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Financial markets

Commodity trading Insights into the first ever asset class

Before the development of today's global transportation networks, only the most expensive commodities were traded in bulk. Now commodities trading covers a wealth of goods from wheat and gold to oil and gas. 

Date
Author
Maggie Elliott, guest author
Reading time
4 minutes
A photographic composition of maize, beans, coffee and gold
From weather to geopolitics, the price of corn and other commodities depends on a wide range of political, regulatory and market-specific factors.

Commodities are raw materials used to create products like food, petrol, furniture, and clothing. Traded in large volumes, commodities are interchangeable with other goods of the same type, no matter where they're sourced. For instance, all Soft Red Winter wheat and Western Spruce-Pine-Fir timber is the same. While consumers don't buy wheat or timber directly, the companies producing bread or furniture do, often using commodity exchanges.

Commodity trading is fundamentally about supply and demand: low supplies of a commodity lead to higher prices; higher prices may lead to falling demand. Commodity exchanges allow manufacturers to manage their current and future requirements for raw resources. They offer a spot price, for delivery of a commodity immediately; or a future price, for delivery at a later date.

Storage to manage supply

A person wearing a woven sun hat harvests rice in a rice field
Receipts for future deliveries of rice in 17th century Japan foreshadowed today's futures trading. © istock/ti-ja

Commodity trading began around 9,000 to 8,500 BCE, when communities started exchanging agricultural goods. The desire to  stabilise prices, which were often affected by the weather or war, was an incentive to manage supply issues through storage.

This led to the development of the first forward contracts. Thought to have been created in 17th century Japan, buyers paid in advance for deliveries of rice. The grains were held in a warehouse for later consumption, allowing year-round supply, with merchants selling receipts for future delivery of the stored rice. These receipts were used as an informal currency, presaging the futures trading we know today. 

Trading empires

Scarcer commodities played an outsized role in the development of trading empires. Silver and gold, spices, tea, coffee and cocoa were traded between Asia and Europe. Increasingly sophisticated transport links facilitated this trade, which moved along the Spice and Silk Routes on both land and sea. Transport costs were always an issue until railways and industrial shipping changed the picture in the 19th century, lowering the cost of sending goods long distances.

The façade of a building in a large city decorated with two flags
Chicago: Thanks to the canal and rail links between the Great Lakes and the Mississippi River, the city became home to the world's first futures exchange. © Stefan Falke/laif

Nevertheless, commodities trading remained largely agricultural, and mostly localised, until the Chicago Board of Trade (CBOT) opened in 1848. Chicago was a central hub for agricultural commerce thanks to the canal and rail links between the Great Lakes and the Mississippi River, and it made sense to establish a central grain exchange here, benefiting farmers and buyers alike.

Other exchanges followed, including the Chicago Produce Exchange, which started with spot pricing for eggs and butter. In 1919, this became the Chicago Mercantile Exchange, which expanded beyond agricultural commodities like pork bellies and cattle to include metals and eventually financial futures. Today, almost all commodities can be traded on formal exchanges like these, and on global electronic trading platforms. 

Inflation; the commodity holder’s friend

Commodities are divided into two groups: soft and hard. Soft commodities are grown or raised, and include corn, wheat, rice, soybeans, and livestock. Hard commodities are mined or drilled, like gas, oil, coal, aluminium, and gold. But the risks and potential benefits of commodity trading are common to both groups.

As physical assets, commodities react differently to changing economic conditions to how stocks and bonds respond. Rising inflation is good for commodities: if the prices of goods increase, so do the prices of the commodities used to produce them. Thus investing in commodities may provide a hedge against inflation. (Stocks and bonds do better with stable or falling inflation, since rising inflation lowers the value of future dividends and coupons paid by stocks and bonds.)

Low correlation with traditional asset classes

Performance over time is also different. Since 1970, annual returns on the broad Bloomberg Commodity Index show very low correlation with equities on the MSCI World Index. The correlation is close to zero with global bonds on the Barclays Global Aggregate Index. By contrast, the Bloomberg Commodity Index is positively correlated with the OECD's inflation figures.

Gold moulded into bars in a refinery
As the most defensive of asset classes, gold - seen here at a refinery being formed into bars - glitters amid geopolitical uncertainty. © Getty Images/Andrew Rudakov/Bloomberg

These low correlations with traditional asset classes mean that commodities can provide diversification within a portfolio, lowering volatility and risk, and improving returns. 

Susceptible to specific risks

But diversification and inflation hedging cannot protect investors against the risk of loss. Thanks to their physical nature, commodities face risks that don't directly affect financial assets: the weather can influence the price of grain, livestock, and natural gas; geopolitical instability moves gold and oil values; and labour issues like strikes affect the price of metals and minerals.

Commodities can also be impacted by political, regulatory, and market conditions. Gold, for example, a global store of wealth, tends to rise in value at times of political instability. The prices of hard commodities can be modified by regulatory changes (including sanctions) that rapidly alter the supply and demand equation.

Many ways to invest

A typical American breakfast of eggs, bacon, pancakes and coffee from a bird's eye view
Instead of buying physical commodities, financial investors buy exchange-traded funds (ETFs) or futures and commodity indices - including an index made up of just American breakfast commodities. © Getty Images/Alexander Spatari

Financial investors rarely acquire physical commodities, except gold and silver, to avoid storage, insurance and liquidity costs. Instead they use exchange-traded funds (ETFs), or futures and commodity indices. ETFs based on broad commodity indices give the widest access, typically with exposure to energy (natural gas and crude oil); grains (wheat, corn, and soy); soft agriculture (cotton, cocoa, and sugar); industrial metals (aluminium, zinc, copper, nickel, and lead); and precious metals (platinum, gold, and silver).

Energy usually makes up the largest part of these indices, which can be unattractive to investors steering clear of fossil fuels. But there are also indices covering a narrower range, like industrial or precious metals, or soft commodities. One index only includes American breakfast commodities: bacon, orange juice, wheat, coffee, and sugar!

Limit commodities in a portfolio

Investors can also buy stocks or futures in companies that produce, process, or distribute commodities. Commodity futures are mainly traded by industrial manufacturers or specialist professional traders; they are too risky for individual investors.

Finally, although commodities can offer potential investment benefits, they are as volatile as equities. So investors should only include a small percentage of commodities alongside stocks and bonds when constructing a diversified portfolio.

Stacked gold bars in a bank vault
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