1
Introduction
Definitions
What are commodities? The word stems from the Latin word commoditās, which means timeliness or convenience. From the same root come the words “commode” and “commodious.” The Oxford English Dictionary defines a commodity as “a thing of use or advantage to mankind; especially useful products, material advantages, elements of wealth.”
In modern parlance, commodities commonly refer to physical materials that are economically useful and valuable to the global economy. These materials typically are either extracted from the Earth’s crust, such as fossil fuels or metallic ores, or harvested from nature, such as grains, animal products, and even sunlight. Hence the term “natural resources” is often used interchangeably with “commodities,” though not all commodities are purely natural in origin nor or all of Nature’s goods useful resources. One could also consider intangible goods to be commodities, such as bands of the electromagnetic spectrum auctioned for use by the telecommunications industry or cloud computing power.
Indeed, almost any chemical element in the periodic table can theoretically be a potentially useful commodity. But chemical elements rarely remain in their pure form in nature. Instead, they combine into an almost infinite number of permutations called molecules, some of which are also tremendously useful for modern society.
For example, chain enough hydrogen and carbon atoms together and you will get molecules called hydrocarbons. If the chain is long and heavy enough, the hydrocarbons become liquid at room temperature and pressure, yielding the familiar petroleum oil that powers our automobiles, trains, and aircraft.
To give another example, when iron is first mined, it is usually in the form of iron oxide ore, a mixture of both iron and oxygen. This reddish hued stuff is convenient to store and transport before it is finally smelted and mixed with carbon atoms from coke to make the steel that supports our buildings and bridges.
Yet even more complicated organic structures are also widely used commodities. An example is the rice grain, which feeds billions of people around the world. Zooming in on the grain with a microscope will reveal intricate biological structures vastly more complex than metallic ores or hydrocarbons.
Fungibility
In addition to their typically (though not always) physical nature and the significant role they play in the global economy, the final defining characteristic of commodities is their fungibility. Fungibility implies that the value of a commodity is derived from its intrinsic characteristics regardless of its origin or creation. As such, a unit of the commodity is interchangeable with another unit from different sources.
An example of fungibility is provided by a barrel of crude oil. Small variations in heaviness and sulfur content aside, oil extracted from sources in the United States is pretty much the same molecular combination of hydrogen and carbon as oil extracted in Kazakhstan, halfway around the globe.
Since the consumer values oil because of its intrinsic chemical composition of hydrogen and carbon (which combusts with oxygen to produce carbon dioxide, water, and energy) and not because it happens to come from a particular place, the oil is said to be fungible.
A consumer with an automobile should be indifferent to whether a barrel of oil from one place is swapped with a barrel of oil from another place. After all, the oil in both barrels is chemically identical and would work equally well in an automobile engine. Hence, barrels of oil from around the world are often priced almost identically.
Contrast this indifference to origin of a barrel of oil with the differential attitude toward a finished automobile. Here the origin, type, and history of the automobile can matter significantly. Prices can differ greatly depending on whether the vehicle is designed or manufactured in Japan, Germany, China, or the United States. Other features, such as the make, model, and year of manufacture, also figure in important ways in how a consumer determines its value. Consumers are willing to pay much higher prices to buy a recent premium automobile from a famous marquee name than a common compact.
Another example of a nonfungible good is this book. Physically, books are just collections of ink-imprinted paper. But the true value of a book lies in its informational content and the meaning to be derived from the special ordering of the inked letters, which justify a higher price for some books than for other, physically and chemically indistinguishable collections of inked paper in a binding.
As a last example of a nonfungible good, consider the market for art. An original Picasso commands immensely higher prices than a copy that is virtually identical in every other way, including the same chemical composition of the canvas and pigments and even the same brushstrokes by a master counterfeiter. The painting is valued not just for its intrinsic physical characteristics but for its history. It is unique and not interchangeable with a physically identical alternative. That makes it nonfungible.
Perfect Substitution and Globalization
Why does fungibility of commodities matter? Because fungibility changes the dynamics of the market in which it operates. Economists would say that a unit of a commodity is a perfect substitute for another unit.
This fungibility matters tremendously for the economics and markets for commodities. The owner of an oil field in Texas should care a lot if a new oil field is found halfway around the world in Kazakhstan, since all the consumers of the world are perfectly willing to switch from his Texas oil to Kazakh oil because of oil’s fungibility.
Meanwhile, the maker of luxury automobiles in Germany cares less if a new factory for subcompacts opens in India, as German luxury automobiles are not perfect substitutes for Indian subcompacts.
And finally, the owner of an original Picasso shouldn’t care much at all if a million copies of the Picasso spit out of a printer somewhere as they aren’t substitutes at all.
Hence the study of commodities requires an intellectually distinct approach from other economic goods, not only because of the importance of commodities to the global economy but also because of the specially interconnected nature of their markets. They are the quintessential global economic good, arguably affected most by globalization. It is the study of these special dynamics that is the focus of this book.
Types of Commodities
As of this book’s writing, there are four main categories of commodities widely traded in global markets:
- 1. Energy commodities
- 2. Base metallic commodities
- 3. Precious metallic commodities
- 4. Agricultural Commodities
Energy commodities include the hydrocarbon fuels of petroleum, natural gas, and coal, but may also include substances such as hydrogen fuel or uranium fuel for nuclear fission reactors.
The base metals consist of the familiar “basic” metals, such as iron, copper, nickel, aluminum, lead, zinc, and tin.
The precious metals usually includes gold, silver, and platinum, highly prized for their beauty and used in jewelry and decorative artwork, though they can also have some industrial applications.
The agricultural commodities can be divided into grains and soft commodities. In turn, grains can be further subdivided into the grass-based cereals (such as rice, corn, and wheat) and the legumes (such as soybeans and peas). Soft commodities include agricultural products such as sugar, eggs, milk, beef, pork, and orange juice. The latter are labeled “soft” because they are fragile and can easily perish if not appropriately stored.
Is this an exhaustive list of commodities? Absolutely not.
There are many other commodities: water, timber, pearls, silk, leather, diamonds, spices … the list goes on. Commodities can be almost any fungible element or molecule derived from the periodic table of the chemical elements.
Nevertheless, some commodities are more important on financial markets because of the volumes and values being traded in the global economy, both physically and on financial markets through derivative securities. Figure 1.1 shows the overall market value of some selected commodities in terms of global production and consumption in 2012.
Figure 1.1 Overall market values of selected commodities, 2012.
Sources: Data from United Nations, U.S. Geological Survey, the U.S. Energy Information Administration, and BP.
As is evident from figure 1.1, the energy commodities, particularly liquid petroleum oil, dominate in value and importance in providing the raw materials to feed the global economy (though obviously the exact global value of any commodity fluctuates according to its price, which can be very volatile).
There is also a highly developed financial market that trades trillions of dollars’ worth of financial derivatives linked to the price of oil and other energy commodities. This is primarily why this book concentrates on and draws examples from the energy space.
Meanwhile, many other valuable commodities, such as water, pearls, and so on, have not developed the type of financial depth seen in commodities such as oil.
Other commodities were once extremely important and traded heavily but have become much less noteworthy. Salt, ivory, silk, herring, sperm whale oil, dyes, animal furs, and sugar have faded from their once preeminent positions. The history of civilization is replete with tales of fortunes made and lost and even empires going to war in connection with once valued commodities that subsequently were eclipsed or forgotten as societies and technology moved on. (Box 1.1 discusses a historical case involving sugar.)
Box 1.1
When Sugar Was King: Canada, the Caribbean, and the 1763 Treaty of Paris
The Seven Years’ War (also known as the French and Indian War in North America) was primarily fought by Great Britain, Prussia, and Britain’s allies against France, Spain, Austria, Russia, and allies. The war lasted from 1754 to 1763. The war was described by among others, Winston Churchill, as a “world war” since its combatants, the rival camps led by the European superpowers of France and Great Britain, fought in far-flung geographies across Europe, North America, the Caribbean, West Africa, India, and East Asia.
At its end, the Kingdom of France had suffered military defeat in nearly every theater and faced financial ruin. Yet the British government was also war-weary and wished for peace. In the Treaty of Paris, signed in 1763, France ceded its immense colonies of Canada and its territories east of the Mississippi to Great Britain. In return, France was allowed keep the tiny Caribbean islands of Martinique, Guadeloupe, Saint Lucia, and Marie-Galante.
As surprising as it may seem to modern ears, the French negotiators felt they had received good terms, while in Britain, the statesman William Pitt the Elder criticized the treaty as being too generous to the French, allowing them to maintain their maritime and commercial powers intact.
How could these tiny Caribbean islands be more valuable than all of French Canada?
In a word, the answer was sugar. The Caribbean islands were the world’s major producers of sugar. By the late eighteenth century, taste for the tongue-pleasing commodity had swept Europe so thoroughly that a vast industry had emerged extracting the “white gold” from sugarcane plantations, run by thousands of slaves forcibly brought from Africa to labor and die under the hot Caribbean sun. At incalculable human misery, the plantations were incredibly lucrative to their European owners. Successful sugar planters could command immense fortunes and formed an integral part of global trade.
Hence, France readily acceded to giving up all of Canada in return for being allowed to retain some of its prized sugar-producing islands. And when Britain’s American colonies revolted against the motherland’s rule, France, nursing hopes of revenge against its arch-enemy, allied itself with the rebellious colonists, and the Caribbean once again became a war zone.
Today, with modern industrial technologies, sugar can be mass-produced so cheaply that sugary soft drinks and candies are extremely common and sugar is handed out for free in coffee shops. Many of the famed Caribbean sugar islands, once synonymous with fabulous wealth, no longer even produce sugar and are among the poorest countries in the world.
Myriad forces cause the various commodities to rise and fall in importance. Technology is an obvious one, sometimes single-handedly creating a societal use for a commodity where there once was none. For example, the invention and popularization of the lithium-ion battery caused usage of the otherwise lightweight but unremarkable metal to surge.
But economic and political factors can matter as well. Cotton has been cultivated since the dawn of civilization, but the invention of the mechanical cotton gin during the Industrial Revolution allowed cotton-based textiles to become much cheaper, displacing but not entirely eliminating older wool textiles.
The expansion of the Silk Road and Mediterranean trading connections between Venice and the Near East introduced a taste for Middle Eastern coffee into Europe. Coffee was introduced into Brazil only in the early 1700s by European settlers, and now Brazil is the largest producer and exporter of coffee in the world.
It is difficult to predict which commodities will be used in the future or be consigned to the dustbin of history.
No one would deny that water, the essence of biological life, is an essential commodity. Population growth, urbanization, climate change, and other trends are expected to stress the planet’s water ecosystems.
However, many governments still maintain municipal water systems that provide water more or less for free to retail consumers. Some experts predict that all water supply will soon have to be traded financially, but the political obstacles to charge for water are immense.
Petroleum oil is perhaps the most heavily traded and valuable commodity at present, but will its position change if electric vehicles challenge the dominance of hydrocarbon fuels in transportation?
Some engineers and architects predict that carbon nanomaterials will become the building material of the future. Will these materials displace the iron and steel used ubiquitously in modern skyscrapers, pushing steel down the same path to obsolescence that other commodities have taken?
These are difficult questions to answer, but at the least, in trying to formulate an educated answer, one would need to know not just the technology but also the economic and political forces driving commodity prices. It is these latter aspects of commodities that this book discusses.
Now let us go through each of the major commodity types currently in use in more detail.
1 Energy Commodities
Energy commodities are unusual in that their value is derived not from the substance itself but from the physical energy inherent in the substance.
What is energy? From the point of view of a physicist, energy is one of the fundamental properties of a physical system, like time, mass, and space. And famously, energy is always conserved in a closed physical system. (See box 1.2 for a discussion of a deep relationship between the conservation of energy and time.)
Box 1.2
Noether’s Theorem: The Conservation of Energy and the Invariance of Physical Laws
The conservation laws of physics hold that energy, linear momentum, and angular momentum are conserved in a closed physical system. These laws are quite familiar to any high school physics student. Less well known is the deep mathematical linkage between these conservation laws and the invariance of physical laws to translation.
For example, when we consider the physical laws describing the motion of a bouncing ball, we know the exact same laws should apply no matter where or how we toss it. Hence, all else equal, the ball should move in the same manner if I bounce it in one location or if I bounce it five meters to the left of the original location. Similarly, the laws of physics should be the same if I rotate myself, say, 90 degrees clockwise, or if I wait ten minutes later before I bounce the ball. In other words, the laws of physics are invariant to spatial, rotational, and temporal translations.
Remarkably, the German mathematical physicist Emmy Noether showed that these invariances of the laws of physics to spatial translation, rotation, and time shifts are why linear momentum, angular momentum, and energy, respectively, are conserved. This equivalence is known as Noether’s Theorem and is perhaps one of the most beautiful patterns underlying the structure of the universe.
However, it can be transformed from one state to another. For example, as a ball is tossed into the air at a certain velocity, the kinetic energy of the projectile is transformed into gravitational potential energy before finally being converted back to kinetic energy again (figure 1.2).
Figure 1.2 The transformation of kinetic energy to potential energy and back to kinetic energy.
Though energy is always conserved, it can come in many different forms: kinetic energy (as mass travels at a certain velocity), gravitational energy (as mass resists the gravitational pull of objects), electromagnetic energy, chemical energy, thermal energy, and so forth.
Hence, from an engineer’s perspective, energy is useful because its form can be converted from one type to another and, in the process, energy can do useful work (scientifically defined as force times distance). In other words, by harnessing an energy source, we can get things to move in the way that we want.
For example, a counterweight trebuchet converts the stored gravitational energy of the raised counterweight into kinetic energy of the fired projectile. An internal combustion engine converts the chemical energy stored in the hydrocarbon molecules inside its gasoline tank into the motion of pistons that propel a vehicle forward.
Indeed, the ability of Homo sapiens to harness outside energy sources to do work, move, and shape matter to human will may be a defining characteristic of our species. Other intelligent animals also use tools, have sophisticated methods of communication, and live in large interconnected societies, but no other animal uses extrinsic sources of energy to the scale and power humans do.
From an economist’s perspective, energy is like capital or labor, a fundamental input of the production function. In the classical production curve framework, economists often lump energy in with capital, but energy is arguably different from other capital inputs such as computers, furniture, or automobiles. These items are all highly useful but are not absolutely essential for the basic functioning of society. Our ancestors led long and productive lives without these appliances, but ever since the first humans harnessed fire from wood and other energy resources, the usage of energy sources has been an integral part of our societies.
From the perspective of a historian or an anthropologist, our species has not just relied on its own muscle power but has utilized the energy obtained from burning wood, the labor of domesticated animals, and other sources of energy, including wind and moving water to improve our lives.
But it was not until the Industrial Revolution that humans crossed a remarkable inflection point by tapping vast energy sources in the form of fossil fuels, first coal, followed by oil and natural gas, in service of large-scale industrial production.
Indeed, a bold historian might argue it was the ability of Western European powers—first Great Britain, followed by its continental rivals—to unlock and tap new sources of energy that led directly to the railroads, steamships, and other machinery that underpinned their political, military, and economic dominance over the world for much of the nineteenth and twentieth centuries, a legacy still felt today. Figure 1.3 shows U.S. consumption of energy by source since the seventeenth century.
Figure 1.3 U.S. energy consumption by source, 1635–2013.
Source: The U.S. Energy Information Administration.
Remarkably, despite two centuries of technological progress, as of yet no alternative energy source has been identified that combines the cheapness, efficiency, and power of fossil fuels. Despite the rapid rise in renewable energy sources, they still accounted for less than 3% of global energy usage in 2015, compared to the more than 85% accounted for by the fossil fuels. For the moment, we are still living in a hydrocarbon era.
2 Base Metals
We turn next to the metals, sometimes called the “base” metals to contrast with the precious metals (to be discussed below).
In fact, most elements on the period table are chemically metals, but humans primarily use only a handful them. Base metals are sometimes referred to generically as “metals,” though they should be distinguished from the precious metals.
Base metals tend to have highly useful physical properties, such as a remarkable combination of strength and malleability. This allows them to be smelted and molded into all kinds of desired shapes and sizes. Their relative sturdiness makes them suitable for use in buildings, bridges, and cars, yet they can be flexible and bend rather than break, allowing, for example, steel buildings to expand in the heat of a hot day without bursting.
Base metals can also be great conductors of electricity because of the free-floating electrons in their atoms. In particular, copper’s conductivity, cheapness, and ability to be easily flattened and shaped into long and flexible wires make copper widely used in telecommunications equipment and electric wiring.
Iron is not as useful as copper as a conductor but it is essential as strong material for tools and building materials, especially when mixed with carbon to create that wonderful material, steel. Other base metals such as nickel, tin, and aluminum have various properties of conductivity, strength, and brittleness valued by engineers and builders.
In addition to the desirable properties of base metals when used alone, they can be mixed with other metals to produce alloys that have other desirable properties. For instance, mixing copper and aluminum yields bronze. Mixing copper and zinc produces brass. Mixing tin with a little copper, lead, and antimony yields pewter.
The varying degrees of strength, malleability, durability, conductivity, and hybridizability make the base metals central components of modern life.
3 Precious Metals
Precious metals, such as gold, silver, or platinum, are a special case among the metallic commodities because their value is not necessarily tied to any inherent physical property but to the willingness of others to exchange valuable goods for them. In this sense, precious metals are like gemstones such as diamonds, rubies, sapphires (though precious metals and gemstones can also have industrial applications).
But most buyers of precious metals do not “consume” precious metals in the same way that they utilize other commodities. Unlike gasoline or iron, which is burned up or rusted away as it is used, people buy precious metals simply to own them, such as for aesthetic pleasure mounted into jewelry or stored as ingots. As they are chemically durable, precious metals do not rust away but simply sit there! Indeed, estimates suggest over 95 percent of the gold that has ever been mined is still in circulation.
Not only are they pretty and durable, but precious metals are rare and a conveniently small and portable amount of a precious metal can have a high value. This means they are a practical store of value, with owners confident that the precious metals can be exchanged for other objects in the future. Ultimately, precious metals are valued not for their intrinsic usefulness but because they retain a marketplace exchange value. This is sometimes known as the diamond-water paradox in economics.
In The Wealth of Nations, Adam Smith pointed out this difference between “value in use” versus “value in exchange.” In his words,
Nothing is more useful than water: but it will purchase scarcely anything; scarcely anything can be had in exchange for it. A diamond, on the contrary, has scarcely any use-value; but a very great quantity of other goods may frequently be had in exchange for it.
The relative scarcity of gemstones and precious metals compared to the abundance of water helps clarify this seeming paradox. Nevertheless, precious metals must be considered a special class of commodities. Rather than fundamental demand-and-supply dynamics, financial and psychological realities such as currency fluctuations, the time value of money, and the dictates of fashion are the most important factors in determining the market for precious metals.
Unfortunately, as fascinating as it is, a full treatise of the myriad of purely financial factors, such as real interest rates and inflationary expectations, as well as market psychology and consumer fashion driving the completely different dynamics of the prices of precious metals requires a whole another book and is beyond our scope. We will largely put the precious metals aside and focus on the more “practical” commodities for the remainder of this book.
4 Agricultural Commodities
Agricultural commodities, the last class of commodities to be considered, fall broadly into two categories: grains and soft commodities.
Grains in turn are divided into cereals and legumes. Cereals, such as wheat, rice, and maize (corn), are the seeds of specialized strains of grass domesticated through millennia of selective genetic breeding. Legumes, such as soybeans or lentils, are the seeds or fruits of nongrass plants similarly grown for human or animal consumption.
Together, the cereal and legume grains form the primary staple diet and source of carbohydrates for the human population. Much as the energy commodities power our tools and vehicles, agricultural commodities power our own bodies.
The soft commodities are an ill-defined category that includes a grab bag of various animal and plant products, among them beef, pork, poultry, eggs, milk, oranges, coffee, apples, and almonds. The soft commodities are distinguished from the other commodities by their “softness,” that is, their fragility and perishability, and therefore by the additional cost of transporting and storing them, especially over longer periods of time.
All agricultural commodities, but especially the soft commodities, have the tendency to spoil if not properly stored. The availability of modern refrigeration has lessened this tendency, allowing consumers to enjoy agricultural commodities grown, harvested, and transported from thousands of kilometers away. Nonetheless, it is important to recognize that, unlike a piece of iron ore or a barrel of oil, a bushel of corn or a liter of milk will spoil and lose value if left alone. The biological nature of agricultural commodities also means that their production may be subject to the vagaries of the harvest season, causing cyclical fluctuations in their supply.
Despite the explosive rise of energy commodities since the eighteenth century as the most heavily traded and valuable set of commodities in the world, it was the Agricultural Revolution (which predated the Industrial Revolution by some ten millennia) that was perhaps even more epochal in the history of humankind. Humans’ success in domesticating plants, which allowed people to shift from a largely nomadic hunter-gatherer lifestyle in small bands to a sedentary farming lifestyle in larger aggregations, gave rise to civilization itself. The human population on Earth has been expanding exponentially ever since.
And despite horrific episodes of crop failures and famines, global food prices have been on a generally downward trend over the past few centuries. The “green revolution,” aided by the use of irrigation, mechanization, fertilizers, and selective crop breeding, has continued the trend. Currently, pressures from climate change, water scarcity, crop diseases, and desertification threaten to break that trend. But human ingenuity has allowed an escape from these “Malthusian” traps.
The so-called “new green revolution,” characterized by the use of genetic modification techniques to produce ever tougher strains of crops, shows great promise in keeping food supplies plentiful and affordable for the ever increasing human population on Earth.
Conclusion
This brief tour of commodities has introduced various types of commodities—energy, metals, and agricultural—and their usefulness to the world economy, their inherent physical nature, and their fungibility. Because of their outsized importance to the global economy, the energy commodities, especially petroleum, receive the bulk of the attention for the rest of the book, with a particular focus on their economic and financial dynamics. However, the underlying principles distilled from the economic and financial dynamics of energy commodities are universal enough to be applicable to all commodities.