Commodities underpin our way of life…
Commodities underpin our way of life…
They are the raw materials of our food, clothing, mobility, heating, medicines and entertainment, and crude oil is the most traded commodity in the world. It is a vital constituent of gasoline for cars, kerosene for jet fuel, feedstock for chemicals, plastics and pharmaceuticals as well as consumer products such as nylon, toothbrush bristles and Liquid Petroleum Gas for cooking. Base metals, including aluminum, nickel, copper and iron ore, remain essential for old economy industries including steel, electric wiring and the pipes in construction. For the new economy industries, including laptops, smartphones, tablets and electric car-batteries, strategic commodities such as tantalum, lithium and cobalt are vital — so much so, that their prices have tripled in the last two years according to consultancy CRU.
What is a commodity?
Commodities are the raw materials of our consuming universe and undifferentiated wherever one lives. For example, the natural gas used for heating homes in London is no different from that used in Rome or Moscow. Energy, metals, livestock and agricultural products are the three most valuable traded commodities. Energy is headed by crude oil worth some $788 billion in 2015, heating oil, natural gas and petrol. Precious metals like gold, silver and platinum and traditionally traded base metals have been augmented by the strategic metals of new industries. Traded agricultural products include coffee, beans, wheat, cotton, corn, sugar, oats, rice, soybeans and animal products, either on the hoof or frozen, and eggs. One must also think of service commodities such as internet bandwidth, carbon credits and crypto currencies, including Bitcoin, Monero and Ethereum.
The commodity cycle: boom and bust
Prevailing business conditions, such as market confidence, government trade policies, currency fluctuations as well as weather conditions, are the principal factors affecting the demand, supply and price of commodities, and these factors vary from commodity to commodity and over time. Commodity trading notoriously follows a cycle of boom and bust. A case in point is the spectacular rise in the price of crude oil to a peak of $114 a barrel in summer 2014 and its subsequent collapse to $28. Weakness in commodity trading in 2015 was due to such factors as economic slowdown in China, severe recession in Brazil and falling prices for oil and other commodities alongside exchange rate volatility. In January 2018, the record setting cold in the U.S. and northern China triggered a surge in prices of natural gas. Brent crude oil rose to $70 dollars a barrel on the back of OPEC and Russian production cuts, a fall in U.S. crude inventories and the pending U.S. decision on whether to extend temporary waivers on sanctions against Iran.
The price of an individual commodity generally rises and falls in a cycle. A reduction in economic growth is accompanied by a fall-off in demand and price. This discourages investment until supply and demand are rebalanced and then prices rise, which in turn encourages additional investment and when supply overshoots demand the price again falls.
Factors affecting demand and supply
Demand for energy and metallic commodities is directly related to levels of economic growth and market confidence. Rising disposable income and population around the world underpins primary demand for agricultural products. Tougher environmental government policies and subsidies for renewable energy are reducing demand for coal by utilities. A case in point is the U.K. which plans to close all its coal plants by 2025.
Supply of commodities also depends on incentives such as rising and high prices which encourage farmers, miners and drillers to increase output over time in order to capture higher profit margins. Uniquely, shale oil drillers are highly responsive to rising prices with just a 4-6 month gap between drilling and production but agriculture and mining have a much longer cycle.
Who trades in commodities?
A commodity broker executes orders to buy or sell commodity contracts on behalf of clients for a commission. A trader works on his own account, physically owning the commodity and profits from the difference between the buying and selling price. But the world’s leading traders are, in fact, companies like Vitol, the largest physical trader in oil and gas, Glencore in minerals, Cargill for agricultural commodities including biofuels and Trafigura for energy. The bulk of commodity trading is centered on commodity exchanges in London, Frankfurt, Chicago and New York. For instance, the London ICE Exchange accounts for half of all crude oil and derivatives traded worldwide. The New York Mercantile Exchange (NYMEX) focuses on natural gas and oil and the London Metal Exchange (LME) covers aluminum, copper, tin, nickel, zinc and lead.
Commodity contracts include futures, options and similar financial derivatives. Clients who trade commodity contracts are either hedgers, using the derivatives markets to manage risk, or speculators, who are willing to assume the risk from hedgers in hopes of a profit. A futures contract offers the producer or trader a known price for delivery at a future date. Farmers sell their crops early in the growing season at a guaranteed price for delivery after the harvest. The spot market entails the customer payment within two days of the contract and prices are in real time reflecting supply and demand. For example, the recent (December 2017) simultaneous force majeure on the Forties pipeline and the explosion at Austria’s Baumgarten gas hub immediately caused a major surge in gas prices.
Commodities are the vital components of human existence on our planet and their exploitation continues to be the essential vehicle both of world trade and domestic economies.
READ MORE: Energy traders words by Nicholas Newman