some buyers and sellers use options instead of futures contracts. Options, like futures contracts, guarantee the price at a specific time in the future. However, unlike futures contracts, an option doesn’t require the buyer to purchase the commodity at the end of the period; it merely gives the buyer the right to do so if they wish. This limits the buyer’s risk if the price doesn’t move in the right direction.

Another type of trade is the commodity swap, which involves exchanging the spot price for a fixed future price. Swaps are often used as a way to secure future oil prices.

Do Businesses Need to Invest in Commodities Futures?

There are several reasons businesses invest in commodities futures. Companies directly involved in consuming, producing or selling commodities may use futures contracts to ensure guaranteed prices, reducing their risk. Farmers, mining companies and oil producers can sell contracts that match their expected output at a specified future date. Because they know how much money they’ll receive and when they’ll get it, they can invest in growing their operations with greater confidence. Similarly, companies that use those commodities can better plan their production and sales activities because they know how much their raw materials will cost.

Businesses can also use commodities investments to diversify their portfolio, reducing financial risk. Because commodity prices typically rise with inflation and are not correlated with stock prices, they can provide a way to hedge against the impact of rising prices and a falling stock market.

Why Invest in Commodities?

Investing in commodities offers several potential advantages — and disadvantages. Commodities prices often diverge from the price of other financial assets such as stocks because they’re affected by different factors. While commodities can provide a way to diversify investments, prices can be volatile and sometimes underperform the stock market.

Advantages of commodities. Investing in commodities typically offer three major potential benefits: inflation protection, portfolio diversification and the potential for higher returns.

• Protect against inflation. Commodities prices typically increase when inflation is rising, so investing in commodities can offset the negative impact of rising costs. In fact, rising commodity prices are a key factor in driving inflation, because commodities are used in many everyday products and services — so when commodity costs rise, so do prices overall.
• Diversify financial portfolio. Typically, U.S. stock prices are broadly correlated with each other — they tend to rise or fall at the same time. Commodity prices, in contrast, have a low to negative correlation with the prices of stocks and other financial assets. For example, while commodities often rise with inflation, the stock market is often adversely affected by inflation. And when stocks fall, investors see gold as a safe haven, which pushes up gold prices.
• Boost returns. Over time, global economic growth pushes up demand for commodities, so commodities tend to rise in value. Specific factors can also cause the price of individual commodities to rise sharply. For example, natural disasters can cause crop shortages that drive up prices. Therefore, investing in commodities can provide significant gains — although it requires specialized knowledge.

Disadvantages of commodities. Investing in commodities can present several types of risk, including price volatility and the possibility of underperformance.

• Underperformance risks. Commodities sometimes underperform the stock market for long periods, making commodities investments less attractive than stocks for investors seeking to maximize returns.
• Volatility. Commodity prices can change rapidly due to shifts in supply and demand. During the second half of 2021, iron ore prices fell by more than half compared to the previous year, for example. Investing in commodities requires specialized knowledge because it’s hard to predict all the factors that can affect supply and demand.
• Potential for losses. Investment in commodities futures contracts is often performed on margin. That method means investors initially only need to come up with a fraction of the total contract value, but it also means they can lose more than their initial investment if commodities prices don’t move in the way they hoped.
• No dividends. Some stocks reward investors with dividends, which provide regular income even if the stocks don’t rise in value. Commodities don’t offer that benefit: any gains are due purely to a change in value.

Types of Commodities

Commodities are generally divided into three main categories: agricultural, energy and metals. Sometimes the agricultural category is further divided into crops and livestock.

• Agricultural commodities include some of the world’s most important crops: corn, wheat, rice, soybeans, canola oil and sugar. These commodities become raw materials in an enormous variety of foods and non-food products. The category also includes livestock such as hogs and cattle.
• Energy commodities include crude oil used for transportation and making other products such as plastics, natural gas used for heating and generating electricity, and gasoline.
• Metals include steel, which is used to make cars, machinery, appliances and many thousands of other products. The category also includes other widely used materials such as aluminum and copper as well as precious metals like gold, silver and platinum.

Types of Commodity Buyers

Buyers of commodities include businesses, traders engaged in the physical transfer of commodities, investors looking to gain from market price changes and portfolio managers seeking asset diversification.

• Businesses that use commodities. Many businesses use commodities, but some are especially reliant on them and get involved in large-scale commodities purchases. For airlines, fuel costs have a big impact on operating expenses and profits. Airlines therefore buy futures contracts to ensure a steady supply of fuel at predictable prices. Similarly, manufacturers that use metals as raw materials may buy futures contracts to secure their supplies.
• Companies involved in trading physical commodities. Some companies buy commodities from their original producers and resell them to other businesses. They may also invest in commodities futures to hedge against the risk of unfavorable price changes between the time they buy a commodity and the time they sell it to another company.
• Speculators. Some investors buy and sell commodities futures and other derivative financial products purely to benefit from price movements. These buyers don’t aim to actually take possession or transfer the commodities. Commodities trading is a specialized skill, since commodity prices can be volatile and influenced by many factors.
• Portfolio managers at businesses. Portfolio managers may buy commodities or related financial products such as exchange-traded funds (ETFs) to diversify their investments.

Alternatives to Buying Commodities Futures

For businesses and investors seeking to invest in commodities, there are alternatives to buying commodities futures on exchanges. These alternatives typically require a lower level of investment and may involve less risk than trading directly in futures.

• Commodity pools. Investors can combine their funds into a commodity trading pool operated by a licensed commodity pool operator (CPO). A key benefit is that the pool has greater buying power and can provide investors with more leverage and diversification than if they invest individually.
• Exchange-traded funds (ETFs), mutual funds and exchange-traded notes (ETNs). Businesses and individuals seeking to invest in commodities can do so via a variety of funds designed to track commodities markets. These funds may invest in futures contracts or in stocks of commodity producers. Some funds track specific groups of commodities such as metals or energy products. ETFs and mutual funds are baskets of commodities or other financial assets. ETNs are bonds that are designed to track commodity prices and are issued by financial institutions.
• Stocks. Another way to gain exposure to commodities is to invest directly in stocks of commodities producers, such as mining, oil or agricultural companies.

What Influences Commodities Pricing?

Commodities prices are driven by supply and demand and can be affected by many different factors. Anything that constrains supply can drive up prices, as can anything that increases competition for that supply. Not all those factors are predictable — and further complicating the picture, a factor that impacts the price of one commodity may have no effect on the price of another. Unfavorable fall weather may drive up prices of some crops but have no impact on the cost of oil or metals, for example.

Here are some common factors that can influence commodity pricing.

• Economic growth. Economic expansion generally increases demand, driving up commodity prices. For example, rapid manufacturing growth in emerging economies has contributed to rising costs of raw materials. In contrast, a weak economy usually means lower demand for products overall, resulting in less demand for the commodities used to make those products and correspondingly lower commodity prices.
• Politics. Political events, new policies and political uncertainty can cause rapid, drastic changes in commodity pricing. Wars, embargoes, sales taxes and increased tariffs can all drive up prices.
• Seasonality. Prices of agricultural commodities vary depending on the season. Prices also may increase in anticipation of a poor harvest or decline if a big crop means an abundant supply suddenly becomes available. Natural gas prices tend to rise during cold weather due to increased demand for heating.
• Weather. Extreme weather and natural disasters such as floods can impact production and transportation, reducing supply and driving up prices.
• New sources of demand. The growth of new product categories can drive up demand for specific commodities. For example, the rise of electric vehicles and renewable energy sources has increased demand for metals such as lithium, which is used in batteries.
• Competition from other commodities. Buyers can sometimes switch to a cheaper commodity. For example, livestock farmers facing high prices for the wheat they feed to their animals may switch to less-expensive corn. That shift changes demand — and pricing — for both commodities.
• Ripple effects of other commodity prices. One commodity’s rising price can drive up the price of others. For example, oil is widely used in agriculture, both to produce the fuel used by farm machinery and to make fertilizers and pesticides. Therefore, rising oil prices can contribute to increases in the price of commodity crops.
• Supply-chain problems. Bottlenecks anywhere along the supply chain can mean that not enough of a commodity is available to meet demand, which drives up the commodity’s price.

History of Commodities Trading

Commodities trading is almost as old as civilization itself, which is perhaps not surprising since commodities are essential for any society. Thousands of years ago, Sumerians used clay tablets to record quantities of agricultural products to be delivered — the ancient equivalent of a modern commodities futures contract.

In the U.S., modern commodity trading began in 1848 with the establishment of the Chicago Board of Trade (CBOT). The CBOT provided a centralized forum for the exchange of contracts that enabled buyers and sellers to lock in future prices for products. These evolved into the futures contracts, options and other financial derivatives that are now widely traded. Today, the commodities market is highly sophisticated, encompassing many different types of raw materials and other products and operating internationally via exchanges worldwide.

Report With Accuracy, Close With Confidence

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All businesses rely on commodities either directly or indirectly, because commodities are used in just about all products and services. Because commodity prices can vary so much, businesses that produce commodities or use them in production often engage in commodities trading to secure guaranteed future pricing. This reduces risk and enables companies to plan with more confidence. Investing in commodities is also a way to diversify a financial portfolio.

Commodity FAQs

What are five commodities?

Five commonly traded commodities are crude oil, steel, soybeans, sugar and gold.

What are the types of commodities?

Commodities can be divided into three main types: energy, metals and agricultural. The energy category includes crude oil and gas. Metals include common raw materials such as aluminum and steel as well as precious metals like silver. Metals and energy are considered hard commodities — commodities that are mined or extracted. Agricultural products are sometimes further divided into crops and livestock. Hard commodities are mined or extracted. They include oil, gas, steel and copper. Agricultural products are considered soft commodities.

What is a commodity item?

A commodity item is a raw material or product that can be easily exchanged for other goods of the same type. Some commodities are grown or extracted from the earth, while others are created using industrial processes.

What are the main commodities?

Among the most widely traded commodities are crude oil and several products related to it, such as gasoline and heating oil. Natural gas is also an important commodity. Other major commodities include sugar, wheat, corn, copper, steel and gold.

What are examples of commodities?

A wide variety of commodities is traded on exchanges. Energy commodities include oil, ethanol and natural gas. Metals considered commodities include gold, platinum, silver, iron ore and steel. Agricultural products include corn, cocoa, coffee and even frozen concentrated orange juice. Other commodities include rubber, wool and wood pulp.

What is considered a commodity?

A commodity is a widely available raw material or product that is essentially uniform in quality and sells for the same price no matter who produced it. Quantities of the same commodity can therefore be traded on exchanges with the price fluctuating based on supply and demand.