What Are Commodities? A Quick Overview of Markets and Instruments
Book: Commodities: Markets, Performance, and Strategies
Editors: H. Kent Baker, Greg Filbeck, Jeffrey H. Harris
Publisher: Oxford University Press, 2018
ISBN: 9780190656010
A Really Old Market
Commodities have been traded for thousands of years. We are talking sheep, goats, and pigs being used as money back in 1500 BC. Rice futures traded in China over 2,000 years ago. The word “commodity” itself comes from the French word commodite, meaning benefit or profit, and dates back to the 1400s.
The first modern organized futures exchange started in 1710 at the Dojima Rice Exchange in Osaka, Japan. Merchants stored rice in warehouses for future use and traded contracts based on that rice. In the United States, futures trading kicked off in the mid-1800s at the Chicago Board of Trade (CBOT), the oldest commodities exchange in the country.
So when people talk about commodities like they are some new alternative investment, keep in mind that humans have been trading this stuff for millennia.
How Commodities Are Traded
There are two main ways to trade commodities: directly and indirectly.
Direct trading means buying the actual physical commodity. You buy gold bars, barrels of oil, or bushels of wheat. Most people do not do this because it comes with a bunch of headaches like storage, insurance, and quality control.
Indirect trading is way more common. This includes futures contracts, options, and exchange-traded funds (ETFs). Most individual commodities are traded through futures, where you are not buying the commodity itself but rather a contract to buy or sell it at a certain price by a specific date.
Why futures? Two reasons: speculation and hedging. Speculators try to profit from price movements before the contract expires. Hedgers use futures to lock in a price so they are protected from wild swings. A farmer might lock in the price of corn before harvest. An airline might lock in fuel costs months ahead.
Commodity futures and options are highly leveraged, meaning you can control a large position with a relatively small amount of money. They are traded in contract sizes rather than shares. This makes them accessible but also risky.
Benefits of Commodity Investing
The chapter lays out several reasons investors look at commodities.
Diversification is the big one. Harry Markowitz showed back in 1952 that combining assets with low correlation can lower your portfolio risk without giving up returns. Commodities historically have had a low or even negative correlation with stocks and bonds. When stocks go down, commodities might go up, or at least not fall as much.
Inflation hedge is another draw. Commodities tend to have a positive correlation with inflation. When prices rise across the economy, the raw materials that feed into those prices tend to go up too. Stocks and bonds do not always keep pace with inflation, so commodities can fill that gap.
Potential for strong returns exists, though the evidence is mixed. Some research (Bodie and Rosansky, 1980; Gorton and Rouwenhorst, 2006) found that unleveraged commodity futures indices delivered stock-like returns historically. Other researchers found limited evidence of consistent risk premiums for individual commodities.
The Risks Are Real
Here is the thing: commodities are volatile. Returns tend to be positively skewed and have fat tails (leptokurtic in finance speak), meaning extreme price moves happen more often than you would expect from a normal distribution.
The chapter is honest about this. Commodity prices will not go up in a straight line. Some periods will have negative returns. Investors who are not prepared for substantial volatility can get hurt.
Another important point is that most commodity return distributions show high extreme risks. You can make a lot of money, but you can also lose a lot. Positions can be long or short, and the leverage involved amplifies both gains and losses.
Four Ways to Invest
The chapter outlines four main approaches to commodity investing:
1. Direct Investment in Physical Goods
This gives you the purest exposure to a commodity’s price. But you need to worry about quality, storage costs, insurance, and the opportunity cost of tying up your cash. For most investors, this is not practical.
2. Stocks of Natural Resource Companies
The most common indirect approach. Buy shares in companies that produce or process commodities. Mining companies, oil producers, agricultural firms. The catch is that your return depends on both the commodity price and the company’s stock performance. Sometimes a mining stock goes down even when the metal price goes up, because the company has its own problems (management issues, debt, production problems).
3. Commodity Mutual Funds and ETFs
These give you exposure to commodities through a single investment vehicle. ETFs track the performance of a specific commodity or a basket of commodities. They are simpler than managing futures contracts yourself. Good for investors who want diversification and hedging without the complexity.
4. Commodity Futures
The main trading groups include energies, grains, metals, meats, and more. Futures carry greater volatility and potential for both losses and gains. But disciplined investors can use them well.
When you hold a futures contract, you do not take delivery of the commodity (usually). At maturity, you close your position with an opposite trade or roll the contract forward. You do need to post margin, which is a deposit to cover daily price fluctuations. Positions are adjusted daily through mark-to-market.
What Drives Commodity Prices?
Forecasting commodity prices is hard. Supply and demand are the main drivers, but they are influenced by everything from weather and geopolitics to monetary policy and technological change.
The chapter notes that commodities with the best opportunities for gain tend to have two things in common: they are geared to global growth, and supply constraints exist. Unlike stock prices, which reflect long-term expectations about a company’s cash flows, commodity prices are driven by supply-demand dynamics that are often short-term.
Energy prices are especially important. They made up over 56 percent of the S&P GSCI Commodity Index in 2017. When energy prices move, the whole commodity sector feels it.
The Big Picture
This first chapter sets the stage for the rest of the book. The key takeaway is that commodities are a legitimate asset class with real benefits for portfolio construction, but they come with serious risks that investors need to understand.
Over the long run, commodities have given investors a positive real rate of return. But the path to those returns is bumpy. The 28 chapters that follow explore every angle of this market, from the economics and regulation to behavioral biases, derivatives, and trading strategies.
It is a lot to cover, and we will work through it step by step.