Commodities & Derivatives

Understanding Commodities

Most commodities are raw materials, basic resources, agricultural or mining products, such, or grains. Commodities can also be unspecialized mass-produced products such as chemicals and computer memory.

Commodities are most often used as inputs in the production of other goods or services. The quality of a given commodity may differ slightly, but it is essentially uniform across producers. Commodities are broken down into the following categories:

The general idea is that there is little difference between a commodity coming from one producer and the same commodity from another producer. A barrel of oil is basically the same product, regardless of the producer.

When commodities are traded on an exchange, they must meet specified minimum standards for use as the asset of a futures contract. The basis grade is the minimum accepted standard. This grading is also known as par grade or contract grade. 

 

Understanding Derivatives

Derivatives are contracts that are used as financial instruments whose value is determined based on the price of another asset, such as a commodity. The name derivative comes from the fact that the price of the underlying asset creates the value of the contract.

 Derivatives fall under one of the following two categories:

  • Options – Securities that provide investors with an opportunity to either buy or sell the asset that is linked to the option contract based on a predetermined price before a specific date. Options come in two types, puts and calls. 
    • Puts allow for investors to sell the linked security at a fixed price. 
    • Calls allow for investors to buy the linked security at a fixed price.

Investors use options to take advantage of expected changes in the price of a stock. 

  • Futures – This is where commodities come in. Futures are legal obligations where contracts are established based on pre-negotiated prices for raw materials and products which are set for delivery some time in the future. For example, let’s think about oil. Companies must explore and drill for oil which could take a long time, with a lot of operating costs. Companies that use oil for manufacturing or other means may be interested in futures contracts as it would allow for the buyer of a futures contract to be guaranteed a delivery of oil based on a predetermined fixed price regardless of what the current market value is at that time. 

Many investors trade derivatives to speculate on the future price changes of commodities. Corporations also trade derivatives as a way to manage, or hedge, future price changes of commodities that are primary materials used in the manufacturing process.

 

Commodity Exchanges

We complete many transactions in our everyday lives that require us to interact with different types of commodities markets. Just like stock exchanges that allow investors to buy and sell a public company’s stock, commodity exchanges do exactly the same thing. Using legally binding contracts that outline the details of what material or product is being delivered in exchange for a predetermined amount of money – not always U.S. dollars.

As we learned in the previous section, these investment products are known as Options and Futures contracts. For this reason, commodity exchanges are also known as Designated Contract Markets (DCMs), Futures Markets, and the Futures Exchange. Commodity exchanges were initially created to provide further infrastructure and support to the agriculture industry over 150 years ago, with most exchanges initially established as non-profit companies.

As commodity exchanges grew and evolved many exchanges converted their business to a for- profit company in order to make money based on increased demand by providing access to investors who never intend on buying bushels of wheat or ever delivering barrels of oil. Investing in commodities and derivatives are known to be one of the riskiest investments. Investors speculate by investing in contracts at a price that will turn a profit before or on the scheduled delivery date for the specified commodity.

Types of Commodity Exchanges

In the United States there are currently two primary commodity exchanges and one independent exchange:

Primary Commodity Exchanges

  • Chicago Mercantile Exchange (CME) Group Inc. is a publicly traded company that currently has shares of its company listed on the NASDAQ. Through its exchanges, CME provides products across all asset classes, including futures and options based on interest rates, equity indexes, foreign exchange, energy, agricultural products and metals. The CME Group was originally known as the Chicago Butter and Egg Board. Following a number of mergers and acquisitions which created the Chicago Mercantile Exchange Group Inc. (CME), with subsidiaries that include, Chicago Board of Trade (CBOT), New York Mercantile Exchange, Inc. (NYMEX), Commodity Exchange, Inc. (COMEX) exchanges, and also 90% ownership in the S&P Dow Jones Indices. The company provides electronic trading around the world on its CME Globex platform.
  • Intercontinental Exchange Inc. (ICE) also known simply as The ICE, is also a publicly traded company, with shares listed on the New York Stock Exchange (NYSE). It operates regulated marketplaces for listing, trading and clearing a range of derivatives and securities contracts across the asset classes, including energy and agricultural commodities, interest rates, equities, equity derivatives, exchange traded funds, credit derivatives, bonds and currencies. The Company also owns the NYSE following a merger and acquisition in 2012.

Independent Commodity Exchange

  • The Minneapolis Grain Exchange (MGEX): The MGEX is the last remaining independent commodity exchange, located in Minneapolis, Minnesota. They primarily trade wheat contracts with the Canadian grain market.

 International Commodity Exchanges

Many countries around the world have established commodity exchanges in order to trade natural resources with other countries and investors worldwide.

 These exchanges include:

  • Taiwan Futures Exchange Taiwan, Province of China 
  • Sydney Futures Exchange (now part of ASX) – Australia
  • Euronext London International Financial Futures Exchange – United Kingdom
  • Kansai Commodity Exchange – Japan
  • Mexican Derivatives Exchange – Mexico
  • Russian Trading System – Russian Federation
  • South African Futures Exchange (now part of JSE) – South Africa
  • Singapore Commodity Exchange – Singapore
  • Shanghai Futures Exchange – China
  • Zambian Agricultural Commodity Exchange – Zambia

The U.S. Central Intelligence Agency (CIA) publishes a Field Listing of mineral, petroleum, hydropower, and other resources of commercial importance, such as rare earth elements (REEs) from countries around the world. Products generally appear on the list if they make a significant contribution to the economy, or are likely to do so in the future. A link to the Global Natural Resource Field Listing is located in the Resources page.

 

Regulation of Commodities

Every transaction that is executed with regard to buying and selling commodities and derivatives is monitored by the Commodity Futures Trading Commission (CFTC). The mission of the Commodity Futures Trading Commission is to promote the integrity, resilience, and vibrancy of the U.S. derivatives markets through sound regulation.

The CFTC operates under a framework that has been created through the The Commodity Exchange Act (CEA), which was passed in 1936, and regulates the trading of commodity futures in the United States. The CEA has been amended several times since 1936, and under this Act, the CFTC has authority to establish regulations that are published in title 17 of the Code of Federal Regulations (CFR). Title 17 is the section of federal law that governs commodity exchanges.

The CFTC has the ability to issue recommendations for the creation of new rules and regulations that investors must follow. The Commission’s authority to issue rules derives partly from the Commodity Exchange Act and the Dodd-Frank Act.

Following the financial crisis in 2008, the Dodd-Frank Wall Street Reform and Consumer Protection Act was created and implemented in 2010. The CFTC has written rules to regulate the derivatives and commodity marketplace.

Commodities Risks and Challenges

Over the past several decades the futures markets , also known as commodity markets, have grown significantly. This growth has been due to the increasing number of investors who are in search for higher rates of return, along with an increase in the variety of contracts available that represent investments in physical materials such as: propane, coffee, lean hogs, swiss francs, copper, etc. Investing in commodities involves a large amount of risk and speculation.

There is no way to know exactly what the future price of a product will be. This risk is known as price volatility.

  • Price Volatility is the changes in price over time of the underlying commodity. Per the Energy Information Administration (EIA), price volatility is measured by the day-to-day percentage difference in the price of the commodity. The degree of variation, not the level of prices, defines a volatile market.

Some additional risks of equal importance involved with investing in commodities and derivatives include:

  • Geopolitical Risks: Commodities are based largely on natural resources located around the world. Geopolitical risks are based on potential political conflicts between countries, organizations, and sovereign nations.
  • Corporate Governance Risks: While regulations have been created in an attempt to prevent fraud, one major risk when it comes to investing in commodities is fraud due to poor corporate governance.

 

Do The Research

Investing in commodities and derivatives can be extremely risky, while at the same time a versatile investment with potential for high rates of return and opportunity to hedge or manage price volatility. Regardless, it is important to do research before investing, The Commodity Exchange Act requires certain firms and individuals to be registered with the CFTC.

An example of risky investment comes from the late 1990’s utility company Enron that began trading weather commodities. Yes, just like you’re thinking, forecasts on actual weather conditions. This came after the price of natural gas was deregulated in the 1980’s. This meant that the price of natural gas was based on demand from the market’, in contrast to price stability, which is regulated to avoid large price changes that could disrupt market efficiency.

At the same time that Enron began to take bets on the weather, they were also trading natural gas futures/derivatives contracts. As a utility company they also agreed and promised customers to deliver natural gas to any location within the United States, with no time restrictions. Overtime Enron’s commodity investments in weather were valued at over $3.5 billion within the U.S. , with 90% of their overall revenue directly from trading futures. In July 2004, Ken Lay, CEO and founder of Enron, was indicted on 11 counts of securities fraud.

The National Futures Association (NFA) has created a verification tool following an increase in fraud that provides investors with the ability to verify registrations and backgrounds of commodity and derivatives industry professionals. A link to the tool is available in the Materials &  Resources section.

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