By definition, a commodity is a good that can be uniformly supplied across space, time, and form without qualitative differences. Said differently, a bushel of corn is a bushel of corn – regardless of whether you are in Virginia or Nebraska. Commodities are usually either fully or partly fungible. With fungible properties, buyers and sellers treat the commodities the exact same regardless of where they were grown.
As an example, let’s think about a grain elevator. Grain elevators are used to store vast quantities of grain that producers bring them throughout the year. When a producer decides to come get his or her grain from the elevator do you think they are worried about whether they are getting the exact same grain they sent the elevator? The producers only concern is whether they are getting the same quantity and quality of grain that they gave the elevator. This is where fungibility comes into play. The producer is happy because the corn he gave the elevator around harvest is fungible, so the grain he gets back from the elevator has the same relative value as the grain he dropped off.
The fungibility of commodities is a huge difference from other goods that are branded and differentiated. Think about it, you would probably be upset if you went to a bar and set your iPhone down for a charge, only to come pick it up a few hours later and be given back a Samsung. Although the phones may be able to serve the same purpose, there are real branding and product differences between the two.
Transformations of Space, Time, and Form
Since commodity markets tend to operate in somewhat centralized locations and have seasonal production periods, the space (i.e. location) and time (i.e. delivery period) of commodities tends to be very important. Additionally, some commodities can be transformed from one commodity to another (i.e. soybeans to soybean meal and oil), which adds importance to where you are in the value stream.
When looking at a commodity in regards to its space component, most market participants are taking into consideration the fact that production tends to be somewhat concentrated whereas use tends to be somewhat dispersed. In order to make money on the space component there needs to be differences in price between one location and other that will create an incentive to move the commodity. For example, there is a lot of corn grown in Ohio every year, but not much is grown in Virginia (relatively speaking). Additionally, there is a decent amount of protein production in Virginia, but not much in Ohio (relatively speaking). This difference between supply and demand causes grain prices to be lower in Ohio than in Virginia and creates an incentive for traders to move the grain from one location to the other.
The component of time refers to whether a commodity is storable or not and the incentives created by that storability. Some commodities are produced on a continuous cycle, whereas others are produced seasonally (oil vs corn). Likewise, some commodities are highly storable whereas others are not (corn vs fresh pork). These changes in storability create different incentives that traders can use to profit over periods of time. For example, corn is produced once a year (in the US), but consumption occurs year round. That means that the market needs to create an incentive to store corn from when it is harvested until the next harvest so that there is continuous availability. The market creates this incentive by adjusting the forward price of the grain higher or lower, depending on market conditions.
Commodities can also be transformed into completely new goods. Take the soybean complex for example, the complex starts as a soybean, which is then crushed for its meal and oil. From the beginning to the end of the process you convert one commodity into two other commodities. There are also cases where you can covert a commodity into a non-commodity though. Take lean hogs for example, lean hogs themselves are a commodity but once they are slaughtered and processed they become differentiated products that are no longer commodities.
Storable & Nonstorable
As we mentioned above, one of the key differences between different types of commodities is their storability. A few examples of storable commodities are:
- Crude Oil
- Natural Gas
Likewise, there are also commodities that are not storable in nature. A few examples of these are:
The storability of commodities has a huge impact on their prices both in the short term and the long term. With storable commodities, like corn, the commodity is produced and then stored until it is needed. This means that prices are related to one another from one period to the next. Said differently, since there is usually corn in storage there is usually also someone evaluating the market to determine the best time to sell that corn out of storage. This constant evaluation process causes prices in the future to correlate to prices today and vice versa.
This is not the case with nonstorable commodities. Nonstorable commodities tend to be more volatile in the short term because previous supply cannot be brought forward to meet the current demand. Take pork for example, during the Coronavirus outbreak in the spring of 2020 pork processing facilities were forced to shut down due to labor shortages. These forced shut downs caused lean hog futures to plummet because of the sudden oversupply and caused cutout prices to sky rocket due to the lack processing occurring. If processors had the ability to store fresh pork for longer than a few days it would have reduced the sudden shock to the market.
Continual & Seasonal Production
Another key difference in commodities is whether they are produced on a continual or a season basis. There is production seasonality is all commodities based on their underlying supply and demand factors, but some are much more pronounced than others. A few examples of highly seasonal production are:
These highly seasonal production cycles occur with commodities that are grown once per year (at least domestically). Take corn for example in the US, it is planted in the Spring every year and harvested a few months later in the Fall. That is the only domestic production cycle for US corn. Generally speaking, as you approach the next harvest your domestic supplies of corn are going to be the lowest amount for the year. Likewise, right after harvest domestic supplies of corn are going to be at their highest for the year. These swings from periods of relative low supplies to periods of relative high supplies tend to correlate with price movements. This also means that the market tends to focus heavily on the production periods for these commodities. If the growing season goes bad one year the market could be required to wait another 12 months for replenished supplies, which would cause a lot of price volatility.
This is not the case with all commodities though. There are also commodities that are produced on a continual basis such as the below:
- Crude Oil
- Soybean Oil
- Natural Gas
While the continual production process of these commodities removes some of the seasonal supply driven price moves, it does not remove all seasonality. The seasonality of continual production commodities is more driven by demand inputs such as the summer driving season for gasoline, or grilling season for beef.
The differences between continual production and seasonal production commodities also impact the way that market analysts try to determine what the fair value is. For example, when most analysts are trying to determine the fair value of corn, or any other seasonal production commodity, they will look at what’s called the stocks to use (S/U) ratio. The stocks to use ratio is simply the ending stocks of a commodity (the amount left at the end of the year) divided by the total use of the commodity for that year. What is tells you is the percentage of the commodity that will be left over at the end of the year and carried into the next year. This is of great importance for seasonally produced commodities because it is a gauge of how tight supplies will be before harvest comes and they are able to be replenished.
Most analysts who are trying to determine the fair value of crude oil, or any other continual production commodity, will tell you that the stocks to use ratios is of less importance because the ending stocks is a moving target. What most analysts will look at instead is whether the market is over producing or under producing relative to the demand for that time period. Knowing whether the commodity is being overproduced or underproduced will give market participants an idea of whether prices should move higher or lower.