A commodity is a raw material or basic good — like oil, wheat or cotton — used to manufacture goods that can be sold and traded for consumer use. Unlike branded products, a commodity is the same no matter who produces it. For example, one barrel of crude oil is the same as another barrel of the same grade of crude oil, wherever it's produced. That consistency makes commodities easy to trade on global markets.
Commodities power the global economy and have also become a popular way to invest. Here’s how they work and what you need to know before jumping in.
Wise Takeaways
- Commodities are raw materials or basic goods that are used to produce finished products and traded on global markets.
- Their prices are driven by supply and demand, production trends, and investor activity, making them highly responsive to market shifts.
- You can invest in commodities through direct ownership, futures contracts, ETFs, mutual funds, or commodity-related stocks.
- Common examples of commodities include oil, gold, wheat, corn, cotton, and natural gas.
What is a commodity?
Commodities are raw materials used to make finished products. This includes things like oil, wheat or cotton. They aren't unique or branded, and they're produced in large quantities using standardized processes. Because they're uniform in quality, commodities are easy to trade and interchangeable no matter where they come from.
Commodity trading dates back to the 1800s, when farmers sold wheat and corn via local markets.1 Today, the market is more advanced, with global systems that allow investors to buy and sell commodities at set prices, regardless of who produced them.
How do commodities work?
To understand how commodities work, it helps to look at three key factors: the supply chain, the forces of supply and demand, and the role of investors who try to profit from price changes. Each one plays a part in how commodity prices are set and how the market operates.
The supply chain
Commodities rely on a system that connects producers to consumers. A producer, such as a farmer, miner or rancher, generates the raw goods. Those goods often pass through a middleman, like a processor or wholesaler, before being sold in bulk to retailers. The retailer then sells the finished products to consumers.
Supply and demand
The value of commodities is greatly based on supply and demand.2 Producers aim to sell a product at a certain price and quantity, but that price ultimately depends on a consumer’s willingness to purchase the product at that cost. The more popular a product is, the more consumers are willing to pay, and the value increases with the extra demand.
Commodity investors
Beyond producers and consumers, commodities also attract investors. Speculators try to profit from changes in price by buying when prices are low and selling when they rise. These speculators can be individual traders, hedge funds, or investment firms, and their activity can influence market prices, especially in times of volatility.
Speculators take many forms, whether they are individual commodities traders, portfolio managers and hedge firms and trading firms.
How to invest in commodities
There are several ways to invest in commodities, including purchasing the physical goods, trading contracts like futures or buying into funds and stocks tied to commodity prices. Here’s a breakdown of the most common options and how to choose the right one for you.
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Direct investment
You can purchase a commodity yourself through a direct dealer. This eliminates any markup from a third party, and you can often sell back to the same dealer, greatly simplifying the process. One popular commodity for direct investment is gold, which can be easily purchased by a coin dealer and sold at any time.
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Exchange-Traded Funds (ETFs) and mutual funds
ETFs and mutual funds can offer less risk because traders gain wide exposure to different commodities while minimizing risk. They are often purchased through an investment fund, which means traders can benefit from professional guidance. This makes them ideal for beginners to investing.
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Futures Contracts
More advanced investors may look to a futures contract for their investments. This is a commodity derivative managed from a brokerage account. These are typically used by larger companies instead of individuals because a certain amount of capital, or margin, is required. A margin call may later be required, which is when you are required to deposit more capital in order to maintain your holding.
Commodity stocks
There is also the option to purchase direct stock from the manufacturer itself. These stock prices are heavily based on demand and can take many forms, such as oil stocks, metal stocks or energy stocks.
Most commodities are exchanged via ICE Futures US and the CME Group, which together control four major exchanges. These include the Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange (NYMEX) and the Commodity Exchange, Inc. (COMEX).
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Why invest in commodities?
There are many reasons why an investor may want to look into commodities:
- To take advantage of market highs
- To reduce investment volatility
- To take short-term positions
- To join the market as a speculator
- To diversify your portfolio
Because commodities generally balance out high inflation, they are considered a safer and more reliable way to begin investing, as long as you choose the right investments at the right time. A licensed financial advisor can help you choose the right options for your portfolio.
Examples of commodities
Commodities are classified as either a hard or soft commodity.
Hard commodities
A hard commodity is a natural product that is extracted from the earth. This includes petroleum, ore and silver.
- Energy commodities: An energy commodity includes those materials extracted from the ground, including energy sources like crude oil, ethanol, gasoline and uranium. Energies also include renewable energy, such as wind or solar power.
- Ore commodities: Precious metals mined from the ground are considered hard commodities, such as gold, silver and platinum. Also included are industrial metals, such as aluminum, nickel, lead and copper.
Soft commodities
A soft commodity is one that is grown, such as wheat, soybeans and lumber. This also includes those products that cannot be stored long-term, such as sugar, cotton and coffee.
- Commodities for human use: These commodities include those for human consumption like sugar, cocoa and coffee. They also encompass some non-edible items, such as lumber and clothing.
- Agricultural commodities: Agricultural commodities include livestock or animals that can be raised, such as cattle and hogs. It also includes products made from animals, such as leather and gelatin.
Examples of hard vs soft commodities
| Hard commodities | Soft commodities |
|---|---|
| Crude oil | Livestock |
| Ethanol | Cotton |
| Coal | Sugar |
| Gold | Cocoa |
| Silver | Soybeans |
| Palladium | Lumber |
| Aluminum | Leather |
Who sets the price of commodities?
Because they are essential products that are used every day, commodities form the basis of the global economy. They are traded, bought and sold in financial markets. Manufacturers are able to set a value for their goods and enter into contracts with investors for that price. Should the price increase, investors receive a higher value for their investment, but they are also left vulnerable to losses should prices plummet.
The price of commodities depends on several factors:
- World economy: Global conflicts can easily affect the price of commodities such as oil or grain. The World Bank reports that unexpected economic shocks can be attributed to several fluctuations in the price of commodities dating back to 1996.3
- Natural disasters: Weather-related disasters, such as hurricanes or typhoons, can also cause great price instability among commodities, especially for those materials destroyed during the storm.4
- Political events: Elections and other major political events can also influence demand, thus affecting the price of commodities.5 For example, duties on imports and exports can fluctuate, impacting the overall price of the product.
- Competition: Competition among suppliers can also affect the price of commodities. Newer technologies can create a lower overhead and lead to faster processing, thus bringing the overall price down.6
- Season: Changes in season can also affect availability and demand, such as those commodities in harvesting.7
Risks of investing in commodites
Investing in commodities can be an extremely lucrative venture when done correctly. However, it is not without risk, as the commodities market is extremely volatile, and prices can easily fluctuate.8 Decreases in consumer demand economic recessions can easily lead to losses if positions are not sold in time. While this draws speculators, it is not ideal for newer traders who may lack the experience to accurately time the market.
Commodities vs stocks
Commodities are very different from stocks in several ways.
| Feature | Commodity | Stocks |
|---|---|---|
| High volatility | ✓ | 𝒙 |
| Leverage | 𝒙 | ✓ |
| Pays dividends | 𝒙 | ✓ |
| Short-term investment | ✓ | 𝒙 |
| 24/7 trading | ✓ | 𝒙 |
Commodities pros and cons
There are several advantages to commodities, but they are not perfect and should be approached with caution. After all, even products with a high demand can incur losses. There is no way to predict the future, and sudden or catastrophic events like extreme weather or a change in political leadership can easily impact the price of commodities, changing the value of your investment. However, if you time the market just right, it could result in major profits generated from short-term trading.
Pros
-
Can bring short-term gains
-
Protection against inflation
-
Adds to portfolio diversification
Cons
-
Can be very volatile
-
Dependent on macroeconomic events
-
No regular dividends
FAQs
Lena Muhtadi Borrelli brings over 20 years of experience in the finance industry. She began her career at Morgan Stanley before transitioning over to media. As a finance writer, she has served as an authority for several respected outlets, including Forbes, TIME, Newsweek, Bankrate, Investopedia, Insurance.com, and InvestorPlace. No matter what she is writing, Lena has a unique ability to simplify complex topics, making finance more approachable and relatable to the average reader. When she is not writing or scanning the news for the latest headlines, she is happiest spending time in the Florida sunshine with her husband and two pups.
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