The Commodities Market: Looking into the Financial Future

Laura Shin
Posted

The golden cornfields of the heartland seem a world apart from the golden fixtures in Wall Street boardrooms, but what happens out in farm country does affect the financial markets.

Take, for instance, the recent news that the U.S. Department of Agriculture is projecting a smaller corn harvest. This perfectly illustrates how heat and drought in the Midwest can ripple out and affect a financial market for something called commodities futures.

We’ll lay out for you both what commodities and  commodities futures are, and how they impact you.

Corn

What Husks Have to Do With It

Drought and temperatures that were 8 degrees Fahrenheit above normal this past summer—the Midwest’s hottest since 1955—could mean that the global supply of corn may reach a five-year low at the same time that global corn usage is expected to increase (primarily since China’s economy will expand by an estimated 9% next year.)

Just as you might expect, since demand is predicted to go up and supply is predicted to go down, the price of corn is rising. And in fact, annual prices are at an all-time high.

And where there are prices rises and falling, there’s an opportunity for people to make money on those price fluctuations: Enter the commodities futures market.

The Origin of the Commodities Futures Market

First, some definitions. A commodity is a good that is the same no matter where you buy it. For instance, the commodities sugar and rice are the same no matter who produces them. In contrast, non-commodities differ by manufacturer the way a cell phone by Apple differs from a cell phone by Nokia.

The only thing is that back before modern commodities markets, if you produced a commodity, you would show up to market without any idea of demand and just hope to sell your goods. Whatever you couldn’t sell would go bad.

Clearly, this system was inefficient for both buyers and sellers.

In the mid-19th century, farmers and buyers of certain grains started creating contracts for the farmer to produce a certain amount of a grain and for the buyer to buy that amount for a set price at a set future date. These are what we now call futures contracts.

Fast forward 150 years, and now there are commodities futures for all sorts of commodities beyond grains, such as for metals like silver and copper, energy resources like natural gas and crude oil, and other food items such as pork bellies and cocoa.

How Commodities Futures Impact the Future

Outside investors who have no interest in actual sugar or oats buy and sell sugar and oats futures, hoping to make money on their price fluctuations.

For instance, you might buy a commodities future in corn at a low price, betting that it will rise in the future and you will be able to sell it at a profit then.

Just as with stocks, what people think of the value of a commodity ends up affecting the actual value. Meaning, if people think Company X’s value is going down, they are more likely to sell stock in it, and few people will be willing to buy, driving the price down. Likewise, if people think a commodity will be worth less in the future, that will drive the futures and actual price down.

(This is why, when you hear people in the news talk about the price of a commodity, they are usually referring to the price of the future.)

On the other hand, the price of the future is also affected by current events, which is why, to bring us all the way back to where we started—this summer’s drought in the Midwest is pushing up the price of corn.

Commodities: Not for Beginners

If you’re interested in investing in commodities futures, you should know that they are pretty risky. First, because they are volatile. Second, because you need to keep a minimum amount in your account in order to hold your investment. And third, because if that minimum changes, you could owe a lot of money fast.

If you’re interested in investing in commodities but can’t handle the risk, check out commodity pools or commodities mutual funds which spread out the risk more. That way you won’t bet your future on corn.

Image Credit: Flickr/bkkkpewsey

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