Physical Commodities: From Raw Materials to Investment Assets

Book: Commodities: Markets, Performance, and Strategies
Editors: H. Kent Baker, Greg Filbeck, Jeffrey H. Harris
Publisher: Oxford University Press, 2018
ISBN: 9780190656010

Chapter 7, written by Erik Devos, Seow Eng-Ong, and Andrew C. Spieler, kicks off Part 2 of the book. It explains what makes physical commodities different from every other financial asset you might invest in. And honestly, it is a lot more complicated than just buying a stock.

Commodities Are Not Like Stocks

When you buy a share of Apple, you own a tiny piece of a company. When you buy a bond, you own a promise of future payments. Clean, simple, digital.

Commodities are nothing like that. They are physical things. Wheat needs to be grown. Crude oil needs to be drilled, stored, and shipped. Every commodity type has its own quirks around quality, transportation, and shelf life. The actual physical stuff of the same class varies in quality too. Not all crude oil is the same. Not all wheat is the same.

This means that trading commodities involves way more moving parts than trading financial assets. You have to think about shipping costs, storage facilities, spoilage, and government tariffs. Because of all this complexity, regular retail investors almost never deal with physical commodities directly. Instead, they use derivatives like futures contracts or commodity ETFs. The actual physical trading is left to big players: producers, manufacturers, commodity trading firms, and large financial institutions.

Three Transformations

The authors highlight three key transformations that happen to commodities, and I think this framework is really useful for understanding the whole space.

Spatial transformation means moving commodities from where they are produced to where they are consumed. Think of grain being shipped from Iowa to China, or oil going from the Middle East to Europe.

Time transformation means storing commodities for later use. Crops get harvested once a year, but people eat every day. Storage smooths out the gap between production and consumption.

Form transformation is about turning raw materials into other products. Corn becomes feed for livestock. Crude oil becomes gasoline. Soybeans get crushed into meal and oil.

These transformations happen at different stages: upstream (production), midstream (transport and storage), and downstream (manufacturing and retail). Traders look at price differences between these stages and try to profit from them.

Super Cycles

The chapter covers commodity super cycles, and this is where it gets interesting for long-term investors. Super cycles are extended periods where commodity prices rise because of massive demand from industrializing economies.

Researchers have identified several of these. The nineteenth-century industrialization of the United States. The post-World War II reconstruction of Europe. And the rapid growth of China since 2000. During these super cycles, copper and other industrial metals saw price growth of 20 to 40 percent above their long-term trends.

But there is a counterpoint. The Prebisch-Singer hypothesis says that over really long time periods, commodity prices actually decline relative to manufactured goods. A study of 25 commodities spanning the seventeenth to twenty-first centuries found that 11 of them showed this exact pattern. The explanation? Commodity markets are highly competitive, so producers earn close to zero economic profit. Manufacturers, on the other hand, often operate in more concentrated markets and can charge higher margins.

Contango, Backwardation, and the Cost of Carry

The chapter goes deep into how spot prices and futures prices relate to each other. If you have heard the terms contango and backwardation thrown around but never fully understood them, this section is gold.

Contango happens when the futures price is higher than the expected spot price. The person agreeing to sell the commodity later needs compensation for storage costs, insurance, and other carrying costs. So the buyer is essentially paying for storage when they agree to the higher futures price.

Backwardation is the reverse. The futures price is below the expected spot price. This happens because of something called the convenience yield. If you are a manufacturer and you need a steady supply of copper to keep your plant running, actually holding that copper in inventory has real value to you. When this convenience yield exceeds the carrying costs, you get backwardation.

Airlines provide a great example of the complications here. They need to hedge jet fuel costs but there is no liquid jet fuel futures market. So they use heating oil or gasoline futures instead. These are imperfectly correlated with jet fuel, leaving airlines exposed to basis risk, which is the risk that the hedge and the actual commodity price move differently.

Who Trades Physical Commodities

The big players in physical commodity trading are commodity trading firms (CTFs) like Vitol (energy), Glencore (agricultural, metals, energy), and Cargill (diverse portfolio). These firms operate across the entire value chain: upstream, midstream, and downstream. They profit not from simple speculation on price direction but from performing the three transformations described above. They move stuff, store stuff, and process stuff at large scale.

Large financial institutions also got into the game, especially after the Gramm-Leach-Bliley Act of 1999 opened the doors. JP Morgan Chase, Goldman Sachs, and Morgan Stanley all built massive physical commodity operations. By end of 2012, these three firms held a combined $35 billion in physical commodity inventory.

Goldman Sachs even got a complaint filed against it by Coca-Cola in 2011. Coca-Cola claimed that Goldman was hoarding aluminum in Detroit and Chicago warehouses, disrupting supply chains and driving up aluminum prices. Since aluminum cans are central to Coca-Cola’s business, this directly hit their bottom line.

But the era of big banks in physical commodities may be ending. The Federal Reserve has been contemplating capital charges as steep as 1,250 percent on bank commodity holdings, which would make the business far less attractive.

What I Found Most Interesting

The wheat price comparison stuck with me. The authors cite research showing that the price difference for wheat between Omaha, Nebraska, and Portland, Oregon, was 18 times greater than the price difference for IBM stock trading on the NYSE versus the Paris stock exchange. That really drives home how much geography and transportation matter in commodity markets compared to financial markets.

This chapter does a solid job of laying the foundation for the rest of Part 2. Before you can understand agricultural markets, energy markets, or metals markets, you need to understand what makes physical commodities fundamentally different from everything else in your portfolio.

Previous: Fundamentals and Commodity Prices

Next: Agricultural Commodities Part 1: Grains, Oilseeds, and Crop Markets