Commodities are typically the products which are extracted out of natural resources in short supply on earth, which are usually traded across global markets by the investors, with a perspective of making some gains in future, by virtue of fluctuation in market value of such products in future.

<img class="alignleft size-full wp-image-2065" title="commodities" src="https://financetrain.com/wp-content/uploads/2011/06/commodities.gif" alt="" width="159" height="159" />In broad perspective, the commodities which are popularly traded across the world in different commodity markets, include some mining products, non ferrous metals, precious metals, agri-products and crude oil.

Typically, all such products have a limited supply in the world, and the prices vary depending on climatic changes, the supply available compared to demand, the degree of risk associated with diminishing value of holding popular currencies like US $ and the usage of such products.

Defining Commodities

Typically, there are different types of commodities which are popularly acceptable as tradable with a time value across the global markets.

Base Metals

Base metals, extracted out of earth include the non ferrous metals like zinc, copper, aluminum and few other metals which have a high demand in futures markets in commodity markets. The major global markets, which are known to determine the value of such futures include the London Metal Exchange (LME), where all metals-ferrous and non ferrous are tradable. Apart from same, there are other international commodity markets like Chicago Board of Trade (CBT), or Chicago Mercantile Exchange (CME) in US where such products are traded for future value on a daily basis.

Precious Metals

Apart from base metals, precious metals like gold, silver, palladium and few others are also popularly traded on CME, in options and calls, apart from future lots with an expiry date. In India, typically all the commodities have common platforms to trade on and include NCDEX and MCX.

Other Commodities

Apart from non ferrous metals and precious metals, the other types of commodities which are popularly traded across the world include crude oil, gasoline and natural gas, whose supply always remains restricted compared to forecasted demand, and the agri-products like corn, soya bean, guar seeds, palm oil, chana, sugar and many more agri-products except onions.

Commodity Markets - Types of Commodities

The traders in commodity markets for different commodities are of two types:
<ul>
	<li>One who like to leverage on the future value of such commodities by taking some risk on shoulders with a view of gaining out of future value, which may fall or rise according to the forecast.</li>
	<li>The other traders of such commodities are such companies whose main business risk is associated with the fluctuation in future market value of the product/ commodity, but they simply try to bring down such a risk by hedging in such commodities, till their risk gets exhausted in main business line of operations.</li>
</ul>
For instance, the jewelers carrying large stocks of gold jewellery, may like to profit out of selling jewellery in the markets, but are always interested in bringing down their risk associated with carrying large inventory due to fluctuation in gold prices, by hedging the same in futures markets.

But their main objective always remains to make gains out of selling jewellery, and through hedging. Hedging is used by such people only as a tool to minimize their future risks.

Commodity Traders and Future Value

There are several kinds of markets where the commodities are traded. Typically, the commodities which are meant to change hands physically for use in daily life like agricultural commodities are traded over the counter where the buyers and sellers meet to decide the price. These are usually the spot markets, where instant cash is used to physically exchange the commodities, which pass from sellers hands to users. However, given that most of the products traded in commodity markets have a large volume and need some storage space, it is noticed that spot markets for commodities are popular only for physical exchange of goods from one party to another for cash, where they may be of use for the buyer. The key issues surrounding the settlement in cash/ OTC spot commodities markets are the lack of clarity of contract size of commodities, for settlement, and the period involved, which may vary from two days to 45 days. Apart from same, the transaction costs in spot markets are also high, and the credibility of the buyers can not always be ascertained offhand.

In sharp contrast, forward markets and future markets are derived for trading of commodities in markets, with a view of ascertaining a future value of the same commodity, after keeping view of the demand, the geo-political factors, climatic conditions, fluctuation in currency and inflation and the supply available for the commodity. In forward markets, the settlement is done by physical delivery and payment is settled close to 6-7 weeks from carrying out the trade, but is done after backing the same with physical delivery and not merely by exercise of options and calls.

The most popular form of trading in commodity markets, from base metals, precious metals, oil and energy and agri-products, is carried out in the futures market, where the contract size of every lot of commodity is pre-determined, and the date of expiry of options and futures is also earmarked in advance, as per the exchange rules. In such cases, the commodities are traded in options and futures by paying some margins at the time of entering into contract in any commodity, and the exercise of options/ futures could be settled till the date of expiry of contract date, by the person who holds such a right by paying a premium for the time value in advance.

The date of expiry of contracts is always determined in advance by the relevant exchange, and the traders buy or sell options/ calls based on the forecast of the price they anticipate of the commodity by the date of maturity of contract. In most of the well regulated and advanced commodity markets, the mechanism works almost on lines similar to futures trading in the stock markets, and such contracts are matched on electronic basis. With time, the physical delivery of commodities have paved way for the futures trading in the commodity markets, and the exchange authorities monitor the system of collection of margins from traders, based on mark to market basis, after a base margin.

Usually, the traders themselves are involved in active trading in commodity markets in the products of their knowledge and interest. But at times, they may also act as brokers for other parties wanting to get the hedging done, to typically safeguard their main business line from risks. Apart from these classes, there are other traders, who like to take advantage of arbitrage between the price differences two different commodity exchanges operational in the same country, to make gains out of such wild movements of same commodities in separate directions in different commodity markets.

In India, the popular futures markets for commodity trading are MCX and NCDEX, and both of them even offer facilities of evening trading, to tune the local prices, in line with the major international markets with a time zone gap. Ever since the growing popularity of commodity exchanges in futures over the past two decades in our country, the number of products to have been permitted to be traded have been increasing gradually. The average daily turnover in commodity exchanges has noticed a significant uptrend over the past 10 years, since the increased retail participation and awareness on commodities.

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Types of Markets for Commodity Trading

Futures contracts in <a title="Defining Commodities" href="https://financetrain.com/defining-commodities/">commodity markets</a> perform two important functions of <a title="What is Price Discovery?" href="https://financetrain.com/topic/what-is-price-discovery/">price discovery</a> and price risk management with reference to any commodity-irrespective of the fact whether it is a base metal, precious metal or agri-products or even crude oil/ any other form of energy. It is useful to different segments of economy. A seller can get an idea of the price likely to prevail at a future point of time and hence can decide between various competing commodities, the best that suits him. On the other side, it also enables the consumer to get an idea of the price at which the commodity would be available at a future point of time. He can do proper costing and cost benefit analysis and also cover his purchases by making forward/ futures contracts. Futures trading is very useful to the exporters as it offers the privilege of providing a advance indicative price likely to prevail and allow the exporter to quote a realistic price in a competitive market. It enables him to hedge his risk by operating in futures market. Other benefits of futures trading are:

Price stabilization-in times of heavy price fluctuations 

The mechanism dampens the peaks and lifts the bottom of price, thus reducing the volatility in the market to some extent.
<ul>
	<li>It leads to integrated price structure throughout the country.</li>
	<li>Facilitates lengthy and complex production and manufacturing activities.</li>
	<li>Helps balance in supply and demand position throughout the year.</li>
	<li>Encourages competition and acts as a price barometer to farmers and         other trade functionaries.</li>
</ul>
Market Governance

Futures trading is also capable of being misused by speculators. In order to safeguard against uncontrolled speculation certain regulatory measures are introduced from time to time. They include:
<ul>
	<li>Imposition of upside limit on open position of an individual operator to prevent over trading</li>
	<li>Limit on price fluctuation (daily/weekly) to prevent abrupt upswing or downswing in prices</li>
	<li>Special margin deposits to be collected on outstanding purchases or sales to curb excessive speculative activity through financial restraints</li>
	<li>Minimum/maximum prices to be prescribed to prevent future prices from falling below the un-remunerative level and from rising.</li>
</ul>
 

During times of short supply of commodity, extreme steps like skipping trading in certain deliveries of the contract, closing the markets for a specified period and even closing out the contract to overcome emergency situations are taken by regulatory authorities, or the government itself.

With the gradual withdrawal of the government from various sectors in the post-liberalization era, the need has been felt that various operators in the commodities market be provided with a mechanism to hedge and transfer their risks.

Futures trading is necessarily organized under the auspices of a market association so that such trading is confined to or conducted through members of the association in accordance with the procedure laid down in the Rules &amp; Bye-laws of the association and by the authorities regulating the commodity exchanges.

It is invariably entered into for a standard variety known as the "basis variety" with permission to deliver other identified varieties known as "tenderable varieties".

The units of price quotation and trading  are fixed in these contracts, parties to the contracts not being capable of altering these units.

The delivery periods are specified.

The seller in a futures market has the choice to decide whether to deliver goods against outstanding sale contracts. In case he decides to deliver goods, he can do so not only at the location of the Association through which trading is organized but also at a number of other pre-specified delivery centres.

In futures market actual delivery of goods takes place only in a very few cases. Transactions are mostly squared up before the due date of the contract and contracts are settled by payment of differences without any physical delivery of goods taking place.

Commodity Markets: Price Discovery, Price Risk Management and Regulation

With the maturity of commodity markets in different parts of the world, the size of daily trading across commodity market platforms has risen substantially with time over the past two decades. This article explains the regulation of commodity markets in US and India.

In India, ever since the inception of MCX and NCDEX nearly two decades back, the size of trading and the number of products to get traded across the commodity markets have shot up substantially, as the  same has found more retail participation.

Almost all countries with developed systems of commodity trading have got their commodity regulatory bodies, almost on similar lines as they have stock markets regulatory bodies like SEC in US or SEBI in India. For instance, in case of India, Forward Markets Commission oversees and regulates the functioning of commodities markets. The functions of the Forward Markets Commission are as follows:
<ol>
	<li>To advise the Central Government in respect of the recognition or the withdrawal of recognition from any association or in respect of any other matter arising out of the administration of the Forward Contracts (Regulation) Act 1952.</li>
	<li>To keep forward markets under observation and to take such action in relation to them, as it may consider necessary, in exercise of the powers assigned to it by or under the Act.</li>
	<li>To collect and whenever the Commission thinks it necessary, to publish information regarding the trading conditions in respect of goods to which any of the provisions of the act is made applicable, including information regarding supply, demand and prices, and to submit to the Central Government, periodical reports on the working of forward markets relating to such goods;</li>
	<li>To make recommendations generally with a view to improving the organization and working of forward markets;</li>
	<li>To undertake the inspection of the accounts and other documents of any recognized association or registered association or any member of such   association whenever it considerers it necessary.</li>
</ol>
In US, a different body was evolved with almost similar regulatory powers with the mission of controlling and overlooking the transactions and trading carried out in the commodity markets.

Commodity Futures Trading Commission (CFTC) was as an independent agency set up in US with the mandate to regulate commodity futures and option markets in the United States. The history of CFTC demonstrates, among other things, how the futures industry has become increasingly varied over time and today encompasses a vast array of highly complex financial futures contracts.

The CFTC's mission is to protect market users and the public from fraud, manipulation, abusive practices and systemic risk related to derivatives that are subject to the Commodity Exchange Act, and to foster open, competitive, and financially sound markets.

Today, the CFTC assures the economic utility of the futures markets by encouraging their competitiveness and efficiency, protecting market participants against fraud, manipulation, and abusive trading practices, and by ensuring the financial integrity of the clearing process. Through effective oversight, the CFTC enables the futures markets to serve the important function of providing a means for price discovery and offsetting price risk.

Typically, in countries like India where the inflation rates have always been a reason to bother for the government, the centre takes decision from time to time to stop forward/ futures trading in some products tradable in commodity markets like cotton, sugar or other products, to ensure that excessive speculation in futures markets across commodity markets does lead to any artificial rise in the prices of such products, which are otherwise required almost on daily basis in the society in a high quantity. Such measures, however, are withdrawn when the prices and inflation comes under control. With time, it is expected the Indian commodity markets are expected to mature in a better manner, and may not need such artificial measures of control.

Regulation of Commodity Markets

A market is said to be in Contango, when the price of a futures contract is above the expected spot price. As the time passes and the delivery approaches, the futures price will converge to the spot price. In commodity markets, the reason for contango could be the cost of storage and insurance of the commodity underlying the contract.

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What is Contango?

A market is said to be in backwardation when the prices of a futures contract is trading below the expected spot prices at the contract maturity. The futures curve in this case will be downward sloping. If we are talking about oil, it means that it will be more expensive to buy oil today than to agree to buy oil in a future date. This is generally because of the convenience yield. It is also called Normal Backwardation.



Let's try to understand this by looking at the following oil futures curve. 



<figure class="wp-block-image size-large"><img src="https://financetrain.com/wp-content/uploads/futures-curve-1024x723.jpg" alt="" class="wp-image-27239"/></figure>



As you can see the future curve is inverted. This means that it is more expensive to buy oil today in the spot market than to agree now to buy oil at a fixed price at a date in the future. This could be for various reasons, for example, it could be that in the present there is a shortage of oil due to some reason and the shortage will not be there in the future. For this reason, people may be willing to pay a premium for the oil in the spot market.



Another reason is that it is possible that the expected price for the oil in the future is actually higher compared to the futures price but people are still agreeing to sell it now at a lower agreed price for a future date (lower than the expected price). This is possible because the oil sellers may want a guarantetd price and not be susceptible to the volatility in oil prices. And for this guarantee they are willing to agree to sell it at a lower price in the futures market compared to the expected spot price on those future dates. This will lead to an inverted futures curve. 



This phenomenon is commonly refered to as backwardation - that the futures market is in backwardation. So, we can say that backwardation happens because the sellers are willing to sell the commodity at a discounted price compared to the expected price in order to avoid volatility and get a guaranteed price. However, it may be difficult to observe backwardation in this way as you don't really know the expected oil price in the future.



<figure class="wp-block-image size-large"><img src="https://financetrain.com/wp-content/uploads/spot-prices-1024x790.jpg" alt="" class="wp-image-27240"/></figure>



When the market is in backwardation, as the time passes and you move closer to the futures contracts delivery dates, you would notice the futures prices of those contracts to be rising and converging to the spot prices. This is a much more real way to observe that the market is in backwardation.

What is Backwardation?

This video provides a quick review of the concept of <a href="https://financetrain.com/what-is-contango/" title="What is Contango?">contango</a> and <a href="https://financetrain.com/what-is-backwardation/" title="What is Backwardation?">backwardation</a>. These two are opposite of each other.

A market is said to be in Backwardation, when the prices of a futures contract is trading below the expected spot prices at the contract maturity. 

A market is said to be in Contango, when the price of a futures contract is above the expected spot price.

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Backwardation and Contango

Commodity Markets

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Commodity Markets

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