5.

6 Web Resources: Commodities and their

risks and returns
What are commodities?
Commodities are processed or unprocessed natural resources that are bought and sold by
various parties, including investors. These goods are traded on a global market, which
means that, ignoring transport costs and so on, a commodity’s price in US dollars – the
currency in which nearly all commodities are traded – is typically the same all over the
world. Coffee beans, a popular commodity, are traded for the same price in New York, Rio
de Janeiro, London, and Cape Town (Commoditytrading-sa.co.za, n.d.). 

Like the prices of all goods and services, the price of commodities is driven by supply and
demand. Some common examples of commodities produced in South Africa are gold, silver,
platinum, wheat, maize, cotton, sugar, and coffee. The largest global commodity market is
the market for oil.

Soft commodities are resources that are cultivated or farmed, such as wheat, corn, sugar,
cocoa beans, rice, and cattle. Hard commodities are resources that are mined or taken from
the earth, such as oil, gas, silver, aluminium, and gold. 

Krugerrands and gold: 

The Krugerrand is the world’s most actively traded gold bullion coin (Rand Refinery,
n.d.). It was first minted in 1967 to help promote the gold market in South Africa (JSE,
2017). Krugerrands are gold coins, so their value is derived from the price of gold,
although they typically trade at a premium to this. There are different sizes of coins,
each with a different value.
By investing in Krugerrands, investors are effectively investing in gold, and they are
essentially trading in gold if they are buying and selling these coins. Gold has
historically had a low correlation with most financial asset classes, and is traded as its
own investment type, even though it is a commodity. Thus, gold can be an effective asset
to hold for diversification purposes.
Investors can open a brokerage account with the JSE and invest in Krugerrands in this
way. There are also brokerage accounts available to trade other commodity types.

This following resource differentiates between the soft commodities market and the hard
commodities market. When reading this article, focus on these differences and the way that
the demand and supply of these goods affect their markets. 

Access the resource.

How are commodities traded?

Physical commodities are demanded all over the world because they are needed for use and
consumption, and are therefore widely traded. So how do commodity traders make money?
Commodities require time for processing before they are delivered from the producer or
seller to the buyer. One of two methods of trading can be agreed on by the producer and
buyer; the purchase can be done based on the spot price, or through forward contracts.
The spot price is the price you pay for buying the commodity immediately – in other words, it
is the current market price. 

If a buyer requires the commodity in the future, they can enter into a forward contract with
the producer, which contractually fixes the future price of a specific amount of the
commodity, as well as the specific future date at which delivery of the commodity and the
payment for it will occur.

These types of contracts also trade on futures exchanges (public futures markets), in which
case they are called futures contracts, or futures for short. Futures contracts are just forward
contracts that are standardised – in other words, hundreds or thousands of them that are all
exactly the same can be created and traded. Importantly, the value of these futures contracts
(in other words, their price) will move up or down as the price of the underlying commodity
moves up or down.
 Figure 1: An example of the way that investors use futures contracts.

 Note that in reality, investors will seldom deal with farmers directly. Instead, they will buy
and sell futures contracts amongst each other, which means that if the wheat price in the
example in Figure 1 increases to above the contract price, the “buyer” of the contract will
make a profit, and the “seller” of the contract will make a loss. 
There are several ways to trade in commodities on exchanges using spot prices and futures
contracts. The resource that follows explains how this can be done using instruments such as
contracts for difference (CFDs) and exchange-traded funds (ETFs), which trade on stock
exchanges. Commodity exchange-traded funds are funds that invest in one or more
commodities, or in futures contracts on these commodities. Note that exchange-traded funds
are explored in more detail in Module 6. 

Access the resource.

The risks and returns of commodities trading

Traders can make money trading commodities using the spot price by simply buying the
commodity at the spot price and then selling it at a higher price. This means that they will
have to wait until the price increases before they sell, thus running the risk of the price
decreasing instead (i.e. they can make big losses as well, especially as commodity prices can
be quite volatile). 

Although futures contracts expire at the agreed future date, they can be traded in the
meantime between willing buyers and sellers on the futures market, which in South Africa is
the South African Futures Exchange (or SAFEX), which is part of the JSE. 

The valuation of a futures contract is quite complex, but the key thing to remember is that the
price at which the commodity must be the bought by the one party and sold by the other at
the future date is fixed by the contract, and cannot change. Therefore, when the expected
future market price of the commodity increases, the value of the contract increases for the
person who has the obligation to buy the commodity when the contract expires (known as the
“long” position in the contract), and decreases for the person who holds the obligation to sell
at that price (known as the “short” position in the contract).

This is because it now looks like the person who has the obligation to buy the commodity at
the fixed price will be better off compared to having to buy the commodity at the market
price, while the person who has to sell the commodity at the fixed price will now be worse
off (by the same amount) compared to selling in the future at the market price. Of course, if
the future market price of the commodity should fall, the exact opposite happens – the
contractual commodity seller (short party in the contract) is now better off, and thus
experiences an increase in the value of the contract, whereas the contractual buyer of the
commodity (the long party) is worse off, and thus for this party, the contract loses value.

In fact, because the changing value of a futures contract is directly dependent on the changing
price of the underlying commodity, a futures contract is one of a group of financial assets
known as derivatives, which are so called because their value is derived from the price
movements of the underlying asset.

For example, an investor could enter into a futures contract to receive a tonne of cocoa beans
in three months’ time for a price of R10,000 per tonne. Assume that the investor does not sell
the contract before it expires, and that at the end of three months, the market value of cocoa
beans has gone up to R13,000 per tonne. This means that the investment is worth more, and
the cocoa beans that the long party in the contract receives for R10,000 per tonne can be sold
for the spot price in the market of R13,000 per tonne, realising a profit of R3,000 per tonne.
Of course, the other side of the contract (the short party) would have made a loss of R3,000,
because in terms of the contract, they would have to sell the cocoa beans for R10,000 per
tonne, as opposed to the R13,000 per tonne that they could have been sold at in the market.
Therefore, at termination, the contract is worth R3,000 to the party who holds it.

The discussion thus far has focused mostly on the investment side of futures contracts, which
often involves trying to predict future commodity prices and trying to profit from these
expectations by trading in the futures contracts whose values depend on these price changes.
This group of participants in the market are known as “speculators”, but there is also another
group of participants who are known as “hedgers”, because they use future contracts to
control (“hedge”) price risk.

For example, farmers frequently use futures contracts to manage the risk that the market price
for their produce can decline by the time their produce is ready for harvest. This means that
they would have to sell their produce at a low price and make a lower profit or even nothing
at all. Video 1 explains how futures contracts and the futures market is used by maize farmers
to mitigate this risk (note that in the US, maize is known as corn).

(Source: https://www.youtube.com/watch?v=CC9VeHrI3Es)
The commodities exchange
Commodities and commodity futures are very similar to shares, in that they can be bought
and sold on exchanges. There are different commodity exchanges around the world, such as
the London Metal Exchange. Platforms like Investing.com offer daily prices on all the
different commodities trading at the moment.

If you look at the London Cocoa futures on this platform, you will note that they are traded in
pounds and the unit traded is in tonnes. It is important to be aware that although commodity
prices are global and usually quoted in US dollars, the unit of measurement will differ. For
example, gold prices are quoted in troy ounces, oil in barrels, etc. Investors or potential
investors can also see price histories of these commodities over a day, a week, or even a
month. There is a host of information in this resource – take some time to explore it further.

Access the resource.

Commodities versus equities

Because commodities and shares are traded in a similar way, a common decision that
investors have to make is whether to invest in commodities or equities. Remember that you
do not have to invest solely in one or the other asset class, as diversification is the best option
for any portfolio if you want to mitigate risk.

This last resource is an article by iBest Futures covering commodities and equities,
differentiating between the two, and explaining why both are good investments.

Access the resource.

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