Who Sets the Price of Commodities?

What Are Commodities?

Do you ever think about what goes into that cup of coffee you reach for every morning? What about the gas that you use to fill up your tank every week? Most of us never realize it, but virtually all of these goods begin with commodities.

Commodities are an extremely important part of the financial market. That's because they are essential for producers and manufacturers. A commodity is essentially a basic product or raw material used to make all the goods and services that we need in our everyday lives.

There are a wide array of commodities, including oil, gas, coffee, soybeans, and rice. These commodities are traded on commodity exchanges around the world such as the Chicago Mercantile Exchange (CME), the London Metals Exchange, and the Intercontinental Exchange (ICE). Investing in commodities provides investors with a way to diversify their portfolios, especially during times of market volatility.

Read on to find out more about the different types of commodities, their price structures, and who sets them on the market.

Types of Commodities

Since commodities are traded on exchanges, their prices aren't set by a single individual or entity. In fact, there are many economic factors and different catalysts that affect and move their prices each day.

Just like equity securities, commodity prices are primarily determined by the forces of supply and demand in the market. For example, if the supply of oil increases, the price of one barrel decreases. Conversely, if demand for oil increases (which often happens during the summer), the price rises. Gasoline and natural gas fall into the energy commodities category.

Weather plays an extremely significant role in price changes for crop-related or agricultural commodities, especially in the short term. If the weather affects supplies in a certain region, it has a direct impact on that commodity's price. Commodities that fit into this category include corn, soybeans, and wheat. Cotton, coffee, and rice are referred to as soft commodities.

Gold is one of the most actively traded commodities because it is used to produce jewelry and other goods. But is also considered to be a worthwhile, long-term investment. Silver and copper are other examples of commodities in the metals group.

Livestock is another group of commodities. This category includes live animals, such as hogs, and cattle.

Spot vs. Futures Price

Commodities are traded via futures contracts on exchanges. These contracts obligate the holder to buy or sell a commodity at a predetermined price on a delivery date in the future. Not all futures contracts are the same. In fact, their details differ depending on the commodity being traded.

The market price of a commodity that is quoted in the media is often its market futures price. The futures price is different than the spot price or cash price, which is the actual price for the commodity today. For example, if an oil refiner buys 10,000 barrels of oil for $50 per barrel from an oil producer, $50 per barrel is the spot price. The futures price can be more or less than the spot price at any given moment.

Many traders use commodity futures to speculate on future price movements. They generally don't trade the physical commodities themselves. That's because buying barrels of crude or bushels of wheat isn't practical. These investors analyze market activity and chart patterns to speculate on future supply and demand. They subsequently enter long or short futures positions depending on which direction supply and demand move prices.

Speculators are distinct from hedgers, who are often the end-users seeking to protect interests in the commodity by selling or purchasing futures contracts. If a soybean farmer thinks prices will fall over the next six months, they can hedge their crops by selling soybean futures today. Hedgers and speculators collectively represent much of the buying and selling interest in commodities futures, making them important parties in determining commodities prices from one day to the next.