Today commodity trading has become advanced with financial instruments such as futures contracts, derivatives, options, and swaps. The most common trading items all over the world are crude oil, gold, silver, copper, natural gas, and soybean.
The world’s largest commodity exchange is in the US known as the Chicago Mercantile Exchange (CME). In India, there are six commodity exchanges, Multi Commodity Exchange (MCX), National Commodity and Derivative Exchange (NCDEX), National Multi Commodity Exchange (NMCE), and Indian Commodity Exchange (ICX). All the commodity exchanges in India are regulated by SEBI (Securities and Exchange Board of India).
How does commodity trading work?
Commodity trading has been there since the dawn of ancient civilization. Ancient kingdoms and tribes thrived on the exchanges of goods through the barter system. A popular example of commodity trading is the Silk Road route that connected the East to Europe, where trading flourished.
The most common trading in commodity trading takes place with futures contracts and spot prices. Futures contracts obligate the holder to buy or sell the commodity on the predetermined delivery date. As an example, if you bought a future contract till 15th August 2022, you would have to buy or sell the commodity on the market price at that date. Not all futures contracts are the same and they differ based on the commodity being traded.
The spot price or cash price is the actual price of the commodity on today’s date. For example, if an oil refiner buys 20,000 barrels of oil for $60 today, then $60 is the spot price of the current oil market.
How is each commodity price determined?
Commodities come in many forms, including crops, energy sources, and precious metals. Traders buy and sell using derivative contracts that use physical commodity as their fundamental.
Metals: Metal commodities consist of gold, silver, platinum, and copper. For example, Indian women hold 11% of the world’s gold since it has the status of reliability and investment value. Gold is one of the most actively traded commodities because it is used to produce jewellery and other goods. When banks and money are seen as unstable or political stability is questioned, gold is sought out for value and safety. Gold is usually traded as a function of sentiment so the laws of demand and supply are affected less. This is because the new gold mines supply outweighs the hoarded gold by people. So, when people try to sell gold the prices go down.
Energy: Energy commodities include crude oil, natural gas, and gasoline. Global economic development and the rise in the demand for oil and energy-related products has made the prices go up. Investors interested in entering the commodities market in the energy sector should be aware of economic shifts because new alternative energy sources such as wind, solar, and bio-fuel seeking to replace crude oil as the primary source of energy can have a huge impact on the market prices for commodities in the energy sector.
Agriculture: Agriculture commodities consist of wheat, corn, rice, cocoa, cotton, sugar, and coffee. In the agriculture sector, the commodities price can be volatile during the summer or due to the period of weather-related transitions. For example, prices of onions in India have hiked due to erratic rainfall. So, the farmers are forced to invest in irrigation facilities. As a result, the producers are forced to sell at a higher price. Similarly, due to floods, crops get destroyed. So, the supply and storage are limited but the customers continue to demand. Therefore, the excess demand with limited supply shoots up the price.
Factors that affect the price of Commodities
Since commodities are traded on exchanges, their prices aren’t set by a single individual or entity. Many factors and catalysts affect the commodity price everyday.
Demand and Supply
This is one of the main factors for the determination of a commodity price. When there is high demand for a commodity and the supply is less. The buyers outnumber the sellers, so the price increases. Similarly, if the sellers outnumber the buyers, the price goes down.
For instance, during the winter season, the need for heating is in demand, so the price of fuel such as natural gas is higher.
Some commodities specifically produced in a certain region can face a great deal of uncertain political tensions. For example, crude oil is largely produced in the Middle East. That means the price of oil can be influenced by tensions that occur there. When the USA imposed economic sanctions on Iran, the crude oil prices were trading at a higher price since the Iranian crude oil supply was cut-off.
Speculation trading is all about making a profit. So, a speculator enters a market with the primary aim of making a profit without having to take any physical possession of the commodity. For instance, a lot of people feel that the future of a particular commodity is promising, they may start buying the commodity in large numbers, thereby increasing the price of the commodity. Speculators in the commodities market maybe individuals or institutional investors trading in high end markets to make profits from commodities price movement.
The growth of a country can also affect the price of a commodity. This is because the economic prosperity of the country determines the buying power of the population. The effect is seen commonly in countries that are major producers or major buyers of the commodity. A good example is the country of Venezuela, a major oil country. The government damaged the country’s oil industry with corruption, lack of investments, and cash shortages. This caused economic downfall and hyperinflation.
Mother nature also has its role in determining commodity prices, especially in the agriculture sector. A favorable climate may result in an abundance of commodities resulting in oversupply and a price decrease. Similarly, harsh weather can destroy commodities, leading to shortages in supply and an increase in demand, which in turn increases the price of the commodity.
Transportation and Storage Costs
Although not a major factor, transportation can also play a part in moving commodities prices. For example, sometimes crude oil tankers double up as storage facilities during the time of oversupply. This action has the effect of taking available tankers out of the transportation market, costing more in shipping rates.
As shown above, many factors can play a role in determining the price of commodities. At times, factors such as government policies can be predictable whereas some factors such as natural disasters are unpredictable. It is important to familiarize yourself with all the major factors so you can be prepared for trading in the commodity market. Trading in the commodity market is a high-risk business so it is important to employ risk-taking strategies and choose a well-trusted provider for those services. At Goodwill, we offer those trusted services to our customers. You can start your commodity trading journey with us by opening a Demat account here.