Commodity Trading (Part 1): History

After discussing oil and fuel hedging, I was asked to give more information on commodity trading in general and to comment on speculation in the oil markets. The flow of capital into commodities has been one of the most important economic developments over the past five years. In the next series of entries, I will try to give perspective to this phenomenon and explain why commodities have attracted so much investment. I plan to cover three main topics:

1. Brief history of commodity trading
2. Inflows of capital
3. Speculation in the energy sector

History of Commodity Trading
For as long as people have engaged in trade, they have needed a system to organize the delivery of goods and make commerce more efficient and predictable. The ancient Sumerians began the standardization process with the trade of sheep and goats. Sumerian farmers used an early form of commodity money - clay tokens baked in the shape of the livestock they were trading. When a farmer pledged a certain number of goats to a dealer, he would put an equal number of tokens in a vessel, seal it, write the number of goats on the outside, and give it to the dealer.

When the farmer delivered the stock, the dealer would break open the jar and count the tokens to make sure he received the proper number of animals. Over time, farmers and dealers began to forgo placing tokens in the jar and simply wrote down the quantity to be delivered. These clay etchings were the first form of futures contracts. Since there were no large state banks to sponsor these agreements, farmers would turn to local banks and moneylenders to help guarantee their reputation and secure contracts with dealers. Eventually, classical civilizations built global markets by trading gold and silver for other goods. States which had efficient systems for backing and clearing contractual activity on trade routes grew their economic power.

The Beginning of Modern Trading
Modern commodity trading has much in common with the first contracts conceived by the Sumerians. The concept of a futures market has its roots in Chicago. In the 1840’s, Chicago emerged as a major commercial center. Railroad and telegraph lines connected Chicago to large markets on the east coast and to new westward expansion. The invention of the McCormick reaper increased wheat production throughout the Midwest and farmers came to Chicago to sell their crops to dealers who could use this infrastructure to distribute grain all over the country.

As more farmers brought their grain to Chicago, problems began to emerge. There were no standards for weighing and grading wheat, so farmers had to visit multiple dealers to find the best price. Since the city lacked adequate warehouse space for, it was difficult for farmers to transport their wheat as they negotiated payment. This led to dissimilar prices for the same raw good and unpredictability for both buyers and sellers.

To help remedy this situation, the Chicago Board of Trade was established in 1848 as a central place for farmers and dealers to meet and negotiate prices. Buyers and sellers would exchange cash for the immediate delivery of wheat. With all of the buyers and sellers in one place, a more fluid market developed where prices and negotiations were transparent. Because weights and grades were standardized, farmers and dealers could set prices based on aggregate supply and demand.

The Emergence of the Futures Contract
As the centralized market became more successful, farmers and dealers began to commit to futures exchanges of grain for cash. For example, a farmer might come to the market in February and promise to deliver 5,000 bushels of wheat in June for a set price today. This has advantages for both parties – the farmer knows how much he will be paid and the dealer knows his price in advance. These contracts were written down and occasionally guarantees (small amounts of money) were paid to secure the agreement.

As these contracts became more common, their terms were standardized. Once there were enough active contracts, banks began to securitize them and use them as collateral for loans. Additionally, contracts began to change hands before their delivery dates. If a dealer decided he didn’t need the wheat he was promised, he would sell his contract to someone who did. Conversely, if the farmer realized he would not be able to deliver enough wheat, he would transfer the contract to someone who could fulfill the obligation (and pay a premium to encourage the new farmer to accept the additional obligation.)

As time went on contracts were traded more frequently. Farmers and dealers realized that the value of the contracts changed depending on events in the market. Bad weather could ruin harvests and raise prices. Declines in demand could cause prices to drop. When trading, buyers and sellers would weigh these factors when valuing a contract because the future contained a fixed price relative to the floating rate in the market. The chart to the left shows how the value of a contract might change in two different scenarios. Eventually, people who had no intention of selling wheat or taking possession of the grain began to enter the market. They tried to buy contracts with low values and sell them when market forces pushed their prices higher. These people were the first speculators in the growing futures market.

Modern Commodity Trading
Today, commodity trading has expanded far beyond wheat in Chicago. Goods as diverse as gold, oil, coffee, and orange juice are actively traded. All commodities have the following three qualities:

1. The good is standardized, raw and unprocessed (wheat is a commodity; flour is not).
2. The item must have an adequate shelf life for delivery.
3. There must be price fluctuation and uncertainty (risk and profit potential) for the good.

There is no need for a futures market if a price is stable. Additionally, the market for the commodity must be liquid enough that trading is possible.

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