practice, commodities which are traded on commodity markets have to adhere to a minimum standard or grade in order for them to be widely traded.
In this book, the use of the term “commodity” will refer to physical goods, usually natural resources, which are grown, mined, or extracted and are traded in a marketplace. The price of the commodity is generally determined by the market as a whole and not by individual producers or consumers. This assumes that a commodity is not differentiable by source, quality, or other specifications. However, in real life, there are minimum standards of quality and quantity that need to be observed for products to be traded in a marketplace. These minimum standards enable trading of large quantities of commodities as buyers do not have to bear the costs of analyzing the provenance of underlying commodities for each transaction. Markets also assign value to quality differences and, by extension, to the sources of commodities. For example, crude oil with low sulfur content and higher fractions of high-end products such as gasoline and kerosene (called light sweet crude oil) is usually assigned a higher price than crude oil with higher sulfur content.
As opposed to other asset classes such as stocks or bonds, which represent claims on a corporation or entity, commodities are more difficult to define as an asset class. They can range from precious metals, such as gold and silver, to agricultural products like corn and wheat, as well as energy products such as crude oil and natural gas. Commodities can trade across physical markets, where participants exchange the actual commodity, or financial markets, where participants exchange claims to underlying commodities (akin to stocks and bonds). In this respect, commodities are better understood by observing the markets in which they are traded.
Commodities can have multiple sources, making classification on this basis impractical. For instance, gold mined in Australia is substantially similar to gold mined elsewhere in the world. It is easier to classify commodities based on shared characteristics such as physical state, method of production, and primary end use. Commodities can be broadly classified under four major classes.
1. Precious metals. Metals such as gold, silver, platinum, palladium, rhodium, etc. can be classified as precious metals. This classification derives from their historical usage as currency, and their scarcity relative to other metals.
2. Base metals/industrial metals. Metals such as copper, aluminum, zinc, nickel, lead, and tin are some of the major base metals traded in global markets. The name “base metals” derives from their tendency to oxidize or corrode, as opposed to noble or precious metals. In mining, the term “base metals” generally refers to non-ferrous metals, excluding precious metals, while the term “industrial metals” expands the definition to include other commonly used metals such as iron and steel.
3. Energy commodities. Commodities that are used for the production of energy come under this category. They include crude oil, derivatives of crude oil such as naphtha, gasoline, gasoil, heating oil, and fuel oil, in addition to natural gas, coal, electricity, biodiesel, and other commodities. Petrochemicals, emissions, and freight, which have close linkages to the energy market, can also be considered as energy commodities.
4. Agricultural commodities. Agricultural commodities encompass a wide range of commodities produced by farming. They can be further divided into sub-classes, based on their usage, availability, and the similarity of their markets.
a. Food grains. Commodities mainly used for human consumption, like rice, wheat, corn, etc.
b. Edible oils and oilseeds. Oils fit for human consumption, including soybean oil, palm oil, soybeans, soybean meal, rapeseed (canola) oil, sunflower oil, etc.
c. Livestock. Live animals, which are mainly live cattle, feeder cattle, and lean hogs.
d. Soft commodities. Other agricultural commodities such as cotton, coffee, cocoa, sugar, orange juice, rubber, etc.
Increasingly, there are linkages between classes of commodities such as energy and agricultural commodities. Commodities such as sugar or palm oil are used not only as food, but also to generate energy in the form of biodiesel. However, we use the aforementioned classification as it is based on the primary usage of the commodity and the major driver of demand for that particular commodity.
ENERGY COMMODITIES
Energy commodities come in different physical forms: solids such as coal and wood, liquids like petroleum, and gases such as natural gas and propane and butane (that are converted into Liquefied Petroleum Gas (LPG)). Most energy commodities in use are hydrocarbons, although nuclear energy and hydroelectric power are notable sources of power that are not hydrocarbon-based.
The main sources of primary energy are oil, natural gas, coal, nuclear energy, hydroelectric power, and renewables. Many of these primary sources are used in the generation of electricity, a secondary form of energy. The International Energy Agency (IEA) provides details on the supply and consumption of oil and other energy commodities. A breakdown of the total primary energy supply (TPES) of the world is shown in Figure 1.1. Oil and coal are the biggest sources of energy, with natural gas not far behind. Of these forms of energy, oil, coal, natural gas, and biofuels are traded in regional and global markets.
FIGURE 1.1 Total primary energy supply for 2012; TPES totaled 13,371 Mtoe (million tons of oil equivalent)
Source: International Energy Agency, © OECD/IEA 2014, Key World Energy Statistics, IEA Publishing; modified by John Wiley and Sons Ltd. License: www.iea.org/t&c/termsandconditions.
The total final consumption of energy provides a picture of the end uses of primary energy (without including backflows from the petrochemical industry). It can be inferred by comparison with primary energy supply that a significant proportion of primary energy sources, especially coal and natural gas, are converted into electricity for final use. As per the IEA, 63.7 % of oil is consumed for transportation, while industrial use of coal accounts for 80 % of its annual consumption (Figure 1.2).
FIGURE 1.2 Total final consumption for 2012; TFC totaled 8979 Mtoe (million tons of oil equivalent)
Source: International Energy Agency, © OECD/IEA 2014, Key World Energy Statistics, IEA Publishing; modified by John Wiley and Sons Ltd. License: www.iea.org/t&c/termsandconditions.
Let us now briefly consider individual energy commodities, starting with crude oil.
Crude Oil
Crude oil or petroleum, derived from the Latin: petra (rock) + oleum (oil), refers to the thick, usually dark-colored liquid that occurs naturally in different parts of the world and is commonly retrieved by drilling. Petroleum is a fossil fuel, which was formed when a large number of dead organisms were buried under sedimentary rock and subjected to enormous heat and pressure over millions of years. Crude oil is the most prominent of the hydrocarbon-based fuels, compounds composed mainly of carbon and hydrogen in varying proportions.
Since crude oil on its own is not of much use and needs to be processed for most modern applications, the value of crude oil is derived from the value of the underlying refined products that are obtained after processing. The products that can be obtained
