A brief history of the commodities market

For many commodity traders, the futures market represents the purest form of trading. Not least because it is the oldest and most established method of trading commodities, in a highly regulated environment, and one which dates back to the days when virtually all futures trading was conducted with real underlying assets, such as grains, livestock, timber, and energy, with the principle purpose being to hedge against future price fluctuations in market prices.

As such, the farmer, producer or supplier, was able to fix the future price for the sale of the asset, accepting by implication, that whilst he was protected from any decline in prices, equally he did not benefit from any increase. Such is the nature of managing risk – it is a balance between a guaranteed price in the future, offset by the possibility of a lost ‘profit’.

In the early days of course, these contracts were merely written agreements, with no standard size for the contract, or quality of goods, nor indeed were there any guarantees of payment, with suppliers regularly failing to receive payment as a result, with the agricultural goods left to rot in the streets as a result. To overcome this problem, futures trading was standardized and centralized, with many of the largest exchanges being established in the corn belt of the American mid west, with the Chicago Mercantile Exchange now the largest futures and options exchange in the world.

In the early years, commodities represented almost all the futures volume traded through the exchange, but in the last few decades the percentage has slowly declined as futures trading has become increasingly dominated by interest rates, equity indices, and forex which is the fastest growing sector of the market in financial futures, with commodities now representing around 30% of all futures contracts traded through the exchanges. However, the recent global commodity boom coupled with the rapid economic development of third world economies has focused attention on this once ‘so called’ specialist sector of the market, as both speculators and institutional buyers seek out new opportunities to make money in the financial markets.

What are commodities?

A simple question perhaps, and the straightforward answer is that commodities are products that are substantially identical regardless of the producer or the originator. Typically they are products which have had a minimal amount of processing and which therefore serve as raw materials or inputs for the production of more refined products. Whilst commodities are not branded, they do conform to industry wide grades or standards, and as such commodities are said to be homogenous. As a result, one unit of a particular commodity is exactly the same as another and in the commodities market this is referred to as a fungible product. In other words each unit is identical to another and are therefore interchangeable. This simply means that buyers and sellers know exactly the type and quality of the commodity they are buying and selling, removing any ambiguity from the market as a result.

Price discovery

The market structure for commodities is typically highly diffuse with a myriad of producers, consumer, speculators and investors. As a result, both the price and the available quantities of commodities are driven by market forces, rather than by the concentrated efforts of market makers or insiders, a common factor in other capital markets. As such, commodity prices are driven entirely by the forces of supply and demand, or put another way, by the market fundamentals and therefore operate in a market which is pure, resulting in prices which settle at the price discovery point by the natural supply and demand dynamic. Simply put, this means that commodity prices provide the benchmark, not just for international buyers and sellers looking for raw products to refine, but in addition, a benchmark against which inflationary pressure is judged and measured, since with rising prices in raw goods and materials, comes inflation, which can either be supply driven or demand led.

Indeed investors have frequently viewed physical commodities as fundamental store of value against the potential ravages of inflationary pressures. Precious metals such as gold or silver have traditionally been accumulated for this reason, although it is interesting to note that other commodities with strategic value such as energy and foodstuffs have also been viewed in this way as well. The question of course is whether the evidence supports this view and therefore whether commodities provide a good hedge in the longer term?

The empirical evidence suggests that there is indeed a positive correlation between commodity prices as measured by one of the major commodity indices, and inflation as measured by the CPI. However this correlation is neither particularly strong or consistent, and there is in fact much stronger correlation between these indices and the so called ‘unexpected inflation’ which occurs when the consensus of opinion and the actual CPI figures vary or diverge significantly. Overall, however the broad conclusion is that physical commodities broadly follow inflationary trends, and of course, as commodity prices rise, then the US dollar is likely to be weakening as a result, since commodities are generally priced against the US dollar.

Commodities as an asset class

One of the most common questions which is often asked is whether commodities can be considered as an asset class, in the same way as equities or fixed income investments. A better question might be whether we can expect to obtain a positive and consistent gain by holding commodities on a purely buy and hold basis, in a similar way to equities, and to answer this we have to look at the benchmark indices for commodities as well as consider the three reasons most commonly cited by investors for taking this approach.

The first of course is that commodities represent a hedge against inflation. The second is that commodities provide a degree of diversity in a portfolio given that they tend to have a negative and relatively poor correlation with equities and bonds.Third and last, commodities can provide attractive returns in their own right, particularly if an investor or speculator is prepared to leverage returns and also to actively manage the portfolio rather than adopt a buy and hold approach.

However, in order to consider this question in more detail one needs to consider the commodity indices in more detail, as these provide the benchmark against which the performance of commodities are measured, and in general there are two primary indices, the S & P/GSCI index and the Dow Jones UBS commodity index. Of these these S & P/GSCI index is the most popular, as it tracks the value of the most actively traded physical commodities including energy, industrial metals, ( and remember silver is an industrial metal not a precious metal ), precious metals, along with agricultural and livestock products. This index, like many others, is periodically reweighted since the energy group which of course includes oil, accounts for approximately 70% of the world production values of the physical commodities in the S & P/GCSI index, a perennial issue, and one which has caused commodity indices to be recalculated more regularly, following the sharp rise in oil prices in the last few years.

An alternative to the above index which has gained some traction in the last few years is the Dow Jones UBS commodity index, and like the S & P has a broad diversity of commodities in its core index, with the CRB Reuters Jeffries Index now also increasing in popularity. All of course, have their own weighting procedures, and all purport to provide the most accurate measure of the performance of the commodity markets in general. There are of course many others, but these are the primary indices that investors consider to be the benchmark for the commodity market and against which to measure investor returns on commodities as an asset class.

Timing of course is everything whether as an investor or a speculator. Gold for example, which everyone currently considers to be a one way bet, languished for many years around the $300 per ounce level and indeed fell in value for several years during the late 1990’s before finally starting it’s long bull run, which saw it reach over $1900 per ounce recently. So spectacular returns, even in the ultimate safe haven of a precious metal are never guaranteed.

The most popular commodity markets

The commodity markets broadly break down into four main groups, namely the grains or softs, which include commodities such as wheat, corn and soybean, the energy sector which includes gas and oil, the metals which covers gold silver and the rare earth metals, and finally the livestock markets for live cattle. Of these the most popular are the softs, the energy market and of course the metals which are covered in more detail in other sections of the site.

Each market of course has it’s own dynamic. The grains market for example is categorized on the basis of whether they are feed grains or food grains. Feed grains are products fed primarily to animals, and generally characterized as high in starch or energy content and include corn oats and barley, and are often referred to as course grains. Food grains on the other hand are primarily consumed by humans and include wheat and rice, with further groups covering such grains as oilseed which are crushed to produce vegetable oils, along with soybean oil, sunflower oil and canola oil. The most actively traded groups here are corn, wheat, soybeans, soybean oil and soybean meal. The supply and demand pattern of price discovery is heavily influenced by both the weather and growing conditions around the world, as well as global demand, and coupled with the fundamental news releases which occur regularly can lead to volatile price action in these markets. During the so called ‘non weather’ months, the focus generally shifts to demand issues including domestic consumption, and of course export demand.

Energy is of course a huge market, and one on which the modern world is powered, whether by oil, gas or other natural resources, with the emerging economies now placing ever increasing demands on the limited resources. As such, energy markets represent perhaps the most strategic of all the commodity markets, and as a result the energy sector is the most actively traded of all the physical commodity markets, with the WTI and Brent crude oil contracts leading the sector.

Livestock futures were originally developed by the CME in the 1960’s and indeed the CME is often referred to as the exchange that pork bellies built! Of course there are many different types of livestock, and the major groups traded on the CME are live cattle, lean hogs and feeder cattle. One of the key differentiating factors for this groups is of course that they are not seasonal. like grains, and as a result the fundamental analysis of this market is entirely different requiring an array of analytical tools, very different to those employed for soft commodities which are seasonal in nature. However, it is important to note that there is one important linkage, and this is between livestock and feed grains, since a rise in the price of cattle feed is likely to result in a consequent rise in live cattle prices in due course, once these prices have filtered through in increased costs of the feed.

Finally of course we have the metals, which includes gold and silver. Gold of course is not only a precious metal, but the ultimate safe haven in times of economic turmoil and an alternative to paper based assets, whilst also providing a hedge against inflation. Many traders wrongly believe that silver is also classified as a precious metal – in fact it is an industrial metal, and is predominantly used in a variety of industrial processes and therefore tends to mirror economic expansion and contraction as demand rises and falls. However, in recent years, with the spectacular rise in the price of gold, many investors have turned to silver as an alternative investment, resulting in a skewing of the price of silver, and distorting the price curve accordingly, something that is seen increasingly in the gold/silver ratio, a measure of the correlation between the two metals.