Commodities are the building blocks of life. We rely on commodities to support our daily existence. From steel and copper to build our homes, gas and coal to heat them, gasoline to fuel our cars so we can travel to work and wheat and corn for food.
As consumers we rarely purchase commodities directly; rather they are typically the raw materials purchased by manufacturing companies that refine them into the goods that we use.
The three main categories of commodities are:
- Energy (e.g. oil, gas and coal),
- Metals (e.g. copper, nickel and gold)
- Agriculture (e.g. soybeans, corn and wheat).
However, the term “commodity” can also be extended to other things, many of which you would not even consider as commodities but share the same properties: internet bandwidth, water or carbon emission credits, for example.
One of the basic characteristics of a commodity is that it should be uniform in quality and lacking in product differentiation. In reality, things are not quite so simple and so there is a spectrum of commodification. Even wheat is not a uniform commodity. Bread makers prefer “hard” varieties with more protein, and cracker makers prefer “soft” wheat.
The demand for a particular commodity is closely connected to the demand for a related product or service – known as “derived demand”. For example, the demand for steel and many other metals is strongly linked to the demand for new vehicles and other manufactured products, so when an economy goes into a recession, we expect consumption of those metals to also decline or at least not grow as fast.
Changes in the price of a commodity also affect demand. If a commodity is seen as a necessity an increase in its price will only lead to a relatively small drop in demand. Think of the gasoline you use to fuel your car to get to work. The price may go up, but you still need to drive to work.
Changes in income are also important. As consumers we typically eat more protein rich foods as our societies become wealthier. In turn this increases the demand for crops such as soybeans to feed livestock.
Increasingly, commodities are being seen as financial assets and so are in demand for their own sake. In contrast to other assets though (e.g. an equity, bond or property), a commodity provides no income stream. Some commodities like gold and many other precious metals are seen as a store of value in times of uncertainty.
The supply of commodities also responds to incentives. High demand and high prices typically encourages farmers, miners and other commodity producers to respond by increasing supply.
However, supply is also sticky. It takes time for supply to respond, whether it is a digging a mine, planting crops and waiting for the harvest or drilling an oil well.
This means that expectations matter a great deal. For example, farmers do not want to plant lots of one type of crop in reaction to high prices, only to see prices collapse by the time they come to harvest.
Thank you for taking the time to read lesson 1 of this course. In the next lesson you will get a greater understanding of the factors that affect commodity prices.
Go to lesson 2