Commodity pricing has many sticky components but in general, the instability of prices and the randomness that comes with it increases the cost of doing business for producers and traders.
Cocoa futures for example have plummeted 12 percent in less than a minute and then recovered in from the “flash crash” but left everyone perplexed. Also, cotton futures can swing wildly tripping market circuit-breakers on many occasions over a trading year. Sugar is another commodity were futures can fall 20 percent in a couple days and then recover.
Just like commodities, food manufacturers and fuel suppliers, need market futures to help them set prices and predict point of delivery costs that can vary from corn flakes to cakes. As a result, farmers use the same information to decide which crops to plant. This interdependent process keeps industries running smoothly and act as insurance policies to hedge the risks inherent in buying and selling raw commodities.
But when prices move unpredictably, it increases the cost of buying the futures and options that protect companies against such changes. The added costs find their way to the grocery store and to the shopping mall for shopping consumers.
A good example of the benefit of the futures market is heating oil. Typically a distributor buys oil only as he needs to supply it, he uses heating oil futures and options as a form of insurance to protect himself against unexpected jumps in prices. However, seven or eight years ago, such protection added only 2 to 6 cents to each gallon of heating oil the distributor bought. But volatile oil prices mean it can costs him 37 cents a gallon for such hedging which is an extra cost to add to customers’ heating oil bill for a given year that can also swing wildly the following year.
Nonetheless, volatility can drive prices down as quickly as it pushes them up. A wide range of commodities can plunge, with the broad CRB commodities index closing up or down 5 percent. Moreover, the situation is more confusing for businesses as commodities have become more volatile for reasons that no one fully understands.
Much such fluctuation is caused by economic supply and demand, especially, when stocks of commodities like cotton, corn and coffee are driven to low levels, setting markets on a hair trigger. As demand for many commodities rises in developing countries like China and India that are becoming wealthier buying ever more food and oil that increases demand and puts pressure of existing stocks.
It follows that other factors are purely financial, like concerns with a weak dollar, oil disruptions on the supply side and a changing perception of the global economy, can also have influence on rapidly changing prices.
Hedge funds and commodity traders have become a massive force in the commodities futures market, in part by a switching to computerized trading. Critics say the technological switch is altering the dynamics of the commodities markets, just as it has in the stock market, which has suffered several “flash crashes” as well.
Traditional players like grain elevators or cotton merchants are being outshined by a new class of financial speculators, including high-frequency traders, who use automated programs to buy and sell repeatedly at high speeds.
“The exchanges, which profit from the increased trading levels, say high-frequency trading now makes up 10 to 20 percent of the futures trading in many agricultural commodities, nearly a quarter of the trading in metals and 30 percent in energy futures markets.”
One important issue to consider is that commodity trading is the purest form of investing. Unlike the stock market there’s no derivation, no abstraction, no three or more levels of separation from the underlying asset. There is a tangible utility like a grain a foodstuff, a fuel in a huge market with numerous players. Commodity pricing is as close as the real world gets to the classical economic concept of a good’s supply and demand curves intersecting at a particular price and quantity.
Changes in supply, not demand, is what dictates most price movements with regard to a particular commodity. But supply is contingent to various ecological factors, consumption patterns and finances that go beyond the control of the people who raise a commodity for a living.
Cocoa for instance is produced far from the world’s financial and trading centers, primarily in the Ivory Coast, Ghana and Latin America, in lots of small-scale family farmers. The effect of having many suppliers offering a uniform product means that each individual supplier has little influence on the market price. In contrast another commodity like gold with an annual production averaging 2,500 tons has a small variation in a comparable period unless great uncertainty sets in the world markets including kinetic war or a trade war making world currencies become volatile.
Karl Marx thought that the amount of labor involved in creating a good determined its value, however, cocoa farmers don’t work five times harder when their product is sold for $4,000 a ton than when it is sold for $800 per ton. An investor knows this, and by extension knows that the only way to earn money in the commodities market is to anticipate price movements. Which is easy to say but very difficult to do and that explains why conservative investors put their money in mutual funds and exchange-traded funds (ETFs).
The Chicago Board of Trade (CBOT) where CME Group is the world’s leading and most diverse derivatives marketplace, made up of four exchanges, CME, CBOT, NYMEX and COMEX. These exchanges are very good reference for monitoring price swings on daily trades as well as futures market.
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