What commodities are: physical goods, standardisation and who trades them

What you will learn

• What makes a good a commodity and how the four main groups differ
• How exchanges standardise quality, quantity, location and time
• How a benchmark price plus differentials sets the price of a real cargo
• Who trades commodities and why their motives differ

Explanation

A commodity is a raw material or primary product that is largely fungible (interchangeable): one tonne of copper of a given grade is treated like any other tonne of the same grade. Because buyers do not care who produced it, the price is set mainly by supply and demand, not by brand or marketing.

The four main groups

"Hard" commodities are mined or extracted; "soft" commodities are grown. In market language, softs usually means tropical crops such as coffee, cocoa, sugar, cotton and orange juice.

Standardisation

An exchange contract fixes every detail that would otherwise need negotiation:

• Grade: for example the sulphur content of crude oil, the protein content of wheat or the purity of copper.
• Quantity (contract size): for example 1,000 barrels of crude oil, 25 tonnes of copper on the London Metal Exchange (LME), 5,000 bushels of corn on the Chicago Board of Trade (CBOT).
• Delivery location and period: for example Cushing, Oklahoma for US WTI crude.
• Price unit and tick: the quotation unit and the minimum price step.

Margin and daily settlement are covered in the Derivatives course. Standardisation lets many participants trade one liquid benchmark instead of many slightly different goods. Many positions are closed or rolled before delivery, but the possibility of delivery ties the futures price to the physical market.

Benchmarks and differentials

A real cargo rarely matches the benchmark exactly. It is often priced as:

Cargo price = benchmark price ± quality differential ± location (freight) differential

Heavy, high-sulphur crude usually trades at a discount because it costs more to refine. Grain far from a port usually trades below the export price by roughly the transport cost. The local cash price minus the futures price is called the basis.

Who trades commodities

• Producers (oil companies, miners, farmers) often sell forward to secure revenue.
• Consumers (refiners, airlines, food processors, utilities) often buy forward to secure costs.
• Merchants buy, store, ship and blend goods and earn from differentials and logistics.
• Exchanges such as CME Group (which includes NYMEX, COMEX and CBOT), ICE, the LME, the European Energy Exchange (EEX) and Euronext provide contracts and clearing.
• Financial participants: funds, speculators and index investors who never use the goods.

Private investors in Germany usually reach commodities through exchange-traded commodities (ETCs), contracts for difference (CFDs) or futures via a broker. Leveraged products such as CFDs and futures can lose money quickly, and losses can exceed a planned stop when prices gap.

Worked example

Hypothetical example: pricing a crude cargo and converting units. Assumptions: the benchmark (Brent) is $72.00 per barrel. The cargo is a heavier, high-sulphur crude with a quality discount of $2.50. The buyer in Rotterdam pays freight of $1.80 per barrel on top. Cargo size 700,000 barrels. EUR/USD = 1.10.

1. Price per barrel: $72.00 − $2.50 + $1.80 = $71.30.
2. Cargo value: $71.30 × 700,000 = $49,910,000.
3. In euros: $49,910,000 ÷ 1.10 = €45,372,727, about €45.37 million.
4. Per litre: one barrel = 158.987 litres, so $71.30 ÷ 158.987 = $0.448 per litre, about €0.408 per litre.

Refining, distribution and taxes explain why pump prices are much higher.

Part 2: grain units. CBOT corn is quoted in US cents per bushel. A quote of 500 cents = $5.00 per bushel. A bushel of corn is defined as 56 pounds (25.4 kg), so one tonne = 39.37 bushels. $5.00 × 39.37 = $196.84 per tonne, or €178.95 at 1.10. Now it is comparable with a European price in €/tonne.

Excluded: insurance, financing, letters of credit, currency conversion spreads and taxes.

Common mistake

Practice activity

Hypothetical data, no costs.

1. A copper buyer pays the LME price of $9,000 per tonne plus a delivery premium of $150 per tonne in Rotterdam. She buys 50 tonnes. Calculate the total in dollars and in euros at EUR/USD 1.08.
2. CBOT wheat is quoted at 600 cents per bushel. A wheat bushel is 60 pounds (27.2 kg), so one tonne = 36.74 bushels. Calculate the price per tonne in dollars and in euros at 1.10.
3. Classify each participant: (a) an airline buying jet fuel forward; (b) a farmer selling December corn futures in spring; (c) a fund buying a broad commodity ETC.

Key takeaways

• Commodities are fungible goods; their price is driven by supply and demand, not brand.
• Exchange contracts standardise grade, quantity, location, time and price unit.
• Physical prices are a benchmark plus or minus quality and location differentials.
• Hedgers, merchants and financial participants trade for different reasons.

Next step

In the next lesson you apply these ideas to the largest commodity market of all: crude oil, its two main benchmarks and the forces behind the oil price.