The commodity markets, primarily traded as futures are a class of assets that are different to the rest.
For the most part, any instrument in the financial markets deals with some form of transaction. For example, currencies, interest rates, bonds are examples of financial markets. The underlying common factor to these types of instruments is finance.
Commodities are rather different, and going by their name, these are types of assets that are physical in nature.
The most common example that comes to mind when talking about commodities is gold or crude oil. These are commodities that you can buy and hold. Think of jewellery or gold bars or coins when it comes to gold.
Likewise, crude oil is also a commodity that is physical. When you fill-up your gas tank, you are buying gasoline, a product of crude oil.
Similar to the above, the commodity futures markets also have other types such as corn, soybean, coffee and many more.
While these asset classes are known as commodities, it is an umbrella term. Within the commodity markets, there are different sub-classifications.
These subclassifications are derived from the way these commodities behave. This article gives you an in-depth tutorial on the commodity markets. More importantly, we will focus on the hard vs. soft commodities and how they differ.
As a trader, it is important to understand these types of commodities. Due to the difference in the behaviour between hard vs. soft commodities, the way you trade them also changes. Let’s now take a deeper look into the commodity markets.
But first, a quick recap on what are commodities and how they are different to other markets such as stocks and forex.
The word commodity refers to anything that is a raw material or a product.
Since the word commodity is a very broad term, it can refer to many things. For example, your refrigerator is a commodity, just as rice is a commodity.
The common thing between a refrigerator and rice is that it can be bought and stored physically. In the case of the former, the refrigerator can be used to keep food and other items cold and fresh. The latter, rice is used for consumption as food.
Since commodities can be bought and sold, it has given rise to the commodity markets. Commodities are primarily traded as futures contracts, settled at an exchange.
Depending on the commodity that you are buying or selling, the contract size, the tick size and terms of trade can vary. But they are all the same because you can buy and sell them.
Commodities are traded mostly by producers and consumers.
This means that rice farmers can use the commodity futures markets to sell their produce. Likewise, a food manufacturing company will use the very same commodity futures to buy the produce.
Other examples include a mining company that is in the business of mining for gold and other raw materials. When the mining company wants to sell their inventory, they can either sell it outright at whatever the market price is, or they can use the futures markets.
Futures markets in commodities enable participants to hedge against the market risk.
The term market risk often comes up when it comes to derivatives markets such as futures.
Market risk is defined as the risk that comes because of fluctuating prices of the underlying asset.
For a rice farmer, the market risk is that demand may fall leading to lower prices. The lower prices can be detrimental especially if it is lower than the cost of production.
Likewise, from a consumer perspective, a company that is buying rice has a market risk of rising prices. The increase in buying price may lead to lower profit margins for the company.
So how can the producer and the consumer hedge against these risks?
They engage in commodity futures contracts that enable them to lock in a price.
Commodity futures contracts allow the buyer and the seller to enter into a contract. A price is decided for future delivery of the underlying product.
For example, a coffee farmer may engage in a commodity futures contract as the seller at a certain price. When there is a counterparty to the trade, the price is agreed upon. When the contract expires, the seller is obligated to deliver the underlying product.
This is regardless of whether the current market price is higher or lower than the futures price that was agreed upon.
It allows both the buyer and the seller the certainty of buying and selling the commodity at a known price.
It eliminates any further risk from the table and allows both parties to predict their cashflows.
The commodity futures contracts work the same way regardless of what the underlying commodity may be.
There are many commodities that you can trade at a futures exchange. They are broadly classified into the following:
- Financial commodities
- Hard commodities
- Soft commodities
Within each of these commodity types, there are further sub-classifications.
The picture below illustrates the commodity markets, courtesy of barchart.com
The picture illustrates the daily change among the different commodity markets that are commonly traded. Let’s now take a closer look at the hard vs. soft commodities and how they differ.
Hard commodities refer to commodities that are naturally occurring raw materials. Due to the nature of the definition, one can deduce that hard commodities are mostly mined or drilled.
The by-product of these hard commodities also falls into the same classification, although they remain a by-product and not the actual raw material.
The most-traded hard commodities are:
- Precious metals: Gold, Silver, Platinum
- Base metals: Copper, Iron Ore, Aluminum
- Energy: Crude oil, gasoline, natural gas, Ethanol
What is common to these hard commodities is the fact that they are very operational intensive. It requires a large capital investment. Thus, hard commodity producers are usually large multinationals.
Hard commodities can be stored for a longer period of time. Thus, the volatility is lower with such asset types.
Trade is usually cross the border between different economies.
Hard commodities are a good way to measure global economic health in terms of the amount of trade that takes place.
When trading hard commodities, the contract sizes will change depending on what commodity you want to trade-in.
For example, the futures contracts between gold and aluminium are different, even though they belong to the hard commodity category.
Soft commodities refer to those that are produced or grown. Many soft commodities include agricultural products including farming.
One big difference with soft commodities is that it is not as intensive as hard commodities. Therefore, the soft commodity producer market is made up of both large multi-national companies as well as individual producers.
The most-traded soft commodities are:
- Grains: Soybeans, wheat, corn, lumber
- Softs: Orange juice, Milk
- Livestock: Pork belly, Lean hogs, cattle
Like hard commodities, the by-product of soft commodities also falls into the same category.
Furthermore, although they may belong to the same category of soft commodities, the contract specifications can vary.
Thus, do not make the mistake that trading one contract of soybeans will be the same as one contract of wheat futures.
Soft commodities exhibit more volatility comparing to hard commodities. The volatility comes from the fact that soft commodities are perishable goods. It means that soft commodities have a smaller shelf-live than hard commodities.
Now that we know the fundamental differences between hard and commodities, let’s draw up a comparison between hard vs. soft commodities.
We will also take a look at the factors that influence both the hard and the soft commodities.
|Hard Commodities||Soft Commodities|
|These are typically resource-intensive and require large capital investment. Hence it is dominated only by large companies.||Softs are also resource-intensive but do not require much capital. As a result, soft commodity producers include both companies and individual entrepreneurs.|
|Hard commodities are naturally occurring, but at the same time, they are also finite in nature.||Soft commodities are grown above the ground and the supply is infinite|
|Hard commodities have a longer shelf life as they are mostly raw materials drilled or mined from the earth.||Soft commodities have a smaller shelf life and are mostly perishable items. Thus, they cannot be stored for long periods of time.|
|Hard commodities usually act as a raw material into producing a consumer good||Soft commodities act as both raw material for producing a consumer good, but they can also be consumed directly|
|Government regulations, environment, geo-political stability, trade are key factors for hard commodity business||Weather, environment, regulation, trade are key factors when it comes to soft commodities. Logistics also play a very important role|
|Hard commodities depend on how vast the natural resources are||Soft commodities are determined by factors such as the weather and are seasonal in nature|
While hard and soft commodities may be somewhat different, the common factor to both these commodity markets is supply and demand.
Supply and demand are what will eventually decide the prices of the commodities in question.
The supply and demand are in turn influenced by a number of other factors.
When it comes to trading the hard commodity futures contracts, there are a number of factors that influence the prices. Below are some of the factors, including official reports that futures traders keep a watch over.
- Commitment of Traders reports: Known as the COT report, this is a weekly commodity report published by CFTC (Commodity Futures Trading Commission). The COT report keeps tracks of large open positions in the market. It typically captures large banks and other institutional holders. It also keeps tracks of the open positions held by producers and consumers.
- Supply and demand reports: Since hard commodities are largely cross-border transactions, the supply and demand play a huge role. For example, Saudi Arabia is the largest producer of crude oil. On the other side, countries like China and India are the largest consumers of crude oil. Thus, production data in one country affects the supply side. Similarly, demand from the other side together determines the market prices of hard commodities.
- Geo-politics and regulation: Because hard commodities are raw materials, they are mostly concentrated to specific countries. Therefore, government regulation on import and export, as well as the political stability of the country also impacts prices of hard commodities
When it comes to soft commodities, most of them are traded within an economy. Only a small amount of this is exported. There are exceptions of course. Soft commodities such as coffee beans are largely concentrated in Latin American countries.
Below are some of the reports that soft commodity trades keep a watch over.
- Commitment of Traders report: This report also covers soft commodities and shows details such as open interest, net short and net long positions for each commodity type. It gives a market overview of whether supply is outperforming demand or vice versa.
- Weather reports (ex: USDA): While each country has its own set of reports, the USDA or the US Department of Agriculture releases reports periodically and covers a large sector. These includes weather patterns that can determine how good the harvest can be. The USDA’s various reports helps the markets to understand whether prices will rise or fall.
Hard vs. Soft Commodities – Conclusion
By now you have a good understanding of the commodities markets. We have covered the fundamental differences between hard vs. soft commodities and their subtle differences.
From a trading (speculative) perspective, it is now up to you to decide which of these two markets you may want to trade. Note that hard commodities and soft commodities basically belong to the same category.
The way these markets behave is of course as a result of the way they are produced and consumed. We have outlined the different factors that influence both production and consumption.
From a speculative trading point of view, these differences play a role in how prices behave.
The above chart shows a comparison between the hard vs. soft commodities. You can see that the trends may look the same, but the short term volatility is different.
The orange price line shows the Crude Oil futures contract, while the blue area chart shows the soybean futures markets.
The technical analysis for both these commodities can be the same. However, the fundamental analysis will greatly differ.