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The commoditization of energy resources unfolded in an accelerated fashion after the collapse of the Bretton Woods system, which ultimately led to the inauguration of crude oil trading on the Chicago Board of Trade (CBOT) and the New York Mercantile Exchange (NYMEX) in 1983. The Bretton Woods system of fixed exchange rates was replaced by a floating exchange rate system that gave rise to increased volatility in financial markets in the 1970s. The need to manage exchange rate volatility led to the development of markets for foreign exchange. Concurrently, oil-producing countries were very concerned about the declining US dollar and started adjusting oil prices to match changes in gold price. In other words, there was reluctance in the oil market to break from the old Bretton Woods system that was pegged to gold. This kept oil prices stable when expressed in the old, “gold-backed dollars” but led to volatility spikes in actual oil prices (expressed in post-Bretton Woods US dollars). Thus, the evolution of the oil market from a regulated market with price controls to a free market necessitated the development of instruments for oil price risk management, akin to agricultural commodities markets. The development of this market depended heavily on the successful commoditization of these energy resources.

A commodity can be defined as any good or service for which there is demand and which is indistinguishable from other goods of the same type. That is, there is no special feature or additional utility provided by a particular good that is not available from another good of the same type. For example, crude oil produced in the USA is fungible with crude oil produced elsewhere in the world and can be used for similar purposes. Thus, all goods of the same type are treated as equivalent and this facilitates the formation of markets as commoditized goods become substitutable for each other. In 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.