What is a commodity, anyway?
Ever since the financial crisis sparked an avalanche of inflation worries, the commodities market has taken off. It’s a lesser known part of the investing universe and was traditionally thought of a little bit like the Wild West, but, more and more, mutual funds and regular old investors are trying their hand in the commodities market. But what is a commodity?
If anyone knows a commodity when he sees one, it’s Layne Carlson, Chief Regulatory Officer at the Minneapolis Grain Exchange. “Anything where something can be contracted for future delivery. In essence, you could have basketballs, you could have pencils as a type of commodity,” says Carlson.
Okay, people don’t actually trade basketball and pencil futures, yet. What they do trade are raw materials like lumber, cotton and oil.
To qualify as a tradable commodity, an item has to be pretty uniform. “Corn is a classic example of a commodity,” says Dan Manternach, Ag Services Director at Doane Advisory Services in St. Louis, “A cereal manufaturer who makes cornflakes will buy anybody’s corn, as long as it meets certain quality standards. It’s grade #2 corn.” Manternach says a true commodity has the same value no matter where it’s from or who produced it.
Also, a steady supply of that product has to be critical to a lot of companies.
Jeff Crist owns a 600 acre apple orchard in New York’s Hudson Valley. We’re standing beside the flume in his packing plant, where thousands of Fuji apples are bobbing along in a moving water bath. In the packing facility, apples get washed, dried, waxed, and polished with giant round brushes before getting boxed up and shipped all over the country.
Around 20 percent of Crist’s apples are turned into juice. Apple juice is the newest commodity getting on the Minneapolis Grain Exchange. Layne Carlson says a few years ago, beverage companies got together and asked for it. “The juice products association said, ‘We have a commodity that has a lot of price volatility and we’re looking for a means to set off that price risk,'” he says.
Beverage companies had started using a lot of apple juice: Chinese consumers have developed a taste for it, so demand has soared, and apple juice is increasingly used to sweeten other juices and food products. Beverage companies had been purchasing it old school–through deals with farmers, but as demand for apple juice increased, more companies realized they needed to turn apple juice into a commodity.
Turns out it was just in time. In 2012, the northeastern apple crop was hammered by a spring freeze “which froze off in some orchards, almost all the viable buds,” says Crist. He’s standing near a row of Empire apple trees. It’s a frosty autumn day and freshly harvested trees stretch out in every direction. Last year, Crist lost almost all of the fruit on these trees: honey crisps, red delicious, Romes. All told, the freeze destroyed half his crop.
“The crop was the poorest crop of apples grown east of the Mississippi in the last 50 to 100 years,” says Crist. “Juice prices, at least in my lifetime, reached an all-time high, due to the shortage.”
But, because apple juice was a commodity, companies were able to protect themselves.
When a commodity is traded on an exchange, companies can buy futures contracts, meaning they can buy the apple juice they need months or even years in advance.
They risk paying more than they’d have to if prices fall, but if there’s a freeze and prices jump, they’re locked in.
Farmers like Jeff Crist can use the futures market too and sell their apple juice at a certain price to beverage companies before the apples are even picked.
But farmers and producers aren’t the only ones who like commodities. “It used to be that corn was only worth as much as it was worth to feed to cattle or to make cornflakes, but now corn has a new component of value: Its value as a store of wealth,” says commodities Analyst Dan Manternach.
Investors are now using commodities as a way to protect against inflation, because the value of copper, wheat and cotton doesn’t depend on how much the US dollar is worth.
Since the financial crash, Manternach says, the number of regular investors putting money into commodities has sky-rocketed and it’s made his job a lot more complicated. “And you go, ‘My goodness, what’s changed from yesterday? Why did the price of wheat go up 25 cents a bushel when there is no news?’ And then you find out, ‘Oh, it’s because the price of gold and crude oil went up sharply, which raised the fear of inflation.'”
Farmer Jeff Crist isn’t too worried about losing money this year. After the disastrous crop of 2012, this year’s is one of the best he’s ever seen.
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