Commodities: Definition, Types, Markets, and Investment Roles
Commodities are basic raw materials used in commerce that are interchangeable with other goods of the same type. They serve as inputs for producing goods and services and are traded in large volumes on specialized exchanges. Commodities are commonly used by producers to hedge price risk and by investors for diversification and inflation protection.
What is a commodity?
- A commodity is a fungible raw material (e.g., crude oil, wheat, gold) that meets minimum quality standards and can be traded without regard to its origin.
- Commodities are classified as:
- Hard commodities: mined or extracted (metals, oil, gas).
- Soft commodities: grown or agricultural (grains, coffee, livestock).
How commodities function in the market
- Commodities are largely undifferentiated: a barrel of a given grade of oil or a bushel of a specified grade of wheat is effectively the same regardless of producer.
- They trade on exchanges in spot markets and via derivative contracts (futures, forwards, options), which standardize quantities and quality for large-scale trading.
- Derivatives enable large-volume trade without physical delivery and are used for both hedging and speculation.
Buyers, producers, and speculators
- Hedgers (buyers and producers): use futures and forwards to lock in prices and reduce exposure to adverse price moves. Example: a farmer sells wheat futures at planting to guarantee a price at harvest.
- Speculators: trade to profit from price movements and typically do not intend to take delivery. Their activity provides liquidity and helps price discovery.
What determines commodity prices?
- Supply and demand is the primary driver. Influencing factors include:
- Economic growth (affects industrial and energy demand)
- Inflation expectations and monetary conditions
- Weather and natural disasters (crop yields, infrastructure disruptions)
- Geopolitical events and production decisions (e.g., OPEC output)
- Investor sentiment and flows into commodity-related investments
- Commodities often rise during accelerating inflation, making them a popular hedge when purchasing power is expected to fall.
Commodities vs. securities and assets
- Commodities are physical goods consumed or used in production.
- Assets (e.g., machinery) persist through use; securities (e.g., stocks, bonds) are financial instruments representing claims on cash flows or ownership, not physical goods.
How to invest in commodities
- Direct exposure: physical ownership (rare for most investors).
- Derivatives: futures, options, and forwards (complex, often requires margin).
- Indirect exposure: commodity ETFs, mutual funds, commodity-producing stocks, and commodity-focused funds—these are more accessible for average investors.
- Allocation guidance: some advisers suggest up to about 10% of a diversified portfolio in commodities for inflation protection and diversification; ETFs/mutual funds simplify access.
Where commodities are traded
- Major U.S. exchanges:
- ICE Futures U.S.
- CME Group (CBOT, CME, NYMEX, COMEX)
- Numerous global commodity exchanges operate internationally for different regional products.
Key takeaways
- Commodities are interchangeable raw materials critical to many industries and are traded in spot and derivative markets.
- They are categorized into hard (mined/extracted) and soft (agricultural) commodities.
- Producers use commodities to hedge; speculators provide liquidity and seek profit.
- Prices reflect supply and demand plus macroeconomic and event-driven forces; commodities can act as an inflation hedge and portfolio diversifier.
Sources (selected)
- Library of Congress — Commodities resource guides
- Financial Industry Regulatory Authority (FINRA) — Futures and commodities overview
- CME Group — Guidance on futures and commodity markets
- Vanguard — Research on commodities and inflation protection