Commodities are physical products, such as food, grain and metals, which are interchangeable with another product of the same type, and which investors buy or sell. While commodities can be traded with actual physical delivery, a large volume of commodity trading takes place electronically through the use of derivatives – contracts that derive their value based on the price of the underlying asset. For instance, an investor bullish on gold can allocate a portion of his portfolio to gold futures contracts.
Commodity Demand & Supply
Commodity prices are affected by demand and supply. When demand increases and/or supply decreases, prices rise – and when demand decreases and/or supply increases, prices drop. While this economy theory applies to any object with a price-tag on it, it affects commodities in the form of super-cycles. Because the production of commodities (to meet new forecasted demand) is a long-term and costly endeavour – for example, opening a new gold mine – the supply curve for commodities takes a long time to move. Conversely, the demand for commodities – for example, automobile-usage driven demand of steel that comes from an increasingly affluent and volumous population – is not something that changes, to the extent that it may affect prices significantly, overnight. The slow-moving but impactful nature of demand and supply swings can lead to long and drawn out upswings and downswings in commodity prices.
Gold as a commodity, unlike some of its other counterparts, has relatively limited use in industry. Instead, gold has been and is still revered as a symbol of wealth and prosperity. Notably, it was used as a backing for paper currency as per the Gold Standard, when in 1792, the US determined the value the US dollar in terms of gold, for which the currency could be exchanged. This is in contrast to today, where the US dollar is a fiat currency – one which has no tangible value attached to it and are used solely as a means of payment.
In large part due to the gold’s usage as a definition of value for currency, investors may see gold as an appropriate investment when they lose faith in a currency. It is not uncommon for there to be a run-up in gold prices when a currency depreciates drastically – this can be seen as investors fearing the diminished value of a paper (fiat) currency and hence buying a tangible storage of value such as gold. The idea of gold as an investment, however, continues to be hotly debated because of the limited use as an (industrial) asset. Those against the idea might suggest that gold is deemed as a medium of value only because the rest of the world thinks so.
Copper is thoroughly used across economic sectors. This forms the basis for the idea of ‘Doctor Copper’, which hypothesizes that movements in the price of copper can help predict global economic swings; rising copper prices might imply a growing global economy, and falling copper prices might precede an economic downturn. These mechanics, of course, are based on supply and demand. With strong demand due to a robust economy pushing prices up, and slow demand due to a stagnating economy dragging prices down. Of course, supply and demand also suggests that ‘Doctor Copper’ must in no way be relied on exclusively. Short-term supply squeezes – for example, an underestimation of demand or a unintended halt in production – can push prices up with no real link to the health of the global economy.
(Crude) Oil is a natural substance found deep in the Earth. Large amounts of capital expenditure is generally necessary to set-up extraction and production facilities for oil. With oil being used as a means of power supply in every industry imaginable, however, the demand for oil may wane at times, but is generally rising over the long-term as economies and populations grow.