Commodity market

Commodity markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts.
This article focuses on the history and current debates regarding global commodity markets. It covers physical product (food, metals, electricity) markets but not the ways that services, including those of governments, nor investment, nor debt, can be seen as a commodity. Articles on reinsurance markets, stock markets, bond markets and currency markets cover those concerns separately and in more depth. One focus of this article is the relationship between simple commodity money and the more complex instruments offered in the commodity markets.

History

The modern commodity markets have their roots in the trading of agricultural products. While wheat and corn, cattle and pigs, were widely traded using standard instruments in the 19th century in the United States, other basic foodstuffs such as soybeans were only added quite recently in most markets. For a commodity market to be established, there must be very broad consensus on the variations in the product that make it acceptable for one purpose or another.
The economic impact of the development of commodity markets is hard to over-estimate. Through the 19th century "the exchanges became effective spokesmen for, and innovators of, improvements in transportation, warehousing, and financing, which paved the way to expanded interstate and international trade."



Early history of commodity markets

Historically, dating from ancient Sumerian use of sheep or goats, or other peoples using pigs, rare seashells, or other items as commodity money, people have sought ways to standardize and trade contracts in the delivery of such items, to render trade itself more smooth and predictable.
Commodity money and commodity markets in a crude early form are believed to have originated in Sumer where small baked clay tokens in the shape of sheep or goats were used in trade. Sealed in clay vessels with a certain number of such tokens, with that number written on the outside, they represented a promise to deliver that number. This made them a form of commodity money - more than an "I.O.U." but less than a guarantee by a nation-state or bank. However, they were also known to contain promises of time and date of delivery - this made them like a modern futures contract. Regardless of the details, it was only possible to verify the number of tokens inside by shaking the vessel or by breaking it, at which point the number or terms written on the outside became subject to doubt. Eventually the tokens disappeared, but the contracts remained on flat tablets. This represented the first system of commodity accounting.
However, the Commodity status of living things is always subject to doubt - it was hard to validate the health or existence of sheep or goats. Excuses for non-delivery were not unknown, and there are recovered Sumerian letters that complain of sickly goats, sheep that had already been fleeced, etc.
If a seller's reputation was good, individual "backers" or "bankers" could decide to take the risk of "clearing" a trade. The observation that trust is always required between market participants later led to credit money. But until relatively modern times, communication and credit were primitive.
Classical civilizations built complex global markets trading gold or silver for spices, cloth, wood and weapons, most of which had standards of quality and timeliness. Considering the many hazards of climate, piracy, theft and abuse of military fiat by rulers of kingdoms along the trade routes, it was a major focus of these civilizations to keep markets open and trading in these scarce commodities. Reputation and clearing became central concerns, and the states which could handle them most effectively became very powerful empires, trusted by many peoples to manage and mediate trade and commerce.

Size of market

The trading of commodities consists of direct physical trading and derivatives trading.The commodities markets have seen an upturn in the volume of trading in recent years. In the five years up to 2007, the value of global physical exports of commodities increased by 17% while the notional value outstanding of commodity OTC derivatives increased more than 500% and commodity derivative trading on exchanges more than 200%.
The notional value outstanding of banks’ OTC commodities’ derivatives contracts increased 27% in 2007 to $9.0 trillion. OTC trading accounts for the majority of trading in gold and silver. Overall, precious metals accounted for 8% of OTC commodities derivatives trading in 2007, down from their 55% share a decade earlier as trading in energy derivatives rose.
Global physical and derivative trading of commodities on exchanges increased more than a third in 2007 to reach 1,684 million contracts. Agricultural contracts trading grew by 32% in 2007, energy 29% and industrial metals by 30%. Precious metals trading grew by 3%, with higher volume in New York being partially offset by declining volume in Tokyo. Over 40% of commodities trading on exchanges was conducted on US exchanges and a quarter in China. Trading on exchanges in China and India has gained in importance in recent years due to their emergence as significant commodities consumers and producers

Investment Returns

This is a much-debated topic within academia. It is generally agreed that commodities have an expected return of 5% in real terms which is based on the risk premium for 116 different commodities weighted equally since 1888 (Source Report 219171-Wharton Business School). It is common for investment professionals to mistakenly claim there is no risk premium in commodites.

Spot trading

Spot trading is any transaction where delivery either takes place immediately, or if there is a minimum lag, due to technical constraints, between the trade and delivery. Commodities constitute the only spot markets which have existed nearly throughout the history of humankind.

Forward contracts

A forward contract is an agreement between two parties to exchange at some fixed future date a given quantity of a commodity for a price defined today. The fixed price today is known as the forward price.

Futures contracts

A futures contract has the same general features as a forward contract but is transacted through a futures exchange.
Commodity and Futures contracts are based on what’s termed "Forward" Contracts. Early on these "forward" contracts (agreements to buy now, pay and deliver later) were used as a way of getting products from producer to the consumer. These typically were only for food and agricultural Products. Forward contracts have evolved and have been standardized into what we know today as futures contracts. Although more complex today, early “Forward” contracts for example, were used for rice in seventeenth century Japan. Modern "forward", or futures agreements, began in Chicago in the 1840s, with the appearance of the railroads. Chicago, being centrally located, emerged as the hub between Midwestern farmers and producers and the east coast consumer population centers.

Hedging

"Hedging", a common (and sometimes mandatory) practice of farming cooperatives, insures against a poor harvest by purchasing futures contracts in the same commodity. If the cooperative has significantly less of its product to sell due to weather or insects, it makes up for that loss with a profit on the markets, since the overall supply of the crop is short everywhere that suffered the same conditions.
Whole developing nations may be especially vulnerable, and even their currency tends to be tied to the price of those particular commodity items until it manages to be a fully developed nation. For example, one could see the nominally fiat money of Cuba as being tied to sugar prices, since a lack of hard currency paying for sugar means less foreign goods per peso in Cuba itself. In effect, Cuba needs a hedge against a drop in sugar prices, if it wishes to maintain a stable quality of life for its citizens.

Delivery and condition guarantees

In addition, delivery day, method of settlement and delivery point must all be specified. Typically, trading must end two (or more) business days prior to the delivery day, so that the routing of the shipment can be finalized via ship or rail, and payment can be settled when the contract arrives at any delivery point.

Standardization

U.S. soybean futures, for example, are of standard grade if they are "GMO or a mixture of GMO and Non-GMO No. 2 yellow soybeans of Indiana, Ohio and Michigan origin produced in the U.S.A. (Non-screened, stored in silo)," and of deliverable grade if they are "GMO or a mixture of GMO and Non-GMO No. 2 yellow soybeans of Iowa, Illinois and Wisconsin origin produced in the U.S.A. (Non-screened, stored in silo)." Note the distinction between states, and the need to clearly mention their status as "GMO" ("Genetically Modified Organism") which makes them unacceptable to most "organic" food buyers.
Similar specifications apply for cotton, orange juice, cocoa, sugar, wheat, corn, barley, pork bellies, milk, feedstuffs, fruits, vegetables, other grains, other beans, hay, other livestock, meats, poultry, eggs, or any other commodity which is so traded.
The concept of an interchangeable deliverable or guaranteed delivery is always to some degree a fiction. Trade in commodities is like trade in any other physical product or service. No magic of the commodity contract itself makes "units" of the product totally uniform nor gets it to the delivery point safely and on time.

Regulation of commodity markets

Cotton, kilowatt-hours of electricity, board feet of wood, long distance minutes, royalty payments due on artists' works, and other products and services have been traded on markets of varying scale, with varying degrees of success. One issue that presents major difficulty for creators of such instruments is the liability accruing to the purchaser:
Unless the product or service can be guaranteed or insured to be free of liability based on where it came from and how it got to market, e.g. kilowatts must come to market free from legitimate claims for smog death from coal burning plants, wood must be free from claims that it comes from protected forests, royalty payments must be free of claims of plagiarism or piracy, it becomes impossible for sellers to guarantee a uniform delivery.
Generally, governments must provide a common regulatory or insurance standard and some release of liability, or at least a backing of the insurers, before a commodity market can begin trading. This is a major source of controversy in for instance the energy market, where desirability of different kinds of power generation varies drastically. In some markets, e.g. Toronto, Canada, surveys established that customers would pay 10-15% more for energy that was not from coal or nuclear, but strictly from renewable sources such as wind.
In the United States, the principal regulator of commodity and futures markets is the Commodity Futures Trading Commission.

Proliferation of contracts, terms, and derivatives

However, if there are two or more standards of risk or quality, as there seem to be for electricity or soybeans, it is relatively easy to establish two different contracts to trade in the more and less desirable deliverable separately. If the consumer acceptance and liability problems can be solved, the product can be made interchangeable, and trading in such units can begin.
Since the detailed concerns of industrial and consumer markets vary widely, so do the contracts, and "grades" tend to vary significantly from country to country. A proliferation of contract units, terms, and futures contracts have evolved, combined into an extremely sophisticated range of financial instruments.
These are more than one-to-one representations of units of a given type of commodity, and represent more than simple futures contracts for future deliveries. These serve a variety of purposes from simple gambling to price insurance.
The underlying of futures contracts are no longer restricted to commodities.

Commodity markets and protectionism

Developing countries (democratic or not) have been moved to harden their currencies, accept IMF rules, join the WTO, and submit to a broad regime of reforms that amount to a "hedge" against being isolated. China's entry into the WTO signalled the end of truly isolated nations entirely managing their own currency and affairs. The need for stable currency and predictable clearing and rules-based handling of trade disputes, has led to a global trade hegemony - many nations "hedging" on a global scale against each other's anticipated "protectionism", were they to fail to join the WTO.
There are signs, however, that this regime is far from perfect. U.S. trade sanctions against Canadian softwood lumber (within NAFTA) and foreign steel (except for NAFTA partners Canada and Mexico) in 2002 signalled a shift in policy towards a tougher regime perhaps more driven by political concerns - jobs, industrial policy, even sustainable forestry and logging practices.