Commodity Markets
Producers (farmers, ranchers), processors, retailers, and consumers rely on each other. Producers need to be able to sell the raw products they produce to processors. Processors then use these raw materials to create goods that are sold to retailers. Producers and processors both require a place to negotiate prices and either buy or sell their agricultural products. But how are prices for commodities determined? The answer is commodity markets.
What is a Commodity?
A commodity is a raw product. Examples of commodities include grains, like corn, wheat and soybeans; livestock like cattle and hogs; metals like gold and silver, and energy sources like crude oil and natural gas. This raw product is typically sold, and then processed and/or packaged in some way. So corn may be sold to a processor who makes ethanol; gold is sold to a processor making jewelry; and crude oil is sold to a processor who makes plastic. These processed goods are then shipped to retailers, who then sell a finished product to consumers.
To make it easier to buy and sell these raw goods, the quality of the commodity must be uniform from all producers. So all the bushels of corn, all the bales of cotton, and all the barrels of crude oil are essentially the same, regardless of who produced them.
Marketing Commodities and Managing Risk
Farming is full of risk. In any year, growers can face weather perils that include droughts and floods. Even when producers escape those extremes, conditions must be favorable at key periods during planting, growing, and harvesting. And even after crops are grown and harvested, producers still encounter risk. Changes in consumer demand, unforeseen international events, costs for fuel, and other circ*mstances can all influence profit. But the greatest risk of all may not be associated with producing commodities, but inmarketing, or selling, them for a profit. Two methods that are commonly used to market commodities are cash marketing and forward contracting, both outlined in this brief video.
Cash Marketing
Cash marketingtakes place when a farmer sells his commodity for cash. For a grain farmer, this is usually done at a local cooperative or elevator. The farmer has not entered into any kind of contract to deliver the commodity at a certain time or at a certain price. In fact, cash marketing can take place anytime after harvest, and can be delayed by months if the producer stores his/her crop. The farmer's primary risk is if prices move lower while holding the commodity, he or she will have missed the opportunity to sell at the higher price.
A trade on the cash market always involves transfer of the actual commodity. The farmer delivers their grain to the elevator after harvest or from storage, and receives the current price.
Forward Contracting
Aforward contractis a way to minimize the risk that the price of a commodity might go down before a farmer sells. A forward contract is an agreement to deliver a specific amount of a specific commodity at a specific time in the future. Because no one really knows whether prices will go up or down, a forward contract "locks-in" a price that is higher than the current cash price.
A farmer who forward contracts with the local elevator is guaranteed a known price for a specific amount of his crop, however, the arrangement doesn't offer much flexibility. If prices move higher before the delivery date, the farmer is still obligated to deliver the contracted grain at the lower, previously agreed to price. Also, the farmer is obligated to deliver the contracted amount of the commodity, even if his yields are lower than expected.
Example: In July, a farmer contracts to deliver 5,000 bushels of corn to a grain elevator operator in November. The contract price is $4.00 a bushel. The cash price of corn could go higher or lower between July and November. In November, even if the market price for corn is only $3.60 a bushel, the elevator operator is obligated to pay the farmer $4.00 a bushel. Likewise, if corn sells for $4.75 a bushel, the farmer still receives only $4.00 a bushel.
What are Commodity Markets?
A commodity market is a place where you can buy, sell, or trade these raw products. But imagine having to transport all of the world's grain, gold, crude oil and other commodities to a single place in order to sell them. It would be unwieldy and costly to have a huge central location, to which all the sellers would deliver their commodities and from which all the buyers would haul them away. So, instead of trading the physical commodity, buyers and sellers in a commodity market tradecontractsrepresenting specific amounts of each commodity. For example, a producer could sell a contract to deliver 5,000 bushels of grain at a set price at a certain time. In exchange for payment, the contract would require the producer to deliver the grain to a specific location by a certain date. A processor could then use the market to purchase the contract for 5,000 bushels of grain at a set price and time.
It is in the commodities market that the prices of raw commodities, such as grain and livestock, are set. In the example of a grain farmer, it is these markets that set the price a farmer will receive when she sells her grain at the local elevator. By understanding how the markets work, processors attempt to buy their raw goods at the lowest price, and producers attempt to sell their commodity for the highest price.
There are many commodities markets around the world. Regardless of their names or locations, these trading centers all provide the same thing: a central location for buyers and sellers to negotiate prices and execute trades. The world's largest commodities market is the Chicago Board of Trade, known as CBOT. The Chicago Mercantile Exchange, or the CME, is another example of a commodities market. The CME, also located in Chicago, is the world's largest agricultural market. It is used mainly for the buying and selling of livestock and livestock products.
There are a variety of participants in the commodities market.Tradersare anyone who buys or sells a contract—also known as " taking a position" in the commodities market.Speculatorsare those traders who buy or sell in an attempt to profit from price movements.Hedgersare traders who "hedge their bets" for favorable prices in one market by buying or selling a commodity in another.
Market Prices & Decision Making
Commodity markets are big business, and for farmers the rise and fall of commodity prices can have a significant impact on the bottom line. Keeping up to date on prices and factors influencing the market helps producers make informed business decisions. Things that can impact the price of many commodities include the weather, government policies, international events, consumer preferences, shifting input costs, and general supply and demand for the commodity.
Because of all of the different factors that influence prices, buying or selling contracts in a commodity market requires detailed data-gathering, critical thinking, and an ability to tolerate and manage risk. There are many sources a producer or trader can use for this data, including industry publications, weather forecasts, news headlines, and government reports. Many traders rely on personal experience and an understanding of market history and trends to help make decisions.
With so many sources for commodities data, how does a producer gather information and data to help make the most informed marketing choices for their business? With all of this uncertainty, how can a farmer ensure the best price for a commodity?
