Characteristics of Commodity Sectors

The recommended approach for segmenting the various asset classes is by Thomson Reuters/Core Commodity CRB Index developed by the well-recognized Commodities Research Bureau as follows:

Energy 

Crude Oil

Crude oil (or petroleum) is a flammable fluid produced by huge quantities of dead creatures (typically algae and plants) confined in rock formations concealed and then subjected to a high degree of heat and pressure over tens of thousands of years. The difference in crude oil quality is commonly reflected in oil prices, dependent on the source.

The supply and demand for crude oil are heavily dependent on economic growth. It is for this reason that the availability and affordability of oil facilitate economic activity by lowering trade costs. Higher oil prices lead to an increase in taxes on the consumer as it has an overall impact on income used to buy goods and services.

Other global drivers for supply and demand for crude oil include the following:

• Technology: The level of technology and efficiency employed in the extraction and in the process of transforming oil into useful products used by engines that burn them.
• Geopolitical conflict: This occasions oil rationing or the impossibility of oil extraction due to the destruction of infrastructure. Conflicts also become a bottleneck to the transportation of oil across the globe.
• The business cycle: Disruption of business through bankruptcy or civil conflict diminishes the confidence of conducting business.

Natural Gas

Its formation process is similar to that of crude oil. Unlike crude oil, it exists in gas form and can be used directly. Compared to crude oil, natural gas can be utilized economically. Besides, it can be used directly in transportation and electric power generation and to rid off impurities, commonly carbon dioxide, after processing.

The factors that affect the supply and demand for natural gas include:

• Transportation costs: These costs are high due to the need to keep the gas under pressure. In addition, special terminals are required to store gas in a liquefied form.
• Weather: Colder seasons drive up natural gas demand due to heating needs, whereas hotter seasons result in higher consumption due to air conditioning which can fundamentally change natural gas prices.

Refined Products

This refers to end-use fuels, e.g., heating oil, gas oil, jet fuel, propane, gasoline, and bunker fuel.

Factors affecting the supply and demand for refined products include:

• Short shelf life: The availability of refined products is measured in days. This explains why there is a need for refineries to continuously run and proper coordination of maintenance schedules to ensure adequate supplies.
• Location and accessibility of refineries: Coastline and port locations ensure easy access for ocean-borne supplies of crude oil.
• Weather: Bad weather catastrophes such as hurricanes and typhoons can disrupt supplies if the refineries are damaged. Still, such weather-related disasters can halt demand where a greater population faces flooding. Weather seasons also dictate the rapid demands and supply of refined products.

Grain

These result from the advancement and development of agriculture due to the rise in civilization. Corn, for example, is consumed by humans and alternatively used as fuel (ethanol) and animal feed.

Factors that affect the demand for and supply of grains include:

• Storage: Grains require a longer life storage period to last many seasons to ensure constant supply to last till the next season’s harvest.
• Weather: Determines yields and acreage through levels of precipitation and heat.
• Disease and pests: Impact the overall yield.
• Technology and politics: Through genetic modifications, biofuel substitutions, and social stress.

Industrial Base Metals

Represent mined ore processed through smelting into copper, iron, aluminum, nickel, zinc, etc.

Factors affecting the demand for and supply of industrial base metals include:

• GDP growth: The price reasonability of copper normally indicates the direction of industrial production and GDP growth.
• Weather: Industrial metals can generally be stored for a very long time and are not affected by weather changes. However, weather patterns can affect their demand. For example, building construction requires conducive weather conditions.
• Business cycle and politics: With labor action (strikes) restraining supply while imposing costs, development choices (mines and smelters have high fixed investment requirements), and environmental concerns related to air and water pollution.

Livestock

The demand for and supply of livestock commodities rely greatly on the following:

• Low-cost inputs for mass production and development cycle in emerging markets: The middle-class population in emerging markets experience dietary shifts from grains to animal products.
• Grain prices: The livestock sector performance is inversely proportional to the events in grain prices.
• Storage: Slaughtered animal meat is frozen after processing and kept over a long period.
• Weather: Impact on weather patterns depends on the individual livestock characteristics and impacts their health and weight.
• Pests and diseases: They have triggered sharp price instability in the past, with some of the diseases driving down prices resulting from fears of human transmission. Still, others increase prices since the animals have to be slaughtered, driving down supply.
• Government regulations: Governments allow the use of drugs and growth hormones to substitute proteins depending on the particular livestock maturity cycle and consumer preferences.
• Cross-border mergers and acquisitions: The livestock sector is becoming more global because the rise of emerging market wealth has led to greater import/export trade and cross-border mergers and acquisitions.

Precious Metals

These include gold, silver, and platinum, which act as a store of value similar to currencies and are consumed as inputs in electronics, auto parts, and jewelry.

Factors that affect the demand and supply of precious metals include:

• Inflation and fund flow: If paper currencies are inflated, then precious metals, such as gold, gain relative value by hedging against paper currencies.
• Technology: Industrial demands for precious metals, especially in automobiles, have led to a shift in major demands for silver, platinum, and palladium metals.
• Jewelry production: Jewelry demand as a status symbol and an outward sign of success has led to the demand for gold and silver, especially in developing countries.

Soft (Cash Crop) Commodities

These are referred to as soft commodities because they are grown rather than hard, mined, and include cotton, coffee, sugarcane, and cocoa. They are sold for income rather than subsistence consumption.

Factors that affect the supply and demand of soft commodities include:

• Storage: Soft commodities are perishable. Storage, therefore, affects their quality and weight since they’re required to remain fresh over a longer period.
• Weather: Soft crops are heavily dependent on high levels of properly timed rainfall. Freezing conditions, diseases, and pests can severely damage crops.
• Global markets: The emerging global markets impact the demand for livestock and cash crops, especially coffee, sugar, and cocoa.

The following table summarizes the characteristics of commodity sectors:

$$\small{\begin{array}{l|l|l|I|} \textbf{Commodity} & \textbf{Storage/Transport} & \textbf{Supply factors} & \textbf{Demand factors}\\ \hline \textbf{Energy} & {\text{Natural storage, pipes, ships}}& \text{Political risk, improved technologies, weather} & \text{Economic growth}\\ \hline
\textbf{Grains} & {\text{Easy}} & \text{Weather, disease, pests, floods, droughts} &\text{Humans, fuel, animal feed} \\ \hline
\textbf{Industrial Metals} & \text{Easy to store, expensive to transport} &\text{Political factors, restrictive environmental regulations.}&\text{Industrial growth, business cycles} \\ \hline \textbf{Livestock} & \text{Linked to grain costs} & \text{Grain costs, disease, weather}& \text{Emerging markets}\\ \hline \textbf{Precious metals} & \text{easy} & \text{Not affected by weather} &\text{Inflation, technology, jewelry}\\ \hline \textbf{Softs} & \text{Freshness is key} & \text{Weather, disease} & \text{Emerging markets, consumer tastes} \\ \end{array}}$$

Question

Which of the following commodities is most likely affected by industrial activity demand?

1. Livestock.
2. Copper.
3. Natural gas.

Solution

The correct answer is B.

Copper is used for construction, infrastructure development, and durable goods, all economically sensitive.

A is incorrect. The middle-class population normally determines the supply and demand for livestock in emerging markets that experience dietary shifts from grains to animal products.

C is incorrect. Weather conditions affect the demand for natural gas, where colder seasons drive up natural gas demand due to heating needs. In contrast, a hotter season results in higher consumption due to air conditioning which can fundamentally change natural gas prices.

Reading 35: Introduction to Commodities and Commodity Derivatives

LOS 35 (a) Compare characteristics of commodity sectors.

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