In some ways, commodity trading is the purest form of investing. There is no derivation, no abstraction, no three levels of suppression of the underlying asset. There is just something tangible and useful – food, fuel – and a huge market with multiple players. This last point is important: the more buyers and sellers of a commodity, the more likely it is that its market price can be influenced by manipulation. The price of commodities is as close as the real world gets to the classic economic concept of the demand and supply curves of a good intersecting at a particular price and quantity.
Take cocoa, which in April 2021 was selling for around $ 2,420 per tonne or $ 1.21 per pound. The price of this raw component of chocolate production fluctuates more than you might think, ranging from less than $ 1,780 to over $ 3,400 between 2015 and 2021.Demand for cocoa is fluctuating to the point that an unexplained global craving for chocolate last summer pushed prices up to record highs.
But it is changes in supply, not demand, that dictate most price movements. At least as far as this particular product is concerned. And the supply depends on various ecological factors, beyond the control of the people who grow cocoa for a living. Temperatures should be around 70º to 90º, with heavy but not too heavy rainfall (no more than 100 “per year).This is not to make it an introduction to growing cocoa, but there is a rigid set of conditions for optimal growth. The imbalance of a single criterion can lead to lower supply and therefore higher prices.
Cocoa is produced far from global financial centers, mainly in Côte d’Ivoire and Ghana, by many small family farmers. Having many suppliers offering a uniform product means that each individual supplier has little influence on the price. Compare that with another commodity, gold.
At $ 1,760 an ounce in April 2021, the price of gold has fallen more than 15% from its 2020 high. And as recently as 2000, you could buy an ounce for $ 250.??This despite an annual gold production of 2,500 tonnes on average during this period, and varying only about 10% in both directions.If gold production is so consistent from year to year, why would there be such large price fluctuations?
The straightforward answer is that gold is in demand because it is so much more than a visually appealing part of jewelry. Unlike cocoa, cattle and pork breasts, gold lasts forever. Small and compact, it can and is itself used as currency. When forex traders fear taking too long a position in dollars, pounds sterling or euros, gold remains a reliable store of value. It is much easier for central banks to print fiat currency as much as they want (and therefore reduce the value of each unit) than for the global gold supply to magically increase.
Supply and demand therefore set prices. Who knew? More importantly, what to do with all this new information? The average investor only consumes commodities, instead of speculating on them. What is the advantage of knowing the factors that explain the market price of cotton or soybeans?
This is not a rhetorical question. If you compare the current price of a commodity to that of a futures contract for that same commodity, you will save yourself the trouble of having to learn about annual rainfall in West Africa and / or the monetary policy of a central bank. Instead, the details of market forces can be distilled into that one thing a smart investor can capitalize on: futures.
Let’s use yet another product as an example. As of this writing in April 2021, wheat costs $ 6.48 a bushel. Futures contracts expiring in September sell for $ 6.52.This means that speculators are offering wheat growers (well, wheat brokers) a small premium for a few months. Both parties to the deal, speculators and farmers alike, believe the price of wheat will rise by then. Speculators hope it will exceed $ 6.52, farmers hope it will stop somewhere below that number, but in any case, we expect wheat prices to rise.
It continues. Futures contracts expiring in December sell for $ 6.60 and climb to $ 6.64 for the following quarter.The reasons are irrelevant. It doesn’t matter whether Chinese and Indian consumers switch to wheat-rich Western diets or new cultivars increase crop yields. All an investor needs to know is that prices should rise and continue to rise. In fact, you can even start with futures prices and then go back and compare them to the relatively discounted current prices to notice which direction the prices are moving.
The bottom line
Karl Marx believed that the amount of work involved in creating a good determined its value. Karl Marx was, to put it mildly, full of garbage. Cocoa farmers didn’t work five times harder when their product sold for $ 3,750 a tonne than when it sold for $ 750. A wise investor knows this and by extension knows that the only way to make money in the commodities market is to anticipate price movements. What isn’t easy to do is why most people stick with mutual funds and exchange traded funds (ETFs). But for the curious investor who wants to broaden their horizons, commodities can be a lucrative but volatile addition to their portfolio.