A Brief History on Commodity Markets and How They Work
by Oluwafunto Olasemo, Market Development Manager AFEX
Once upon a time during the 16th century, one of the Ambassadors of the Sultan of Turkey sent the first tulip seeds and tulip bulbs to Vienna. Along with other crops like tomatoes, pepper, and potatoes that were new to the continent at the time, the commodities were distributed across the continent and eventually reached Holland.
At that time, Holland was going through what is now referred to as the Dutch golden age, it was a growing economic and commercial powerhouse on the continent and had the highest per capita income in all of Europe. Tulips quickly became a status symbol in the country thanks to the intensely saturated color of its petals, and a must-have luxury item for the expanding wealthy class of the country, and with the increase in demand and popularity, its prices rose steadily.
Between June and September, the flowers could be uprooted and moved and that was when they were purchased in “spot” transactions, during the other months of the year, tulip traders entered contractual agreements with tulip growers to purchase specified quantities of tulips at specified prices at specified dates in “futures” transactions.
This story does not have a happy ending, unfortunately, as the tulip trade became ever more profitable, it attracted speculators who purchased tulip “futures” contracts only to resell them for a profit and in the February of 1638 as the prices of tulips started to sharply decline as buyers announced they wouldn’t pay the previously agreed prices for the tulips rendering the futures contracts worthless and crippling the tulip trade in turn. The crash in the tulip prices ruined the fortunes of many however, it left us a story of commodity trading for the ages.
A commodity is a basic agricultural product or a raw material that can be bought and sold, like tulips. Commodities can be traded in either spot trades or futures trades, spot trades as the name implies are transactions where the buyer and seller agree to buy or sell at the present market value and close the transaction in at most a few days. Futures trades are transactions where both parties agree to buy or sell commodities at a predetermined date, price, and quantity. These transactions occur in physical and virtual marketplaces and involve a range of players that include; Producers, End Users, Traders, Speculators, and Regulators.
Producers are responsible for making the commodities available, an example will be small-hold farmers who produce cash crops or livestock in commercial quantities. End users are the party who use the commodities, for example, a burger chain that buys beef from the small-hold farmers for use in its burgers. Traders negotiate prices between buyers and sellers and profit from the difference between the asking price of the producers and the highest amount the end-users are willing to pay for the commodity.
Similarly, speculators are like traders but they don’t deal with the actual commodities but rather bet on the upward or downward movement of the prices of the commodities. Regulators ensure commodities meet set quality criteria and play a watchdog role to ensure all parties in commodities trade carry out their responsibilities, they also ensure the integrity of the commodity market and might intervene by influencing prices, or the number of commodities available to trade for a wide range of reasons like avoiding a repetition of our tulip story above.
The impact of the agricultural industry is enormous. Commodity trading plays an important role in ensuring producers have the incentives in providing the commodities most needed by society at an efficient cost and it prevents any single player in the commodities trade from having undue power to influence the market.