Hot commodities

Why a close look at the exchange of metals, energy resources and foodstuffs can give a valuable insight into the workings of the world's economy

What is a commodity?

A commodity is a type of good which is standardised and so can be traded without differentiation. For example, to commodities traders, a kilo of refined sugar produced by one company is seen as identical to a kilo produced on the other side of the world.

How are commodities traded?

Commodities are bought and sold as contracts to supply a particular kind of good at a certain time and price. These contracts can then be bought and sold by traders through an exchange - for example, the London Metals Exchange - and so ownership rights can be transferred without the physical exchange of goods. Goods are sold either as a spot contract, ie, at today's price, or as a futures contract, which allows the buyer to take delivery of the good at a point in the future at a pre-agreed price. Using futures mitigates the risk to buyers and sellers of large fluctuations in price and stabilises their outgoings or income, as applicable, over a period of time. It also enables traders to hedge or speculate on rises or falls in commodity prices.

How is the demand for commodities is changing, and why?

Jim Rogers, in his book Hot Commodities, claims that the world economy is several years into a long-term bull market in commodities, meaning a sustained increase in prices. That was almost six years ago and, so far at least, Rogers has been proved right. Analysts have suggested various reasons for this state of affairs, in particular, climate change. But, in Rogers's opinion at least, there is one fundamental dynamic driving the rise: a supply/demand imbalance. To put it simply, a growing global need for goods has driven up their cost.

CASE STUDY: The China effect

The global demand for raw materials started to show signs of growth during the 1990s as China began to assert itself on the global stage.

Having been a predominantly rural economy up until the 1980s, the government, moving towards free market principles, embarked on industrialisation. The manufacturing sector exploded, attracting country dwellers to the city in their millions. To accommodate these new city dwellers, new houses were needed as well as new roads, bridges and railways.

China had prided itself on being a largely self-efficient economy, but the sheer force of demand from heavy industry forced the government to look abroad for materials and fuel. Global demand for metals, such as copper and aluminium consequently rose, and so did prices.

China's agricultural economy was also changing. As farmers downed their tools to look for work in the cities, crop yields were no longer able to sustain the country's rising population. Staples such as wheat rice and grains were, for the first time, procured in bulk from overseas markets.

Some ten years on, China's thirst for commodities is still growing. 2009 proved a record year for Chinese imports. Having been a major exporter of coal as recently as 2001, for the first time China became a net importer. Demand for other industrial goods such as copper and iron ore also surged to record levels.

Why has China's consumption remained so ravenous? Quite simply, its economy is still booming. While industrial activity in the West has been reduced to a trickle by the global economic downturn, China shows no signs of slowing down. According to figures from the World Steel Association, 49 per cent of the crude steel produced worldwide in 2009 was made by China - that means Chinese steelmakers need an awful lot of coal and iron ore. And as a consequence of this vast industrial capacity, the UN expects that 400 million Chinese farmers that will move to the cities to work within the next decade, all of whom will need somewhere to live, road and rail links with which to get there, and food to eat to replace the rice and grain they're no longer producing, further accelerating the nation's demand for commodities.