INTRODUCTION

Commodities are an integral facet of the financial markets and the global economy and are the oldest of all spheres of investments, predating bonds, equities, and even money itself.

One could argue without hyperbole that the story of humanity is one of commodities. Long before the small kingdom of Lydia struck the first coins in the 6th century, great nations such as Egypt, China, Phoenicia, and India were already trading wheat, spices, gold, silver, base metals, and other resources. Their interactions created the first economies and the first merchants. Their alliances, wars, and explorations were all driven by a need to have better or greater access to commodities in some form. As the Roman philosopher Cicero noted, it was the Roman merchant who went first to new areas, not the Roman soldier. The legions only came after a reason for conquest had been established.

The reason is simple. Our history and advancement over the millennia have been defined by our access to and control over the natural resources in our environment. Food and drink sustain and thrill us in equal measure while spices add variety. Base materials and metals allow us to craft tools to build our homes, cities, vehicles, and so on. Precious metals add sparkle, greed, envy, and a measure of social stature while energy is vital to propel people, societies, and civilizations forward. Early human history is broken into stages named after commodities: the Stone Age, the Bronze Age, and the Iron Age. Later human history is underpinned by how we harness, craft, and exploit our resources, whether it be the invention of the windmill, the printing press, or the internal‐combustion engine. The discovery of flight, the age of electronics, and even the latest advances, such as robots and nanotechnology, would not have occurred without access to the necessary materials. Needless to say, throughout history, competition for the control of natural resources has been the cause of countless wars.

Given these fundamental links to human endeavor and survival, it is only natural that commodities are integral to the evolution of capitalism and financial markets. The first banks sprang into being in ancient times to fund merchants and speculators seeking to lead expeditions to find, exploit, and profit from the commodities needed in their day. Banks extended credit or directly funded these risky ventures (the precursor of equity) in return for gain, whether it be a guaranteed contractual return on monies advanced, a share of the expected profit, or the right to trade these lucrative goods into hungry markets.

The banks' business models soon grew in sophistication to provide participants with ways of managing risk, leveraging their hoped‐for profits, or both. In medieval Europe, for example, the desire of Benedictine abbeys to lock in the price of future shearings of the sheep roaming their vast lands led to the development of a large market in wool futures. In 18th‐century Japan, a legendary trader known as Munehisa Homma earned the equivalent of over $10 billion in today's terms in a single year by trading the rice markets. The voyages of Christopher Columbus and the Spanish conquistadors to the New World were funded by investors and nations looking for precious commodities and shorter trade routes as were the efforts of European powers to colonize Africa and Asia. Many of today's financial exchanges originated as forums for trading and managing agricultural produce, extracted metals, and energy.

Today, the commodities market is deep and sophisticated, replete with many different types of instruments. Contemporary society is still fundamentally underpinned by trade, making commodities a critical asset class within the global financial ecosystem. Today, commodities are traded to protect against inherent price risk, to speculate from the sidelines on future trends and demand, to use as collateral to fund trade, or to invest in directly to gain exposure.

In this chapter, we outline briefly today's commodities complex, focusing on its fundamentals, the different types of commodities, and the main markets. We examine both physical and derivative investments as well as the different vehicles investors use to access the market. Finally, we examine briefly some of the important macroeconomic trends in the space today, notably the collapse in prices during 2015–2016.

COMMODITY FUNDAMENTALS

Commodities have taken many forms over the centuries, reflecting the demand for natural resources around the world at any given time. In ancient times, for example, tribes and empires traded gold, wheat, pepper, saffron, spices, rice, livestock, shells, and salt. Today, some of these commodities are still in high demand, such as gold and livestock, but, in response to society's changing needs and priorities, others have come into vogue, such as uranium and carbon trading.

Irrespective of the historical period, certain aspects are fundamentally important. Given the importance of commodities to the smooth functioning of an economy and society, product quality, reliability of supply, guaranteed dates of delivery, and the ease of exchange or trade with others (in other words, liquidity) have always been important considerations. Consequently, commodities markets have always been driven by the need to demonstrate reliability and standardization and to safeguard reputation—something that continues to this day in the rules set by financial exchanges. The fact that most commodities are traded without visual inspection makes this even more critical.

This is also important from the view of policymakers—be they kings or regulators—as the trade in commodities has served as the wheels of commerce, driven economic development, and provided valuable revenues for governments. Thus, commodities have also been carefully regulated for much of their history. After all, no one wants to buy a cow only to find that it has three legs.

The commodities markets today are broad and deep, presenting both challenges and opportunities. For the purposes of this chapter, we will hereafter only examine the key commodities traded on financial exchanges along with a handful of other emerging areas of interest, such as renewables.

The key categories of trading commodities today include:

• Agricultural—for example, soybeans, wheat, rice, and coffee, also livestock, such as lean hogs and live cattle
• Energy—for example, crude oil and natural gas
• Metals—for example, gold, nickel, and copper

The prices of these are essentially set by basic economic principles of supply and demand. For example, rapid urbanization and industrialization in China, and the resulting rise of its middle class during the late 1990s and early 2000s, led to an explosion of demand for all sorts of commodities, ranging from base materials for building (e.g., iron ore and copper) to expressions of affluence (e.g., gold) to changes in diet (e.g., a rise in pork consumption). The surge in demand from China led to severe supply shortages and a consequent boom both in physical commodity prices as well as the shares of those companies producing them. Conversely, in 2015, the advent of new technologies in oil drilling, notably fracking, led to a glut of worldwide crude oil and natural gas inventories. The result was a collapse of energy prices and a dramatic fall in the earnings and share prices of producers.

By following these supply‐and‐demand dynamics, investors can take positions and look to profit from both long‐term investing as well as trading. However, commodity trading differs significantly from trading of other markets such as bonds and equities. The sensitivity of commodities to macroeconomic trends and geopolitics has meant that they represent a macro play for many investors on wider dynamics such as political tensions, the pace of technological innovation, and health scares. For example, historically, the price of crude oil has been inextricably linked to the volatile political dynamics of the Middle East. Traders look to leverage the uncertainty created by this volatility by anticipating the price moves generated by events in the region.

This same sensitivity also means that there is a deep pool of producers and users of commodities who seek to manage the volatility of their supply and its economic cost. As we noted earlier, reliability of supply is key. We all drive cars, use electricity, eat food, and so on. Without careful control, price fluctuations can have enormous impacts on key drivers of economic health and consumer sentiment such as inflation and corporate profit margins. For example, in countries such as India, nearly half the inflation bucket is composed of energy in some form as the country imports the vast majority of its fuel. Thus, any volatility in prices has dramatic impacts on both the levels of inflation within India as well as the earnings of many companies. Conversely, producers are also sensitive to these dynamics and would experience wide swings in earnings if they were fully exposed to the prices of the commodities they supply.

To deal with this problem, commodities markets very early on developed sophisticated hedging tools, whereby producers and consumers could control their risk by entering into derivative trades with other market participants, namely speculators, who were looking to profit from rises and falls in the same prices. The size and depth of this market globally means that derivatives such as futures and options are a far more significant part of the financial universe and the investment palette in commodities than other markets. Consequently, access to commodities can be achieved by physically trading them, executing derivative trades, purchasing mutual funds, or utilizing the services of commodity trading advisors (CTAs)

Regardless of the commodity in question, to be regarded as an investable vehicle, certain key criteria apply. These also help to differentiate commodities from other aspects of the financial markets such as derivatives based on interest rates, currencies, and inflation.

• Deliverability: The commodity has to be physically deliverable on settlement date. Although contracts are rarely physically fulfilled, the right of the buyer to actually take physical delivery of the commodity in specie is inviolate. Thus, crude oil theoretically could be delivered in barrels (or an oil tanker) and gold could be delivered in bars.
• Liquidity: This does not mean liquidity in the traditional sense where one might theoretically be able to exit or enter a financial position immediately. Rather, liquidity in commodities means there is a deep pool of buyers and sellers who create a large secondary market for the commodity and its different financial expressions. This liquidity is measured in terms of ease of entry and exit (as with futures contracts, for example).
• Tradeability: An investor must be able to buy and sell the instrument in some way, subject to the other criteria mentioned earlier. That may mean a derivatives contract on a major exchange, but it may also mean the physical commodity itself or proxies such as producers, parts of the supply chain, and ETFs. Thus, crude oil can be traded as actual barrels, futures contracts, oil producers, pipeline owners, and so on. In contrast, lithium is harder to trade but may be accessed through mines (i.e., the physical commodity) as well as companies engaged in exploring or producing lithium for consumption.

All the commodities we will now discuss fulfill these criteria. Additionally, these same criteria mean that new commodities are constantly emerging. For example, renewable energy may now be considered a commodity. While no one can control and deliver the wind or the sun, energy from both can be harnessed and supplied to users. There are buyers and sellers of wind energy and electricity, and it can be traded through companies in the marketplace and in related areas such as energy storage.

TYPES OF COMMODITIES

We now examine and outline each of the three types of commodities; agricultural, metals, and energy. While the individual lists of specific products are not exhaustive, they include the majority of the key commodities that matter to investors today.

COMMODITIES EXCHANGES

Before we delve deeper into the various ways in which commodities exposure is expressed, it is worth touching briefly on commodities exchanges. Simply put, a commodities exchange is a forum where commodities and their associated derivatives are traded. Historically, the importance of trading efficiently in the commodities arena has meant that exchanges have been critical to the development of the sector and continue to be fundamental to the trading of commodities today.

Commodities exchanges help address key issues of reputation, reliability, and standardization. By developing contracts with standardized terms, key quality criteria, and clear deliverables, they allow investors to trade without having to visually inspect the goods. Additionally, standardization makes the commodity market far more liquid and allows people to hedge as well as trade efficiently.

Much of the world's financial ecosystem today sprang from commodities exchanges. The Amsterdam Stock Exchange, for example, originally began as a market for the exchange of commodities before becoming the first‐ever stock exchange. Additionally, key financial developments such as the initial derivatives contracts, forward contracts, options, and the ability to short began there also, as people sought ways of managing their risk and expressing investment views on the supply‐and‐demand dynamics of commodities. In the 19th century, many great financial centers such as Chicago, New York, and London built their reputations on the ability to facilitate trade, ensure quality, manage risk, and set the accepted prices for key commodities.

Today, a number of exchanges around the world allow investors to trade in agricultural products as well as metals, energy, and miscellaneous raw materials such as rubber. Trading is done through a series of standardized contracts that can include spot prices, forwards, futures, and options. Typically, and as demonstrated by the various pools of commodities out there, many exchanges have specialized in particular segments of the market, offering unique contracts. We summarize in Table 31.4 some of the key players today.

In the last decade, there has been significant consolidation among the various exchanges, which has led to an increase in offerings across the board and made it easier than ever for investors and producers to access markets. A large part of this consolidation has been driven by the advent of electronic trading. Today, the two dominant players are the CME group, which acquired the CBOT and NYMEX and is now the world's largest commodities exchange, and ICE, which has in recent years acquired other major players such as the NYBOT, NYSE, Euronext, and Climate Exchange.

COMMODITY CONTRACTS

As noted earlier, the high level of trading activity in commodities is a function of the large pool of participants looking to hedge their pricing exposure for business or purely economic reasons. There are, therefore, many different forms of commodity contracts both on exchanges as well as over the counter (OTC). The latter are bilateral contracts where two parties enter into a bespoke arrangement.

While we cannot go into all the different types of contracts in detail—a book in itself—we can touch on some of the key forms of contracts that are traded. The bulk of these contracts on exchanges in particular are derivatives. In other words, they derive their value from the behavior of the underlying commodity.

KEY CHARACTERISTICS

As noted, futures and options represent the most popular way of investing in commodities for many people. It is worth delving into some of the key characteristics.

A futures contract, simply put, is an agreement to buy or sell in the future a specific quantity of a commodity at a specific price. As we have noted, the macroeconomic nature of the commodities market suggests a higher level of volatility in the commodities space than in other markets such as bonds and equities. Additionally, the depth of the hedging market means that prices can be inferred and set many years out into the future if needed.

The underlying asset for commodity futures can be any of the agricultural, metal, and energy products, as long as they are traded on an exchange. Futures can also be based on any commodity traded over the counter with another participant who can theoretically make physical delivery. In this case, however, the contract is known as a forward to differentiate it from futures traded on exchanges. For the rest of this chapter, we will consider futures contracts only, partly because of the standardization that makes them the dominant mode of investor expression, and partly because the base mechanics are identical for forwards. As noted earlier, the futures contract may be specific to a particular exchange or traded on multiple exchanges, depending on the commodity in question.

Futures market participants fall into two camps. First, there are commercial or institutional users of commodities that need to hedge their exposure to future price volatility. They take positions in contracts to reduce the risk of financial loss from unexpected changes in prices; profiting directly from the futures contract (or option) is not a primary consideration. Second, there are other participants, typically individuals, financial institutions, and investment firms that act as speculators. They hope to profit from changes in the price of the commodity in the future or to harvest premiums (in the case of options). Their expectations are typically set by analysis, which may be macroeconomic in nature (e.g., geopolitics or supply‐and‐demand dynamics) or systemic (e.g., seasonality patterns or observed aberrations). Speculators almost never take physical delivery of the commodity under consideration and typically tend to close out their positions before the contract expires or becomes due.

Futures contracts trade in standardized amounts. We have noted in Tables 31.1 31.2, and 31.3 the typical trading units for specific exchanges. For example, crude oil is traded in increments of 1000 barrels while cocoa is traded in units of 10 tons. This effectively captures how much of the underlying asset the contract represents and is part of the standardization that we discussed earlier. Participants always know in advance how much of a commodity each contract represents. If they wish to buy more, they simply purchase multiple contracts. Buying less is problematic as the contract represents a minimum size. However, the large increase in the number of individual traders in the marketplace has meant that many exchanges have now begun to introduce smaller contracts.

In Table 31.5, we outline an example of a simplified crude oil futures contract at the CME.

Futures contracts also contain large amounts of leverage, which encourages speculation and thereby aids liquidity. Because a futures contract does not need to be funded in full, market participants can multiply their stake in the trade. A buyer or seller of a contract is required to put up a minimum deposit (typically set by exchange rules, the broker, or a regulator). As the value of the contract changes, the amount of money on deposit is continually adjusted (often on a real‐time basis) to reflect the current value of the contract. As the value of the contract rises, money is deposited in the participant's account and may be withdrawn as profit. As the value drops, however, money is deducted from the account and credited to the other side. If the contract value falls below the minimum deposit required, then the participant is required to add more money to the account to keep the contract open. This is known as a margin call.

Margins tend to be small, often only a few percent. Therefore, small changes in price can rapidly translate into significant gains or losses on the amount deposited. This is illustrative of the power of leverage. The ability to leverage trades and the inherent price volatility of many commodities, coupled with the significant liquidity provided by trading on an exchange, explains why speculators are drawn to the commodity market.

In the case of options on futures contracts, the loss is limited to the premium paid (if the participant is buying an option) as the participant can choose whether to enter the contract in the future. However, there is still significant leverage as the price of the option will evolve depending on movements in the underlying commodity and contract as well as the time remaining to the expiration of the option.

INVESTMENT VEHICLES

Given the scope for speculation and the potential for significant profits, it is not surprising that there are a range of investment strategies and vehicles out there for investors. Many fortunes have been built on the back of commodities speculation, such as the Rothschilds, Andrew Carnegie, Cargill, and Glencore—all by employing a range of strategies from owning physical commodities to building companies around commodities trading. Their varying fortunes also bear testament to the volatility of these assets.

More recently, over the last couple of decades, commodities have also found a place in many portfolios across both institutional investors (such as pension funds and endowments) as well as individuals for their diversification benefits. Commodities typically have low to zero correlations with other financial markets such as bonds and equities. Indeed, some commodities such as gold actually boom in times of distress, often giving them a negative correlation. Including commodities in a portfolio, therefore, may reduce overall volatility as well as introduce macro hedges within a multi‐asset allocation that protect the portfolio in tail events.

Even where people act like speculators, many lack the time, resources, or expertise to directly trade instruments such as futures, acquire mining assets, invest in commodity‐linked equities, or the like. Therefore, investment vehicles may provide them with the ability to access specific areas of interest within the commodity complex through leveraging off the expertise of others.

Here we briefly cover some of the chief ways in which investors access exposure to commodities.

FUTURE TRENDS

The future of commodities—like any financial market—is not set in stone. First, there is a continual cycle of gain and loss, similar to the business cycle of an economy. In commodities, however, the cycle is much more pronounced due to the high price volatility and speculation on demand and supply. Consequently, as a sector, commodity companies are also much more prone to booms and busts. Financial history is replete with famous financial crises that were driven by commodities. For example, the infamous Tulip‐mania in 17th‐century Holland was driven by a seemingly insatiable demand for tulips from wealthy investors, which soon found a willing audience of speculators who were willing to trade on his “new commodity” and its demand. The result was a huge boom. Over a three‐month period from November 1636 to February 1637, prices rose by a factor of 20 times, with some rare tulip bulbs changing hands for the price of a small house. As the speculative bubble burst, however, prices began to fall and within another three months had returned to their previous levels and lower as demand dried up. Many fortunes were made and many fortunes were also lost.

Second, as demonstrated by tulips and in the last couple of centuries by oil, lithium, and platinum, there are new commodities constantly emerging. As long a good can be produced or sourced, has demand, and obeys the key rules outlined earlier of tradability, liquidity, and delivery, it is a commodity. The latest ones to emerge are renewable energy and electricity futures.

There is a continual cycle of boom, bust, and renewal. And given their macro‐sensitivity, commodities are uniquely affected by larger trends emerging in the world. We conclude this chapter by noting some of the key trends and dynamics emerging in the space today that bear watching.

BOOM TO BUST AND BACK AGAIN?

The great elephant in the commodities room is China. Over the last two decades, commodities and commodity companies were on a tearaway thanks to the seemingly endless demand from China for all sorts of natural resources. Between 1991 and 2011, China's average annual GDP growth was a whopping 10.5% per annum. The enormous boom fueled an orgy of speculation, investment, and exploration for new resources. This, more than anything else, was responsible for the growth in popularity of commodities and their move into the mainstream as part of the strategic asset allocation for many institutional investors and individuals.

The train began to slow down in 2012 and came to a crashing halt in 2015. China's explosive growth came under growing strain as the vast tracts of debt underpinning all of its development came under pressure. Growth had already started to weaken from 2012 onward, dropping below 8%, but in 2015, it fell below the psychologically important level of 7%.

At the same time, the country has struggled to reorient its economy toward consumption. Chinese consumers are still very much a nation of savers and the lack of a social security framework means that many are unwilling to save less and spend more. The result has been a slowdown in Chinese growth as the government debates how best to reignite the economy as well as manage the debt overhang. In this environment, commodities demand dried up, resulting in steep falls for many.

The stress has been exacerbated by the fact that many commodity companies invested heavily in new mines, projects, capacity, and exploration in anticipation of significant future demand. In the absence of demand and the slowdown in global growth caused by the Great Recession of 2007–09, many have had to write down significant investments, dispose of assets at poor valuations and often with losses on the investment made to date, and deal with an overleveraged balance sheet (thanks to the large amounts of debt taken on to fund these investments). As an example, Glencore—one of the largest commodity conglomerates in the world—has seen its share price fall by over 50% compared to five years ago and by over a third since the beginning of 2015. The company has had to make significant disposals since as it tackles a debt pile estimated at $30 billion.

The fallout has hit many investors hard and led to a number of funds across the board closing down, as they proved unable to cope with losses and the subsequent investor redemptions. For example, crude oil was at $93.96 per barrel at the start of 2014. It rose to over $107 a barrel at the end of June, only to begin a decline that accelerated into 2015. Today, it sits at a mere $41.29 – a decrease of 56% since January 2014. The same pattern is repeated in many other commodities.

The future is uncertain but will depend greatly on the prospects for global growth. Investors will be looking to other countries such as India and the United States, where growth has picked up again, to lead a resurgence. At the same time, supply is excessive for many commodities, leading to a glut that continues to hold down prices. It is a familiar cycle to seasoned investors, and the bravest of them will likely be looking to pick up bargains at today's prices in preparation for the next upswing.

NEW COMMODITIES

Finally, in closure, it is worth touching on some of the new commodities emerging today. Much of our previous discussion—though applicable to all commodities—has focused on established commodities such as metals, crude oil, and so on.

However, the major trend that is reshaping the composition of the commodities universe today and leading to the next generation of hopefuls is climate change. It is now an established fact that temperatures globally have been rising over the course of human history and accelerated in the last century. The Intergovernmental Panel on Climate Change (IPCC)—an international body overseen by the United Nations and tasked with analyzing the socioeconomic impact of climate change—concluded that the likelihood of human influence being the dominant cause of global warming between 1951 and 2010 was somewhere between 95% and 100%. It predicted that in the absence of new policies to mitigate climate change, its projections indicated an increase in global mean temperature of 3.7 to 4.8°C by the year 2100. The impact of such an increase would be widespread environmental devastation and likely impossible to truly imagine.

Consequently, there has been an enormous shift toward developing renewables as well as other avenues such as fuel cells and hydrogen as alternative energy sources. Though these are still some way off in replacing our reliance on crude oil and natural gas, there are increasingly large amounts of funding from both the public and private sectors going into these areas. The most notable example in recent years has been the ubiquitous spread of wind parks across the world and the meteoric rise of Tesla as the future Ford of the electric car world.

But as with much of human history, for these new sources of energy to truly succeed and develop to full potential, a deep financial ecosystem will need to spring up around them that can help manage pricing volatility and enable companies to make the sustainable profits needed to fund continued investment. That points inevitably toward new commodity markets, new futures contracts, and new players.

Some of this has already begun to occur. For example, lithium has become a highly prized commodity in recent years as one of the key ingredients in the longer‐lived and more powerful batteries and fuel cells increasingly used in technology and electric cars. Numerous commodity companies have sprung up to explore for new deposits and several commodity‐focused private equity funds have begun to explore the space. We have already talked about the growing market in solar power and wind power, both accessible to investors through mutual funds and private equity funds.

In recent years, a burgeoning market has grown in electricity futures, possibly one of the purest expressions of what a commodity can be. In today's markets, power generators sell electricity into the market and retailers buy in aggregate from the market. There is something—electricity—that is physically delivered. The natural volatility of supply and demand plays out in the need for electricity during peak surges (e.g., during key sporting events) and lulls (say in the very early hours of the morning). Therefore, there is something that speculators can trade, deliver, and create a secondary market for—all the characteristics of a commodity. For suppliers and aggregators, the supply‐and‐demand volatility translates into a pricing volatility that needs to be managed carefully if profit margins and cash flows are not to be impaired. In other words, there is a need to hedge.

Most notably, we are also seeing the advent of new exchanges. The European Climate Exchange (along with others around the world), for example, is pioneering a market based around the trading of futures contracts where the underlying commodity is carbon emissions (calculated in tonnes of carbon dioxide equivalent). In other words, companies can theoretically trade environmental good behavior. A company with higher emissions of carbon dioxide can purchase the right to emit more from another participant that has fewer emissions and therefore, has environmental goodwill to trade. Overall, the goal is to constrain carbon emissions across the economy and the globe as a whole to minimize the impact of climate change. It is a nascent market but its development will be exciting to chart.

Commodities have been around since the dawn of human history and they will be around till the end. The instruments may change and the indices may evolve, but the rationale and the execution remain unchanged. We await the next chapter in this journey.