What does commodity mean?
Commodities are raw materials that usually come from natural sources. Examples could include beef, oil or precious metals such as gold.
They are treated as “fungible” goods. Basically, this means that the coffee beans grown by one farmer will be treated exactly the same as a farmer on the other side of the country as long as they are of the same quality (or grade.)
Explained: the types of commodities
Generally, commodities are split up into four distinct categories. They are:
· Agriculture: Wheat, corn, sugar, rice, coffee and cocoa are examples
· Livestock: Although this could technically fall under the agriculture category, live cattle, feeder cattle and live hogs are classified separately
· Metals: This is one of the best-known commodity categories – featuring gold, silver, platinum and copper
· Energy: Oil, brent crude, natural gas are among the goods in this category
Many commodities are priced by weight – with quotes for everything from wheat to gold delivered in ounces, pounds and even tons. Oil tends to be priced by the barrel.
Why commodities matter
Commodities are crucial for the business world, as corporations that sell large amounts of product need to buy these raw materials in bulk. A chocolate company would be nothing without cocoa and sugar, while a coffee company would be stuck selling tea if it didn’t have a generous supply of beans. Airlines are heavily dependent on oil.
Prices can fluctuate on a regular basis – and usually, market movements are driven by supply rather than demand. Plentiful amounts of wheat in the marketplace will usually mean businesses pay less, while a disappointing crop could mean this commodity comes at a premium. Purchasing at the wrong time can squeeze profit margins, leaving retailers with no choice but to increase prices for shoppers.
The power of futures contracts
To give the companies producing the commodities consistent sales, and to ensure that businesses know how much they will be paying for raw materials in advance, futures contracts are commonly used. This is an agreement between buyers and sellers to complete a transaction for a set quantity of a commodity, at a set price, on a specific date.
Futures can be beneficial for buyers and sellers alike. Let’s imagine that the current price for a kilogram of coffee is $2.50, and a café chain agrees with a producer to buy a ton of beans at $2.60 a kilo in a year’s time. When the delivery date arrives, both parties are committed to see the deal through – irrespective of how prices have changed. If prices on the day stand at $2.40, this represents a $0.20 gain per kilo for the seller. But if prices have settled at $2.80, it’s a big saving for the buyer.