We all recognize the vital role of oil in powering modern industries and enhancing our daily lives. It not only fuels progress but also significantly impacts our economic development and living standards. Despite the growing focus on green energy, oil remains a necessity. As a commodity, oil represents just one facet of a broader group of goods that play a crucial role in the global financial market. For investors, understanding the concept, characteristics, market structure, and identifying investment opportunities and risks associated with commodities can pave the way for informed investment decisions.

• Commodities are one of the most active trading categories in the global market, playing an important role in the global economy. They have the characteristics of high liquidity and wide participation, with many participants and clear division of responsibilities.
• Investing in commodities can hedge against inflation, achieve portfolio diversification and hedging needs, but also involves price fluctuations and market risks.
• With the growth of global population and economy, as well as the development of finance and technology, the commodity market still shows potential investment opportunities. Investors should assess risks, formulate adaptive strategies and closely monitor market trends to achieve investment goals and returns.

What are commodities, exactly?

Commodities are fundamental economic goods that are widely traded in the global market. They possess standardized characteristics and typically include raw materials or finished products that do not enter the retail sector. Commodities encompass various asset classes spanning different industries, including hard commodities such as precious metals, industrial or base metals, energy resources, and soft commodities like grains and other agricultural products (soft commodities being those produced through breeding or planting).

The commodity market constitutes a globally connected financial market characterized by high liquidity and broad participation. Market participants include producers, consumers, traders, and investors, each playing an indispensable role.

Producers, whether companies or countries, are responsible for the production and supply of commodities. They exert control over resources and production capacity, thus directly influencing market supply.

Consumers, comprising enterprises and individuals, utilize commodities, especially in energy and manufacturing sectors. Their demand significantly impacts market supply and price.

Traders play a crucial role in the commodity market, providing market liquidity and facilitating transactions. They typically maintain inventories of commodities to meet market demand or participate in the price formation process. Traders assist producers and consumers in trading by offering quotes, market analysis, and risk management services.  

Investors also hold a pivotal position in the commodity market, including fund managers, hedge funds, and retail investors seeking to profit from commodity trading. Investors employ various strategies, such as long-term investment, intraday trading, and derivatives trading, to capitalize on commodity price fluctuations. Notably, gold, silver, crude oil, corn, soybeans, and other similar commodities are commonly traded in financial markets. Hence, crude oil and gold are the commodities that receive the most attention from general investors, with crude oil primarily encompassing British Brent crude oil (BRENT) and US West Texas crude oil (WTI) trading.

Commodity prices and trading

1. Factors affecting commodity prices

Supply and demand represent primary factors affecting commodity prices. On the supply side, variables like production capacity, weather conditions, geopolitical risks, and environmental factors significantly impact commodity supply. For instance, the natural gas market is sensitive to weather factors, as temperature fluctuations directly affect supply and demand. On the demand side, economic growth, population changes, industrial demand, and consumer demand exert considerable influence. Moreover, the global economy acts as a pivotal driver of commodity prices. Economic growth and recession affect commodity demand due to the impact on economic activity levels and consumption capacity. Currency exchange rates also play a significant role, influencing import and export prices, which, in turn, affect commodity prices.

Apart from these fundamental factors, investor sentiment and market expectations also shape commodity prices. Market participants' outlook regarding supply and demand conditions, as well as their assessment of the macroeconomic and political environment, have short-term and long-term effects on commodity prices.

2. Commodity trading

The commodity market stands out for its globalized nature and 24-hour trading capabilities. Technological advancements have facilitated trading on major exchanges, enabling participants to trade anytime, anywhere. This global reach and high liquidity present abundant trading opportunities and diversified investment strategies within the commodity market. Commodity trading occurs in both spot markets and derivatives markets, each offering distinct trading methods and tools that allow investors to engage with commodity trading and price fluctuations.

Spot markets constitute physical commodity trading platforms, enabling investors to directly purchase and sell spot commodities. These transactions involve actual delivery and transportation of goods. In spot markets, transaction prices typically rely on the supply-demand relationship and market quotes, with transaction parties assuming responsibility for logistics and goods delivery. Alternatively, trading can occur through derivatives markets, which encompass financial derivatives like futures contracts and options contracts. A futures contract represents an agreement to deliver a commodity at a predetermined date and price in the future. Investors can engage in futures contract trading by buying or selling contracts without needing to possess physical commodities. Meanwhile, an options contract grants investors the right (but not the obligation) to buy or sell a commodity.

Derivatives markets are characterized by high liquidity and leverage effects. Investors can profit from trading price differences between contracts and use leverage to amplify their investment returns. This type of trading offers more flexibility in terms of trading strategies and risk management tools, including hedging or speculating on price fluctuations. Investors must choose the appropriate trading method based on their investment objectives, risk preferences, and financial capacity. The spot market facilitates long-term investment and requires robust logistics capabilities due to physical commodity trading, while the derivatives market offers more trading opportunities and strategies, making it suitable for short-term trading and portfolio diversification. Individual investors should exercise caution when directly engaging in commodity trading.

Commodity trading markets predominantly operate on exchanges such as the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange (NYMEX), and the London Metal Exchange (LME). These exchanges provide electronic trading platforms and centralized markets, facilitating convenient trading and access to market information.

Commodity investment and risk

Investors often include commodities in their portfolios to achieve three primary benefits: inflation hedging, investment diversification, and potential returns.

Commodities, being tangible assets, respond differently to changes in economic fundamentals compared to financial assets like stocks and bonds. For example, commodities stand as one of the few asset classes that benefit from rising inflation. As demand for goods and services increases, their prices usually rise, thereby driving up commodity prices as well. Consequently, investing in commodities can safeguard portfolios against inflation. In contrast, stocks and bonds generally fare better when inflation rates stabilize or decelerate. Accelerating inflation diminishes the future cash flows' value associated with stocks and bonds, as future cash will have reduced purchasing power compared to the present.

Merrill Lynch introduced the Investment Clock theory, which explores the correlation between asset allocation and economic cycles. Over a period of more than 30 years, Merrill's research team conducted back-testing to guide investors on adjusting asset allocation in different economic cycles. Merrill divides the economic cycle into four stages: reflation, recovery, overheating, and stagflation. In each stage, the best-performing assets vary. If the cycle commences in the reflation stage, bond returns perform best, followed by stocks, commodities, and cash.

Nevertheless, investing in commodities entails risks. First and foremost, commodity prices exhibit high volatility, influenced by changes in supply and demand as well as market sentiment factors. This volatility may introduce uncertainty into investment outcomes, particularly for short-term investors. Moreover, market liquidity risk refers to situations where the commodity market lacks sufficient transactions, making it challenging for investors to trade or exit positions. Additionally, external factors such as policy risk, geopolitical risk, and weather disasters can significantly impact the commodity market.

Returns from commodity investments mainly stem from capital gains resulting from price fluctuations. By accurately gauging commodity price trends, investors can achieve capital appreciation and generate returns. Furthermore, some commodity markets offer opportunities for investors to earn spreads and interest income, such as futures contract trading and holding costs.