The World of Commodities - dummies

By David Stevenson

All the different commodity prices in varying places provide a potential profit-making opportunity for the smart investor, especially among the hedge-fund community in the UK and around the world. Financial institutions of all shapes and sizes have piled into the commodity markets in recent decades; according to some estimates, assets under management in commodity-related funds generally are approaching US$410 billion.

Investment-based traders are a major part of the commodity markets, in some cases dwarfing the original market participants — the producers of commodities (mines and energy producers) and their end users (large companies and governments). The table shows the size of different global commodity markets and the financial size of turnover.

Not unsurprisingly given their importance, oil and natural gas dominate with annual turnover of US$23 trillion (though that number also includes a huge amount of speculative transactions), whereas actual physical production accounts for just US$2.3 trillion.

(Note: ‘Open interest’ refers to the number of options and futures contracts that haven’t been closed at the end of a particular trading day; some market watchers believe that a large number indicates more activity and liquidity for the contract.)

Size of Global Commodity Markets: Physical and Financial Market
Size of Major Commodities (2009/2010 US$ Billion)
Commodity Annual Production Annual Exports Inventories (End Period) Annual Turnover Exchange-Traded Financial Market Open Interest
Oil 2395 206 31.2 22843 193
Natural gas 584 67 NA 2084 29
Coal 844 124 NA 24 4
Iron ore 222 117 NA NA NA
Copper 143 44 6 10891 81
Gold 104 NA NA 6249 76
Corn 130 16 23 1093 20
Soybeans 199 68 29 4775 41
Sugar 81 27 14 4425 27

Source: Federal Reserve of Australia — more details available at the IDEAS website.

The huge commodity markets have grown inexorably in the last few decades. Here are a few examples.

The financial market for (West Texas) based oil futures grew from US$30 billion in 1990 to US$120 billion in 2011, closely followed by futures trading in gold, which increased from about US$25 billion to just over US$60 billion. Growth in some other commodity markets has been a tad subdued by contrast.

Back in 1990, markets in natural gas, wheat, copper and sugar were all running at under US$10 billion per year whereas by 2011 that had increased to US$50 billion for copper and about US$15 billion for sugar and wheat.

As these global commodity markets grew in size (both physically in terms of output and financially in hard dollars), they also became volatile. This table shows the volatility of daily returns from investing in a range of commodities (for comparison, data for shares is included).

With just one exception these numbers suggest that the standard deviation (the measure of the asset’s volatility) of daily returns has increased in all key markets since 2007, indicating that volatility has increased in all markets. (Note: A higher standard deviation implies more volatility; a lower standard deviation means less volatility.)

Volatility in Commodity and Other Asset Prices: Standard Deviation
of Daily Returns, Percentage Points
Commodity Indices or Individual Prices Jan 1990 to June 2007 July 2007 to May 2011
Natural Gas 3.6 3.5
WTI Oil 2.3 2.9
Sugar 2.1 2.7
Wheat 1.6 2.6
Copper 1.4 2.2
Soybeans 1.3 1.9
Gold 0.9 1.4
Individual companies on S&P 500 2.4 2.8
S&P 500 Energy index 1.2 2.3
Goldman Sachs Commodity Index 1.2 1.9
S&P 500 Equity index 1 1.7
CRB Commodity Index 0.9 1.5

Source: Federal Reserve of Australia — more details available at the IDEAS website.