This is the second article in a series by Jurie van der Merwe on financial markets. In the first article he covered capital markets. This time he takes a look at commodity markets.

The first use of the word commodity has its origin in the Latin word commoditatem: ‘fitness, adaptation’.

In the original and simplified sense, commodities are things of value, of uniform quality, that were produced in large quantities by many different producers; the items from each different producer are considered equivalent. It is the contract and this underlying standard that define the commodity, not any quality inherent in the product.

Modern commodity markets have their roots in the trading of agricultural products. There are many types of commodity markets. Characteristic of commodities is that their prices are determined as a function of their market as a whole.

Well-established physical commodities have actively traded spot and derivative markets. Generally, these are basic resources and agricultural products such as iron ore, crude oil, coal, ethanol, sugar, soybeans, aluminium, rice, wheat, gold and silver.

South Africa is the second largest producer of gold in the world. However, our global share in production of gold has come down.

In 1970 South Africa accounted for 79% of world supply, producing about 1 000 tonnes. In 2007 production had fallen to 272 tons. This sharp decline was due to the increasing difficulty of extraction, changing economic factors affecting the industry and tightened safety auditing.

In 2007 China overtook South Africa as the world’s largest gold producer, the first time since 1905 that South Africa has not been the largest.

Metal commodities are divided into precious and industrial metals. Precious metals are gold, platinum, silver and palladium. The list for industrial metals is much longer and includes copper, lead and zinc.

The trade in commodity futures are today bigger in volume than the trade in spot commodities. The biggest futures commodity market is the CME or Chicago Mercantile Exchange. CME has the largest options and futures contracts open interest (number of contracts outstanding) of any futures exchange in the world.

The London Metal Exchange or LME is the futures exchange with the world’s largest market in options and futures contracts on base and other metals. Contrary to popular belief, the precious metals, gold and silver are not traded on the London Metal Exchange, but on the over-the-counter market usually referred to as the London Bullion Market, by the members of the London Bullion Market Association.

The London bullion market is entirely different from but often confused with the London Metal Exchange. Only base metals are traded at the London Metal Exchange (LME), while gold and silver are traded by members of the London Bullion Market Association (LBMA), loosely overseen by the Bank of England. Most of the members are major international banks or bullion dealers and refiners. Five members of the LBMA meet twice daily to set the gold price in a process known as the London Gold Fixing.

Gold is traded primarily over-the-counter (OTC) with limited amounts trading on the New York Mercantile Exchange (NYMEX) and Tokyo Commodity Exchange (TOCOM). These forward contracts are known as gold futures contracts.

Spot gold is traded for settlement two business days following the trade date, with a business day defined as a day when both New York and London are open for business.

Unlike many commodity markets, the forward market for gold is driven by spot prices and interest rate differentials (similar to foreign exchange forward markets) rather than underlying supply and demand dynamics. This is because gold, like currencies, is borrowed and lent by central banks and in the interbank market.

Because interest rates for gold tend to be lower than US domestic interest rates (to encourage gold borrowings so that central banks can earn interest on their large gold holdings), except in exceptional circumstances the gold market tends to be in contango (i.e. the forward price of gold is higher than the spot price). This has historically made it an attractive market for forward sales by gold producers and contributed to an active and relatively liquid derivatives market.

The bulk of global trading in gold and silver takes place on the over-the-counter (OTC) market. London is by far the largest global centre for OTC transactions followed by New York, Zurich and Tokyo. Exchange-traded trading has grown in recent years with Comex in New York and Tocom in Tokyo generating most of activity. Gold is also traded as a security on the London, New York, Johannesburg and Australian Stock Exchanges.

Although the physical market for gold and silver is distributed globally, most wholesale OTC trades are cleared through London. The average daily volume of gold and silver cleared at the London Bullion Market Association (LBMA) in December 2004 was 15.4 million ounces (480 000 kg, worth $6.8 billion) and 102.2 million ounces (3 180 000 kg, worth $730 million) respectively. This means that an amount equal to the annual gold mine production was cleared at the LBMA every 5.4 days, and to the annual silver production every 5.8 days.

Agricultural products are another important commodity sector in South Africa. The most important international agricultural markets are the Chicago Board of Exchange and the New York Board of Exchange. Corn, oats, rough rice, soybeans and wheat are traded on the Chicago Board of Exchange. Wheat, cacoa, coffee, cotton and sugar are traded on the New York Board of Exchange. These two markets set the official prices for the abovementioned commodities.

Efficient commodity markets play a crucial role in the success and fairness of global trade. Commodity markets have developed and today the trade in commodity futures outstrip the physicals by far. The next article in this series on financial markets will cover futures markets.

Jurie van der Merwe, UBS South Africa (Pty) Ltd. Wealth Management South Africa. 011 322-7912, Fx 011 322-7998; Mobile 082 560 5834; This e-mail address is being protected from spambots. You need JavaScript enabled to view it ; www.ubs.com