What is the commodities market?
It is clear what is sold on the commodities market. The question is: what kind of commodities are being sold and how? There are three main types of commodities: key agricultural products like corn and wheat; metals like steel and aluminum; and energy-bearing products like oil and gas. The main trade in goods takes place on the exchanges, which set their own rules. For example, a buyer and a seller do not exchange a barrel of oil on the market. The trade is completed via derivatives, called futures.
A derivative is a contract or instrument, its price is defined by the fluctuation in price of an asset. For example, one side is ready to buy a barrel of oil at $100 in three months while the current price is $95. The other side is willing to sell a barrel of oil at $100 in three months. They enter into a contact. This is a simplified scheme. In fact, such contracts are standardized and are created by the exchanges. For example, oil futures on the RTS exchange include delivery of 10 barrels of oil under certain conditions defined by the exchanges. Today, less than 10% of all contracts reach the actual delivery of goods. The main method of execution is to pay the counterparty the difference in price if there is a change.
How was the commodities market created?
Originally it was used by the producers and buyers of certain product groups to insure the stability price levels. For instance, oil companies were interested in the accurate prediction of oil prices and their associated costs. They entered into an agreement with oil producers regarding a fixed price of the oil supply in the future. As a result, consumers were protected from oil price fluctuations in the oil market and therefore protected from risk. Then institutional investors and speculators appeared on the market.
In a contango situation, the price, for example, of a 3 month contract is above the current price for say, oil; this would then suggest that the market expects a rise in price for the good. An example of backwardation would be if the price of a 3 month contract is below the current price, which would suggest that the market expects lower oil prices.
How does one earn income on the commodities market?
Here is an example. You bought a futures contract for delivery of 10 barrels of oil in 3 months for $100 per barrel. If during this time the price of oil increased to $110 per barrel you would not buy 10 barrels of oil and then proceed to resell them on the market. The other side of your contract would cover the difference in prices which would be your profit of $10 per barrel. The exchange acts as guarantor of the obligations of each party.
What are the long-term dynamics of the commodities market, who shouldincludethem in their portfolios?
In the 20th century, commodity prices fell. At first glance, if prices have declined for 100 years, why invest into the commodity market? At the same time, commodity prices have more than doubled since 1998. Why do investors include commodities into their portfolios? They decrease portfolio risk since the returns of the commodity market are weakly correlated with the returns of stocks and bonds.
The arrival of institutional investors trading on the commodity market has changed, as was the case with the foreign exchange market. For example, in the 70’s the foreign exchange market was used for export and import operations. Today, since coming onto the market and after the arrival of banks and other institutional investors, export and import operations represent less than 2% of the turnover of the foreign exchange market.
The above situation can also be applied to the commodities market. Increases in price fluctuations for goods are rejected from their fair market value.
Why not invest in an oil producer, rather than oil itself?
The risks are different. For example, common stock for an oil producer is subject to additional risks: quality of management, expense management, how many fields the company has, etc. There are no such risks when buying and selling oil.
When is the best time to invest in commodities?
The best time is during the last stages of recovery, when inflation is gaining momentum. Commodities have traditionally been considered a hedge against inflation. During this time, bond yields, for example, will decrease as inflation will “eat” away the earnings. The same applies to company stock. In addition, to reduce inflation, the government will raise interest rates, which also limits the growth of bonds and market shares, but not commodities.
Disclaimer: This article contains the opinions of the author. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service. Performance data shown represents past performance. Past performance is no guarantee of future results. No part of this article may be copied, distributed, transmitted or published without the prior written consent of the author.
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