Popular Commodities (Part I): What is Commodity Trading?

Author (s): Yew Jin, Gordon Ong & Grace Chan
| Market Insights | March 2018

Commodities are raw materials that are used as inputs in the production of goods and services, and thus play an important role in sustaining civilisation. Commodity quality are essentially uniform across producers, and those that are traded on an exchange must meet a specified minimum standard (basis grade). In recent years, more investors have turned their attention to the world of commodities due to the inherent trading advantages. In fact, billions of dollars are invested in commodities every day.

 

There are numerous ways for an individual investor to gain exposure to commodity prices, including exchange-traded funds (ETFs), exchange-traded notes (ETNs), options, mutual & hedge funds. Investors can also gain exposure by investing in mining and other commodity-related companies, even though most will only trade in one commodity. However, the most popular way to invest in commodities is through a futures contract – an agreement to buy or sell a specific amount of the underlying commodity at a specified future date and price.

 

We interviewed Cherilyn, a Year 2 business student specializing in banking and finance, on some features of the commodities market that potential investors should know before investing. Cherilyn has been investing in equities since she was 16, and has had exposure to commodities during her internship at the oil trading arm of Caltex Australia.

 

Physical Trading vs Paper Trading

“In commodities trading (some big trading houses include Shell, Total, BP, Exxon), there are generally 2 types – physical and paper trades,” said Cherilyn. “Physical trading involves moving physical commodities from point to point for consumption while paper trades do not. The latter is similar to the stock market that we are familiar with.

 

“[For instance], physical trading, especially in oil & gas, heavily involves the shipping industry as transport takes up a huge part of each trade. In oil trading houses, there are usually huge shipping and chartering teams. Transport can easily erode profits as hiring of vessels easily cost hundreds of thousands of dollars. That is one main difference and interesting part about physical trading.”

 

Volatility and Seasonal Trends

“The commodities market is affected by very genuine and tangible supply and demand forces by consumers like us,” commented Cherilyn when asked for why the commodities market is different from other markets or investment instruments. “For oil,” she said, “prices always spike in December as people require more fuel to burn and get them through the winter. For the supply side, movements by OPEC is one of the biggest influencing factors. In Agri commodities like sugar, corn, wheat, weather definitely plays a big part.”

 

Widely traded commodities

There are many types of commodities that can be traded in the market. Tradable commodities can be grouped into 3 main categories, which are Agriculture, Energy, and Metals:

 

Agriculture Energy Metals
Corn #1 Crude Oil #4 Gold
Soybean #3 Natural Gas Silver
#2 Coffee #5 Brent Oil Aluminum
Sugar Platinum
Wheat Copper
Cotton Tin

 

Let us now look at some of the most popular commodities traded today.

 

#1 Crude oil (WTI crude)

Crude oil is unprocessed oil found beneath the earth’s surface, and is used in the production of a wide range of products from plastics to petroleum. Due to rising demand from emerging countries, it has become the most traded commodity in the world today. But did you know that there are actually different oil markets? Based on their level of liquid density to water and sulfur content, crude oil is gauged by different indexes such as West Texas Intermediate (WTI) and Brent. Depending on their sulfuric content, oil can be classified as sweet or sour. As sweet oil is rarer and easier to process due to its higher purity, investors tend to prize sweet oil at a premium over its sour counterpart. Major crude oil exporters come from the Middle East, as well as Norway, Nigeria and Mexico.

The price of commodities and the USD have historically been inversely correlated, as the USD is the reserve currency of most countries. USD appreciation will therefore reduce investors’ buying power as more currencies is required to buy each USD. The demand of commodities will then fall, leading to a drop in the price of commodities. However, in the case of WTI and USD, the relationship has increasingly become positively correlated as seen in the graph below, due to the USA’s growing role as a dominant oil producer and her growing oil exports over imports.

Trends or policies related to USD valuation are thus also something to look out for when investing in crude oil. As what Cherilyn has mentioned, the price of crude oil is known to fluctuate wildly with regards to global events, making it a challenging yet potentially rewarding investment.

 

#2 Coffee

The second most traded commodity is coffee. Produced mainly in Latin American and Southeast Asian countries, its high demand is mainly derived from the high coffee consumption rates in the United States and Europe. It is estimated that over 2.25 million cups of coffee are drunk worldwide every day!

 

#3 Natural Gas

The third most traded commodity is natural gas. Used everywhere from heating homes to product manufacturing, it has a volatile market. Demand for natural gas has increased sharply in the last two decades due to its relative environmental friendliness. With the world’s crude oil reserves depleting, it is steadily rising as a viable fuel alternative.

 

#4 Gold

Of all the precious metals, gold is the most popular for investment purposes. Previously used as currency, the versatile metal has emerged as an intrinsic part of the portfolio of investors after the Global Financial Crisis in 2008 and is expected to continue doing so in the future. Although it has a history of cyclical performance, the strong symbolic meaning behind the metal, as well as ongoing uncertainty on the global economic front, strengthens the case for gold consumption. In 2016, 55% of the gold bought were used for production of jewelry and electronics, while 45% were used for investment purposes (Statista, 2018).

Even so, trends in the gold market should also be observed alongside those in the silver and copper markets, as these metal markets are closely interlinked (Douglas, 2007). This is because as currencies get devalued or economies experience inflation, more investors will place their money in metals to preserve the value of their wealth. These metals thus serve as hedging tools in unfavourable market conditions.

#5 Brent Oil

After WTI crude oil and natural gas, Brent Oil is the fifth most traded energy product in the market. The name stems from a collaboration between ExxonMobil and Royal Dutch Shell. Brent Oil makes up two-thirds of the global oil production, and is used in the production of gasoline and diesel. The main difference between Brent Oil and WTI Crude Oil is that Brent Oil is heavier than WTI Crude. Brent Oil is mostly found and refined in the Scandinavian countries, and is popular among the European and African nations.

 

Relative Performance of Top 5 Commodities, 2013-2018

Legend:
Orange White Purple Green Blue
Crude Oil (WTI) Brent Oil Coffee Natural Gas Gold


Source: Thomson Reuters Eikon, Spot prices for major commodities, 2013-2018, Base 100

 

Advantages of Commodity Trading

Commodity investing is receiving increased interest lately, and rightfully so. There are many advantages of commodity trading compared to other investments like stocks and bonds, especially during hard economic times. The continuation Popular Commodities (Part II): Advantages and To-Knows will further explore these advantages as well as the market’s potential risks.

 

Disclaimer: The information provided in these articles is meant to help budding investors understand investing better. All recommendations, opinions, advice, or information expressed in the articles are made without guarantee on the part of NTU-IIC or the author(s). We disclaim any liability in connection with the use of this information and hope you will exercise due diligence before any investment decision is made.

 

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