101: Commodities

By Gregg Schoenberg Thursday, September 8, 2011

In our recently concluded two-part post on inflation, we examined the concept of inflation and explored its effects on small-business owners.  We’re now going to take a look at a special class of goods, commodities, some of which have experienced a great deal of inflation recently.

It is helpful to begin with a definition and an explanation of how commodity goods differ from other goods.  For our purposes, a commodity can be defined as having these two characteristics: it is a basic good used in commerce, and it is interchangeable with other commodities of the same type.  An obvious example would be oil: it is essential to a wide variety of different industries, and there is little difference in a barrel of oil from one provider to another.  Compare this with, say, television sets, which differ widely in quality, size, features, and price from provider to provider.

Commodities can be further divided into soft commodities (e.g. wheat, corn, rice), which are grown, and hard commodities (e.g. copper, gold, silver), which are extracted from the earth by mining.

If you happen to belong to the 95% of American households that own a car and/or you find it necessary to eat on a daily basis, you may have noticed that the prices of some of the commodities that we consume the most, gasoline and foodstuffs, have increased quite a bit in recent years. And if you run a commodity-intensive business you may be dealing with increased input costs and their subsequent pressure on your profit margins.

While there are many factors that come into play in determining the market price of different commodities, a common theme that has emerged in recent years is the growth of the large economies of the developing world, in particular those of China and India.  These two countries, with their combined population of 2.5 billion people, have experienced tremendous growth in industry and have seen per capita income and standards of living rise throughout the 21st century.

As the two most populous countries in the world expand the amount of goods they produce and as more of their citizens are lifted up out of poverty, it is not difficult to imagine what effect this is having on the prices of both the hard commodities used by industry and the soft commodities consumed by an increasingly better-off populace.  Clearly, this trend has led to an increase in demand for many different commodities, and if developing economies continue to catch up to the West, it is not unreasonable to expect the demand side of the equation to continue to rise for some time.

How well the world can keep up with this increase in demand remains to be seen; advances in agriculture have helped to feed a growing world population, and improvements in efficiency and extraction methods have enabled us to keep up with increased demand for energy. However, there is only a finite amount of each hard commodity in the ground, and when supplies are exhausted, they are gone forever.

If the future direction of commodity prices is a concern for your business, there are ways to protect yourself from changes in the prices of the commodities that affect your operations. Via the financial markets it is possible to hedge much of the risk stemming from the rise, or fall, in the price of most commodities.  The mechanics and wisdom of this, however, are beyond the scope of this column. If you think it may be to your benefit to hedge some of your commodity risk, you should speak with a reputable financial institution with expertise in the field of commodity hedging.

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