Asset Allocation Part - IV : Introduction to Commodities

Commodities are products that come from earth.  Common commodities are wheat, rice, gold, silver, copper, iron, crude oil and many more. Commodities are used as raw materials by businesses for production of other goods or services. They are converted into different value-added products which are then purchased by other businesses or by individuals and families for consumption.  A commodity is essentially same product regardless of the producer. Same commodity from different producers can be inter-changed with one another as long as they are of same quality.

Types of Commodities

Commodities can be grouped into three categories – agricultural, metals and energy commodities. Let us discuss them further –

• • Agricultural commodities – Agricultural commodities are an important source of food for humans and animals. Common examples of agricultural commodities are wheat, rice, soyabean, various pulses, sugar, coffee and many more.
  • Energy commodities – Energy commodities are used by automobiles for providing transportation services and by factories to generate heat and electricity. Energy commodities are also used to generate plastic. Common example of energy commodities are crude oil, natural gas, coal and many more.
  • Metal commodities – Metal commodities have many industrial (like factories, machinery, tools, and many more) and household uses(like cars, wires, fan and many more). Common examples of metal commodities are Iron, gold, silver, copper, nickel and many more.

History of commodities trading

Ancient trade was essentially commodity trading where two people exchanged their produce under barter system. However with evolution of money, kingdoms were responsible for creating and managing complex systems for commodity trading. Commodity trading used to serve as wheel of economic development, commerce and taxation for the kingdom. And over a period of time a lot of financial products (like derivatives, exchanges) and laws (like laws governing contracts) were created to resolve various issues observed while undertaking commodities trading.

Who all are involved in commodities trading

There are three groups of people who are involved in commodities trading –

• • Producers – Organizations or people who are involved in producing the raw commodity. They are essentially sellers of various types of commodities which is used to create other products.
  • Consumers – Essentially organizations who buy raw commodities for production of other value added products. For example Reliance buys crude oil to produce petrol and other Petro-chemical products. These products are then be sold to other end-users or consumed internally.
  • Speculators – Essentially traders who take bets on future price movement of a particular commodity in order to generate profits. Speculators can be large organizations or individuals looking to generate profits by trading in commodities.

How are commodities traded?

Commodities are traded in two ways – 1) retail purchase by individuals and 2) bulk purchase by large organizations.

Individuals or families make retail purchases. They buy various commodities like food grains, gold, silver, petrol and others in small quantities from a local market shops for daily consumption.

Various government and private sector organizations make bulk purchase in large quantities for various commodities via – 1) spot exchanges (National Spot Exchange Limited (NSEL)) for immediate consumption and 2) commodity exchanges (e.g. Multi Commodity Exchange of India (MCX) and National Commodity and Derivatives exchange (NCDX)) for immediate and future consumption. Both spot and commodity exchange are regulated by various rules and regulations.

Spot versus Forward Transaction

Commodities trading happens in two ways by undertaking – 1) spot transactions and 2) forward transaction.

In a spot transaction, the trading, clearing and settlement happens instantaneously, i.e., ‘on the spot’. Consider this example, today Lakshmi wants to buy 100 gms of Gold. The goldsmith quotes her INR 25,000 per 10 gms. They agree on this price and Lakshmi buys 100 gms of Gold. She pays INR 25,00,000 takes the Gold and leaves. This is a Spot transaction.

Now suppose, Lakshmi wants to buy 100gms of Gold next month. The goldsmith quotes her INR 26,000 per 10 gms. They agree on the ‘forward’ price for 100 gms of Gold at Lakshmi wants to buy and Lakshmi leaves. A month later, she pays the goldsmith INR 26,00,000 and collects her Gold. This is a forward contract where two parties irrevocably agree to settle a trade at a future date, for a stated price and quantity. No money changes hands when the contract is signed. The exchange of money and the underlying goods only happens at the future date as specified in the contract. In a forward contract, the process of trading, clearing and settlement does not happen instantaneously. The trading happens today, but the clearing and settlement happens at the end of the specified period. Forward contracts in form of futures and options are traded on commodity exchanges.

Factors impacting commodity markets?

In general, commodity prices are impacted by these factors –

• • Supply – Any disruption in supply of a commodity causes its prices to rise. This disruption can be caused due to multiple factors like closure of mines, political unrest or change in laws of the country. Similarly oversupply of the commodity will send its price crashing downwards. Oversupply can be caused by opening of new mines or due to technological changes like finding better methods of mineral extraction.
  • Demand – Any change in demand for a commodity also causes the prices to change. If the demand increases the prices rise and similarly when the demand decreases the prices fall. This change in demand can be caused due to new applications for commodity or because of change in availability of more suitable replacement for commodity. For example, replacing petrol driven vehicles with electricity driven vehicles will cause the demand for petrol to decrease.
  • Existing inventories and stock – Inventories are created over time to meet unexpected disruptions in supply of commodity. Existing inventories of a particular commodity help us overcome these temporary disruptions. Thus existing inventory levels of a commodity impact overall commodity pricing.
  • Inflation – Inflation reduces purchasing power of money. Assuming that demand and supply of commodity are in perfect harmony and do not change then price of commodity will increase at the same rate as inflation.
  • Geopolitical factors – Various factors like laws and order situation, government policies towards environment, mining, labor and taxation also impact commodity prices. These factors can lead to change in overall demand and supply of commodity which in turn impacts its price.

Why people invest in commodities?

In India, most common commodities used for investment purposes are gold and silver. Of which gold is considered as primary investment option by many Indians due to following reasons –

• • Throughout history,  gold is considered special and respected as a store of value throughout the world. As a global store of value, gold can provide financial cover during geopolitical risks and economic uncertainty.
  • It is the metal we fall back on when other forms of currency does not work.
  • Owning gold is a protects us against inflation and deflation.
  • Gold helps us in building a diversified portfolio with proper asset allocation.

Conclusion

In this article, we have provided you information about Commodities, different types of commodities, history of commodity trading and different people involved with commodity trading. We have also explained how commodities are traded, factors impacting commodity trading and why people invest in commodities. For more information please feel free to reach out to us via email at – enquiry@taptoprosperity.com or by phone – 91-9515475381.

Next Article – Asset Allocation Part – V : Introduction to Equity

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