Commodities that are grown, such as coffee, wheat and nuts, are known as soft commodities to distinguish them from hard commodities, such as oil or gold, which are generally extracted from the ground. Secondary raw materials such as waste paper and scrap metal are a third category of tradable commodity, deriving from the reuse of materials.
How are soft commodities traded?
Traditionally, physical trading takes place between two parties who agree to exchange a good, such as almonds, for cash. When a transaction doesn’t involve a regulated exchange, it is known as ‘over-the-counter’, enabling the price to be kept private.
Futures markets
Soft commodities like cotton, cocoa, soybeans and livestock can also be traded on global exchanges such as the Intercontinental Exchange (ICE), the Chicago Board of Trade (CBOT) and the New York Mercantile Exchange (NYMEX). This can be done by spot trading, which refers to a commodity that is bought or sold at a live price, for immediate delivery.
However, these markets also trade in contracts known as financial derivatives. A futures contract, for example, is an agreement to buy or sell a certain quantity of a commodity, at a certain price, at some date in the future. Its value depends on the price (forward price) of the underlying commodity when the contract was made. But when the futures contract is bought or sold, it acquires a notional value which may be higher or lower depending on prevailing market prices.
What are futures for?
Farmers, and businesses that rely on farming products, use futures markets to hedge against risks such as volatile prices. So for example, a baker might buy wheat futures to ensure they get a supply of wheat at a known price over the next year. A farmer might enter into a futures contract to lock in a price for their wheat so they can plan ahead for the next year’s crop. Speculators and investors, meanwhile, buy and sell those futures contracts on the exchange to profit from price fluctuations, and to diversify their investment portfolios as a way of managing their own risks.
Why are soft commodity prices volatile?
All commodity prices fluctuate over time, but soft commodity prices can be especially volatile. Changes in the weather, crop disease, or disruptions to logistics that affect delivery of a farmer’s goods to market, all impact on price. The cost of transportation, which is linked to oil prices, and demand-side factors such as changing consumer preferences, can also cause soft commodity prices to rise or fall.
CTRM software
Because soft commodity prices are so volatile and unpredictable, traders in the physical market use commodity trading and risk management technologies (CTRM software) to protect their profit margins. These specialised enterprise softwares help traders and brokers to optimise deal-making and manage the complex logistics of shifting commodities from one part of the world to another. Modern CTRM technologies can also manage chain of custody, where the origin of a shipment of cocoa, for example, needs to be traced for compliance purposes.