Section 1.3

Derivatives

Commodities are essential goods that are interchangeable with other similar products.  Raw metals are an excellent example of a commodity; if a shipbuilder needs 100 tons of iron, they don’t differentiate between suppliers.  They just want the specified amount of “iron” at the best price possible.  Most agricultural products are considered commodities.  Poultry farmers want corn to feed their chickens; they want corn, and they want it at the best price.  They really do not care much where it was grown or who grew it.

Of course, the quality of the commodity matters; commodities are graded and must meet specific standards (“basis grade”) to be placed in a particular classification.  From a retail perspective, commodities are often the inputs (raw materials) that go into the production of other products.  A barrel of crude oil is usually considered a barrel of crude oil, and you as the consumer do not really care who owned and operated the production platform.

The buying and selling of commodities are usually carried out at specialized exchanges that set standards for both quality and quantity of the commodity being traded.  Commodities are typically marketed as futures contracts.  A futures contract is a legally binding agreement between two parties to deliver a commodity (or financial instrument) for a specified amount at a specified future time.  Farming is mostly a futures contract based business.

Bread companies buy wheat futures from farmers; the future date is necessary because the wheat has to be grown before it can be delivered.  Futures contracts came into being because they were mutually beneficial to producers and consumers alike.  Producers needed a ready market for their products, and consumers needed a guaranteed source of raw ingredients.  Futures are also a hedge against market fluctuation; bread companies can lock in a wheat contract that doesn’t send the price of bread through the roof in a drought year.  McDonald’s, for example, couldn’t figure out how to sell McNuggets until brilliant investors showed them how to use futures contracts to keep the price of chicken relatively constant over time.

There are two basic varieties of futures contract buyers.  There are hedgers, and there are speculators.  The hedgers are the actual users of commodities that are trying to lock in a supply of a commodity at a good price.  The speculators are only interested in the profit that can potentially be generated by buying and selling the contract, and they have no real interest in the underlying commodity.  Like any other financial instrument, if you can buy futures contracts low and sell them high, you can make a lot of money.

Successful speculation in the commodity markets requires that you have a good understanding of what causes commodity prices to rise and fall.  If you grow 1000 acres of corn and spend an hour a day following the corn markets and corn growing conditions throughout the United States and abroad, then maybe you could make some money trading corn futures.  Commodity futures are what investors call a pure play because there aren’t many other factors to consider besides the current value of the commodity.  Fortunes can be made in minutes, and they can also be lost.  Unless you have some extreme advantage in knowledge of the commodity that most people don’t have, then stay away from this volatile space.  The logic of this is why I advise staying out of energy sector stocks.  The close ties to commodity prices make the area just too hard.

Volatility

Volatility is the finance term for what we social scientists call variability.  Just like us, economists use the standard deviation to talk about variability.  In the case of financial instruments, that standard deviation usually tells us the average variation of a price from the mean price over a period.  Financial instruments that are very high in volatility fluctuate wildly in price over time.  In finance there is much more concern about the direction of the difference; we are a lot more concerned about standard deviation when it means we are likely to lose money!  Just remember, an investment with no volatility will never go up either.  By definition, it will stay at the mean, which is a terrible prospect.  When you see a volatility statistic associated with an investment, it is usually the standard deviation expressed as a percentage.

For the average investor, the most important thing to understand about commodities is that the fortunes of many companies are intricately linked to some commodity.  If you own those companies, you’d better keep up with the commodity that they rely on.  Let’s say you have Exxon stock in your portfolio.  Exxon ($XOM) is at its heart an oil company, and they will be doing great when oil prices are high.  When oil prices fall very low, Exxon’s bottom line is not as stellar.  When oil climbs up to record highs, then oil companies like Exxon have fantastic bottom lines and their stocks explode upwards.  If you really want to be in this space, you can find less volatile shares in the oil service companies like Schlumberger ($SLB) and Halliburton ($HAL), and pipeline plays like Midland Magellan Partners ($MMP).

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