Global Commodity markets.

Jul 22, 2024

5 min read

The below provides a foundational understanding of the Global Commodity market but is not a substitute for further in-depth reading. I have generally shared trades on Commodities, but you need to fully understand the market structure before making investment/trading decisions.

Brief Foundational Narrative

Hey there! I'm not going to dive deep into all that theoretical and historical stuff - you can find that in the Books and Papers section if you're interested. Instead, I'll focus on the important points that I believe matter.

When it comes to commodities, they're like a mix of financial tools that are used for both consumption and as assets to protect against inflation. And nowadays, they're also being used for speculation to make money from price changes.

The rise in commodity prices is driven by the increase in global industrial activities. Economies require more commodities as they industrialize, leading to higher prices for essential goods. For example, higher manufacturing levels increase demand for industrial commodities such as Copper and Aluminum. Therefore, as economies, particularly the industrial sector, expand, commodity prices typically increase.

The goal is to effectively trade commodities as an asset class. Understanding the market structure is crucial, considering its hybrid nature as both a consumption or processing of goods and a financial instrument.

Market Participant

The commodities market is primarily made up of two market participants:

Hedgers
The Speculator

Hedgers are participants whose primary motive in engaging within the commodities market is to protect their interest from a Sales or Purchase point of view on their production/business activity.

Recall the Hybrid nature of commodities, in the real economy there are producers of commodity assets and also consumers/more appropriately users of commodity assets. Each player would like to protect their interest as follows:

The Producer would like to sell their commodity at the highest possible price for profit gains well above their cost - Short Hedge
The Consumer/User would like to purchase the produced commodities at the cheapest possible price - Long Hedge

So, each Hedging party has its interests, right? They end up either selling short or going long all the time. The producer usually goes short to sell the commodity at a high price, while the consumer tends to go long to buy it at a low price.

But here's the deal - at this point in the report, these hedgers can only really pull this off in the Futures market, not the Spot market.

Spot Market

The Spot market, also known as the Cash market, is where you can make instant purchases and sales of commodities with immediate delivery. For example, if you check the Spot price of Cotton and decide to buy some, you're getting Cotton at that moment's price and receiving it right away.

But here's the thing - the spot market doesn't work for someone like a Cotton farmer who's planting now and won't harvest for 3 months, or for a Textile Processing plant that needs to stock up for production 2 months later. They don't have to buy from the spot market for immediate delivery.

Futures Market

So, the Futures market evolved from the Cash market for a bunch of reasons. It's there to help out the Hedgers by making the underlying commodity product standard, with different delivery periods marked in calendar months.

The futures market is pretty handy for figuring out the demand and supply situation because it shows a lot about what producers and users of the contract are up to.

So, let's say I run a plant that makes Orange Fruit Juice, and I hear through the grapevine that Orange Juice prices are going up by January 2025. To play it safe and not get hit with higher costs, I'd buy some OJF25 (Jan'25) contracts at today's price. This means that when the time comes, I'll get a set amount (15,000 pounds per contract) of oranges to use in my juice. However, if I do not wish to receive the underlying commodity, I would have to close my position before the delivery date.

check out CME website https://www.cmegroup.com/markets.html?utm_campaign=get_started_trading_2024&gad_source=1&gclid=CjwKCAjwnei0BhB-EiwAA2xuBkZH_Mfuja7RRo9Z3pLi2xBRZ5HYD_-ggcbPw7UlxxlVqz0H93rfbRoCQW4QAvD_BwE&gclsrc=aw.ds

Chicago Mercantile Exchange is arguably the biggest exchange for futures contracts.

Futures - Term Structure

Similar to how the bonds market works with its Yield Curve giving a peek into future interest rate trends, the Futures market for commodities has its curve predicting future commodity prices. This curve helps us understand the supply and demand dynamics of the asset.

Before we dive into the nitty-gritty of term structures, let's quickly talk about the concept of Basis.

The basis is simply the price difference between the Spot and a Futures contract.

For example, if we look at the Orange Juice market, the Cash price was at 426.00, while the July’24 contract was at 432.75 and the Sep’24 contract was at 437.05.

The Basis between the Cash price and the July’24 contract is 6.75, and between the Cash price and the Sep’24 contract is 11.05.

This Basis gives us insights into

storage
insurance
transportation costs
financing rates
and convenience yield

The increase in Basis between the Spot and a Futures contract is tied to the rise in any of these costs, affecting the commodity price. The reasons behind changes in Basis are pretty straightforward, except for Convenience Yield.

Convenience Yield is the benefit of physically holding the commodity instead of a futures contract, based on the advantages of immediate use. It's a thumb rule that Convenience Yield rises when commodity inventories drop and falls when inventories increase.

In essence, Convenience Yield hints at the scarcity or availability of the commodity, impacting Basis and the term structure.

Now that we've covered the basics of Basis, let's move on to the different types of Term Structures for commodities.

Backwardation and Contango

Backwardation happens when the spot price is higher (more expensive) than the futures contract coming up. On the flip side, Contango is when the spot price is lower (cheaper) than the futures contract ahead.

A backwardation term structure is an indication of a high-risk premium or anticipated decline in the spot price, hinting at a future expectation in distortion of supply/demand imbalance.

While a Contango term structure is an indication of a potential surplus of the commodity, with no expectation of a large change in supply and demand imbalance.

Volume & Open Interest

When we look at Volume and Open Interest, we get a better idea of what's going on with market participants. Volume tells us about the trading activity, whether it's buying or selling.

Open Interest (OI) is another important tool to consider. It shows us how many contracts are still active. OI helps us understand the dynamics between long and short positions - it goes up when new long positions are taken against existing short ones, and down when existing long positions are closed by existing short positions.

It's best to trade the contract with the highest volume and open interest.

Commitment of Traders Report

The COT report in addition to Volume and Open Interest also provides additional information on the positioning of market participants.

So, the COT chart gives you the lowdown on Commercials (in red), Large Speculators (in green), and Small Speculators (in blue). When you're checking out the data, think of it like a stacked histogram with a zero line smack in the middle. If the line is above zero, it's a sign of going long, and if it's below, time to go short.

A bit more details on the COT Report, the Commercials positioning is information on the hedging position of Producers and Processors. The other group are Non-commercials which include large speculators such as Banks and Hedge Funds, whose primary objective is to speculate on the price of the underlying asset.

The focus is on analyzing the net position of the Commercials and Non-Commercials. When the net position of the Commercials are net long, they are hedging against a potential increase in the price of the underlying asset, and vice versa when they are net short.