Commodities are the raw materials that are the building blocks of most types of production, whether for commercial, military, or industrial goods. Different types of grain, livestock, metals, and energy sources (such as crude oil) are some of the most common commodities.
Although commodities may offer some advantages to investors, commodities are considered a high-risk market, as prices can fluctuate based on numerous factors that are hard to anticipate: e.g. weather events; regional political changes; supply chain issues, and more.
Nonetheless, investing in commodities can be useful for diversification because commodities tend to have a low correlation with traditional asset classes like stocks and bonds. Commodities are considered alternative investments, and thus they may be better suited to some investors than others.
What Is a Commodity?
A commodity is a raw material that can be bought, sold, or traded according to its value in producing other types of goods. Some commodities, like sugar or beef, may be consumed directly.
Understanding Commodities
Many of the things you use or consume in everyday life start off in commodity form. For example, the gas you put in your car is created by refining crude oil.
The hallmark of a commodity is that a unit of one type of commodity rarely differs substantially from another unit of that commodity. Thus one bushel of corn is equivalent to any other bushel of corn. One bar of gold is interchangeable with any other bar of gold.
This is quite different from traditional investments like stocks and bonds, where the quality of one stock can vary widely from another; or where one bond may get a triple-A rating and another is rated as junk.
Another difference is that the market forces that impact the movement of stocks or bonds often don’t apply to commodities, which are driven by supply and demand. So an inflationary period could hurt the performance of stocks or bonds, but might benefit commodities when the prices of certain goods rise.
This is one reason why commodities are considered alternative investments, which are not correlated with the movements of more traditional assets and thus can offer investors some diversification.
Trading Commodities
While stocks are traded on a stock exchange, such as the New York Stock Exchange (NYSE) or Nasdaq, commodities and commodities futures are traded on a commodities exchange, such as the New York Mercantile Exchange (NYME) or the Chicago Mercantile Exchange (CME).
The Chicago Board of Trade has established standards of measurement and grades of quality for different types of commodities that facilitate commodities trading. For example, there are 5,000 bushels of #2 yellow corn per corn contract, and corn can be traded on the spot or cash market, or the futures market.
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Commodity Types and Examples
Broadly speaking, commodities can be divided into one of two categories: hard or soft.
• Hard commodities generally must be mined or otherwise extracted from the earth.
• Soft commodities are sourced naturally either through agriculture or cultivation.
Hard and soft commodities can serve different purposes in the global economy and supply chain. Within these broader categories, you can further distinguish specific types of commodities from one another.
| Types of Commodities | Examples | |
|---|---|---|
| Hard |
• Energy • Precious Metals • Industrial Metals |
• Aluminum Copper • Crude Oil • Diesel • Gold • Lead • Natural Gas • Nickel • Palladium • Platinum • Silver • Tin • Zinc |
| Soft |
• Agricultural Products • Livestock |
• Cattle • Coffee • Corn • Cotton • Orange juice • Palm Oil • Pork • Soybeans • Sugar • Tea • Wheat |
Hard and soft commodities may be traded globally but have a smaller geographic footprint in terms of where they’re sourced from.
For example, nearly 100 countries around the world produce crude oil, but five countries are responsible for 52% of the supply. China, meanwhile, is the world’s largest producer of wheat, generating around 17% of total production.
How Are Commodities Traded on the Stock Market?
Commodities are most often traded on an exchange using futures contracts. A commodity futures contract is an agreement to either buy or sell a specified quantity of a commodity at some future date at a predetermined price. It’s important to note that commodities futures are not regulated by the Securities and Exchange Commission.
Futures are not the only way to trade commodities, however. Investors may also choose to pursue:
• Direct investment via cash (on the spot market)
• Mutual funds
• Exchange-traded funds (ETFs)
• Exchange-traded notes (ETNs)
• Commodity-linked stocks and bonds
Of these options, direct investment tends to prove the most difficult for individual investors. Trading commodities through direct investment requires the exchange of physical goods. However, physically holding one ton of wheat or 1,000 head of cattle isn’t a realistic expectation for most commodities traders.
Mutual funds and ETFs can offer an easier access point to the commodities market while allowing investors to diversify. Rather than tying up investment dollars in a single commodity, an investor may diversify across several different types of commodities within a single fund or ETF.
Regardless of how someone invests in commodities, there are real risks to weigh. Commodities can be highly volatile as there are a variety of outside factors that can influence the direction in which prices move.
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What Determines Commodities Prices?
Supply and demand play an integral role in determining how commodities are valued. When supply exceeds demand, e.g. if there were a drop-off in the demand for copper, the price of that commodity would also likely drop. But if a new technology like AI emerges, creating demand for precious metals, that could drive some commodities prices up.
Global events, such as widespread flooding or war can also trigger fluctuations in commodity prices.
Volatility in commodities pricing can have far-reaching effects on the global economy. Research from the International Monetary Fund (IMF) suggests that swings in commodity prices, meaning what a country pays for its imported commodities vs. what it collects for exported ones, have the potential to hinder long-term economic growth, particularly for those countries that are significant exporters.5
The IMF also determined that instability in commodity prices may also increase volatility in domestic inflation. Rising prices for basic domestic goods, such as food or energy, can be especially burdensome in countries that have developing economies.
The Takeaway
What are commodities? Commodities are all around you, from the clothes you wear to the foods you eat, to the technology you use at home and at work.
Within the financial markets, commodities play an important role in price regulation for consumer goods. As an investor, commodities trading can open up new avenues to diversification, though it’s wise to consider how these investments align with your personal risk tolerance.
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FAQ
What Is a Commodity vs. a Stock?
A commodity is a raw material that’s used to create something else, such as crude oil that’s refined into gasoline or wheat that’s used to produce bread. Whereas a stock represents an ownership share in a company.
Are commodities riskier than stocks?
Commodities can be riskier than stocks because they’re often speculative in nature and their pricing can be highly volatile. Some types of commodities may prove more stable than others, though it’s important to consider how supply and demand may affect pricing.
What is the safest commodity to invest in?
There are no “safe” investments, and there is always the risk of loss when investing. With commodities, choosing one that is more insulated from fluctuations in pricing can be beneficial, but this can be difficult to predict. Gold and some precious metals may fare well when inflation rises, or there’s increased uncertainty in the markets about interest rates. Again there are no guarantees.
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