HardAssetsInvestor

What Are Commodities?

What are commodities? It seems like a simple question. Ask someone on the street and they'll probably say "oil" or maybe "gold."

Those are good examples, but they don't tell you what really makes a commodity a commodity. Gaining that understanding is the first step to becoming a better commodities investor.

Frozen Concentrated Orange Juice (FCOJ)

The best place to start understanding commodities is with orange juice. Seriously. Many investors trace their first experience with commodities back to that old Hollywood farce, "Trading Places." In the 1983 movie with Dan Aykroyd and Eddy Murphy, the pair tries to make a fortune by falsifying information to corner the market for frozen concentrated orange juice (FCOJ).

Orange juice? They can't be serious. They don't buy and sell orange juice on Wall Street.

Oh yes they do ... by the billions of dollars. In fact, FCOJ is a perfect example of what makes a commodity a commodity.

Fungibility

The single most important thing about orange juice is that ... well ... it's orange juice. While refined citrus gourmets might beg to differ, as far as the food industry is concerned, there is no difference between the juice produced in my orchard and the juice grown down the street. It all ends up in the same Tropicana bottle. Economists call this being fungible. As long as it meets certain standards (no little bits of orange tree, reasonably fresh, etc.), my juice is the same as your juice.

Another example of fungibility is gold: Gold in China is the same as gold in New York, as long as it has the same purity.

Fungibility is the first key to understanding commodities. Fungibility lets us trade huge quantities of oil, copper, cotton and natural gas at one price. No one differentiates between my copper and your copper; it's copper, and it sells for $X per ton.

What Does That Mean For The Market?

Fungibility greatly simplifies the commodities market. With no differentiation between products—one barrel of light, sweet crude oil is the same as another barrel of light, sweet crude oil—understanding the market is easy: Prices move in direct response to changes in expected supply and expected demand. That's it. No brands, no intellectual property, no innovation—it's supply and demand, pure and simple. Figure that out and you've figured out the commodities market.

That's not to say that predicting supply and demand is easy—the commodities markets are notoriously hard to navigate, and respond to rumors and new information with lightning speed. But ultimately, keeping supply and demand foremost in mind is the key to understanding this market.

Next Up? Types Of Commodities

The commodities market is more than just oil and gold.