Understanding the Commodities Market

By Joseph Boyle , last updated July 21, 2011

The commodities market is what determines the prices of most of the basic necessities of modern life, including: agricultural commodities like corn, oats and wheat; metal commodities like gold, silver, copper, platinum and aluminum; meat commodities, like pork and live cattle; energy commodities like crude oil, gasoline and heating oil; ‘soft’ commodities like orange juice, coffee, sugar and lumber; and financial commodities like treasury bills, T-bonds, and currencies. The commodities market is also often referred to as the futures market. Since the products it contains are such essential components of daily life, it can be quite important to understand the nature of the market, especially for investors.

There are two common types of players on the futures market. The first are the companies which actually deal in the commodities which are being bought and sold. For example, an agricultural business that actually produces corn. Such producers have a vested interest in hedging the prices of their commodities on the market, in order to ensure a certain amount of profit when the actual commodities they produce are later being sold. The second types are mere speculators, looking to make a profit off the potential rise and fall in the values of such commodities. When someone purchases a futures contract, they are technically purchasing a given amount of the commodity itself; however investors generally are not interested in actually taking delivery of the commodity and will exit the contract before they actually receive the goods.

The way the commodities market works is fairly simple. In order to hedge against the possibility of major losses in the future, commodities producers sell futures contracts. What futures contracts do for the producer is essentially lock in a set price, ensuring that they receive a given minimum regardless of what happens. For example, a corn producer will sell a futures contract to an investor for a set amount, but at the time of the sale, the producer has no way of knowing what the actual value of his commodity will be down the road when the corn is actually harvested. Any number of things could happen in the interim. There could be a drought, or pests might destroy a large portion of his crops. By selling a futures contract, he ensures that he will get a minimum price, no matter what happens to the corn. The alternative is that he may produce an enormous amount of healthy viable crops, and will have sold them for less than they are worth. In this case, the farmer takes a loss, but it is a calculated risk which covers his bases in the event that things go bad.

The other side of the coin is the speculator. The speculator purchases futures contracts on the hope of maximizing profits. If the second scenario mentioned above comes to fruition, then the speculator will stand to make a profit. Speculators make moves based on what they anticipate will occur in the market, buying or selling accordingly.

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