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A Crash Course in Commodities

Carley Garner explains the origin and evolution of commodities markets.
This chapter is from the book

How It All Began

Given the urban nature of the city of Chicago, we often forget that it is located in the agricultural heart of the mid-West. In the mid-1840s the windy city emerged as the agricultural market center for neighboring states. Chicago was the meeting place for farmers looking for buyers of their crops and grain mills looking to purchase product for their operations. However, despite the central location, timing and logistic issues created inefficient means of conducting business and thus inflated commodity prices.

At the time, grain elevators were sparse, which made it critical that a farmer sell his crop upon harvest at the annual meeting in Chicago due to a lack of storage. Even for those who did have a method of storing the grain, frozen rivers and roadways made it nearly impossible to travel to Chicago during the winter months. Likewise, the springtime trails were often too muddy for wagon travel. Thus, during and immediately after harvest, grain supply was in such abundance that it was common for unsold grain to be dumped into Lake Michigan for lack of means to transport and store unsold portions.

As you can imagine, as the year wore on, the grain supply would dwindle to create shortages. This annual cycle of extreme oversupplies and subsequent undersupplies created inefficient price discovery and led to hardships for both producers and consumers. The feast-or-famine cycle created circumstances in which farmers were forced to sell their goods at a large discount when supplies were high, but consumers were required to pay a large premium during times of tight supplies. Luckily, a few of the grain traders put their heads and resources together to develop a solution...an organized exchange now known as the Chicago Board of Trade.

The Chicago Board of Trade

The Chicago Board of Trade (CBOT) was created by a handful of savvy grain traders to establish a central location for buyers and sellers to conduct business. The new formalized location and operation enticed wealthy investors to build storage silos to smooth the supply of grain throughout the year and, in turn, aid in price stability.

The CBOT is still located in downtown Chicago and is the world's oldest futures exchange. After spending the last decade and a half as one of the largest futures trading organizations in the world and a direct competitor to the Chicago Mercantile Exchange (CME), the CBOT and the CME merged July 9, 2007, to form the CME Group, creating the largest derivatives market ever.

  • The CBOT is the world's oldest futures and options exchange. Native Chicagoans describe the organization as "old money."

The CBOT division of the CME Group is the home of the trading of agricultural products such as corn, soybeans, and wheat. However, the exchange has added several products over the years to include Treasury bonds and notes and the Dow Jones Industrial Index.

The Chicago Mercantile Exchange

The success of the CBOT fueled investment dollars into exchanges that could facilitate the process of trading products other than grain. One of the offsprings of this new investment interest is the Chicago Mercantile Exchange. The CME was formed in 1874 under the operating name Chicago Produce Exchange; it also carried the title Chicago Butter and Egg Board before finally gaining its current name.

  • Local Chicagoans refer to the CME as "The Merc."

The contract that put this exchange on the map was frozen pork belly futures, or simply "bellies" as many insiders would say. Hollywood and media portrayals of the futures industry is often encompassed by the pork-belly market. How could anyone forget the infamous scene in Trading Places in which Billy Ray Valentine plots his speculation of belly futures? Ironically, pork belly futures are among the least traded contracts on the CME today in terms of volume and open interest.

The CME is responsible for trading in a vast variety of contracts including cattle, hogs, stock index futures, currency futures, and short-term interest rates. The exchange also offers alternative trading vehicles such as weather and realestate derivatives. At the time of this writing, and likely for some time to come, the CME has the largest open interest in options and futures contracts of any futures exchange in the world.

The New York Mercantile Exchange

Although the futures and options industry was born in Chicago, New York was quick to get in on the action. In the early 1880s, a crop of Manhattan dairy merchants created the Butter and Cheese Exchange of New York, which was later modified to the Butter, Cheese and Egg Exchange and finally the New York Mercantile Exchange (NYMEX).

The NYMEX currently houses futures trading in the energy complex. Examples of NYMEX-listed futures contracts are crude oil, gasoline, and natural gas. A 1994 merger with the nearby Commodity Exchange (COMEX) exchange allowed the NYMEX to acquire the trading of precious metals futures such as gold and silver under what is referred to as its COMEX division.

In March 2008, the NYMEX accepted a cash and stock offer from the CME Group that would bring the New York futures exchange into the fold along with the CBOT and the CME. On August 18, 2008, the proposal was approved by NYMEX seat-holders and shareholders. It is expected that by late 2009, the NYMEX systems will be fully integrated into the CME Group.

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