In some respects, commodity trading is the purest form of investment. No derivation, no abstraction, and no three levels removed from the underlying asset. There are only some tangible and useful things—a food, a fuel—and a huge market with many participants. The last point is important: the more buyers and sellers of a product, the more likely it is that its market price will be affected by manipulation. Commodity pricing is closest to the classic economic concept that the supply and demand curve of commodities intersects with a specific price and quantity in the real world.
Take cocoa as an example. As of April 2021, the price of cocoa is approximately US$2,420 per ton or US$1.21 per pound. From 2015 to 2021, the price fluctuations of this raw material for chocolate production are beyond your imagination, ranging from less than US$1,780 to more than US$3,400.The demand for cocoa varies, so that last summer global demand for chocolate for unknown reasons caused prices to rise to record highs.
But it is changes in supply, not changes in demand, that determine most price changes. At least for this particular product. Supply depends on various ecological factors, which are beyond the control of the people who grow cocoa for their livelihoods. The temperature needs to be around 70º to 90º, and the rainfall is heavy but not too heavy (no more than 100 inches per year).Don’t turn it into a starting point for cocoa cultivation, but there are a strict set of conditions to achieve optimal growth. Losing the balance of a single standard may result in a decrease in supply, which may lead to an increase in prices.
Cocoa production is far from the world’s financial centers, mainly in Ivory Coast and Ghana, and is produced by many small-scale family farmers. Many suppliers provide uniform products, which means that each supplier has little impact on prices. Contrast it with another commodity-gold.
In April 2021, the price of gold was US$1,760 per ounce, a drop of more than 15% from the 2020 peak. As recently as 2000, you could buy an ounce for $250.ofAlthough the average annual gold production during this period was 2,500 tons, the change in either direction was only about 10%.If gold production is so uniform every year, why is there such a huge fluctuation in price?
The direct answer is that gold is in great demand because it is not just a visually appealing component of jewelry. Unlike cocoa, beef and pork belly, gold can last forever. Small and compact, it can be used as currency itself. When currency traders worry that the dollar, pound, or euro is too long, gold is still a reliable means of preservation. It is much easier for a central bank to print fiat money as it wants (thus reducing the value of each unit) than it is to magically increase the world’s gold supply.
So the relationship between supply and demand determines the price. who knows? More importantly, how to deal with all this newly discovered information? Ordinary investors only consume commodities, not speculation. What are the benefits of understanding the factors behind cotton or soybean market prices?
This is not a rhetorical question. If you compare the current price of a commodity with the futures contract price of the same commodity, you will save yourself the trouble of knowing any information about annual precipitation in West Africa and/or the monetary policy of the Central Bank. On the contrary, the details of market forces can be refined into something that a smart investor can use-futures.
Let us take another commodity as an example. As of the time of writing this article in April 2021, the price of wheat is $6.48 per bushel. The price of a futures contract expiring in September is $6.52.This means that speculators offer wheat farmers (well, wheat brokers) a small premium over the next few months. Both parties to the transaction, speculators and farmers believe that wheat prices will rise during this period. Speculators hope it will rise above US$6.52, and farmers hope it will stop somewhere below this number, but either way, we expect wheat prices to rise.
It continues. Futures expiring in December sold for $6.60 and rose to $6.64 in the following quarter.The reason is not important. It does not matter whether consumers in China and India are adopting a westernized diet based on wheat, or whether new varieties are increasing crop yields. Investors only need to know that prices are expected to rise and will continue to rise. In fact, you can even start with futures prices, then work backwards and compare them with current prices at relative discounts to pay attention to price trends.
Karl Marx believed that the amount of labor involved in creating an object determines its value. To be honest, Karl Marx is full of rubbish. When the cocoa grower’s product sold for US$3,750 per ton, it did not sell five times more than when it sold for US$750. A smart investor knows this, and by extension knows that the only way to make money in the commodity market is to predict price changes. This is not easy to do, which is why most people insist on using mutual funds and exchange-traded funds (ETFs). But for curious investors who want to expand their horizons, if volatile commodities are added to her portfolio, then commodities may be profitable.