What the price of a chocolate bar can tell you about investing

Everything is finance. I mean that. Almost everything you see, hear or use in a given day is somehow linked to the giant web of financial markets. Before you smoke that cigarette, get on that bus, or buy that candy bar, a dozen financial transactions happened to make that happen. 

Let’s take a closer look at that candy bar. It probably cost you a euro or two. That money pays for, among other things, all the ingredients in the bar that the candymaker sourced. In this case, that’s sugar, cocoa and milk. 

Surely those things are easy to understand, right? There’s a cocoa price, and the company pays it, and then you pay for the candy bar. 

Think again. The actual price of those ingredients is constantly being guessed and bet on, by companies, farmers, and even investors who never touch the stuff. Welcome to the worlds of commodities and futures.

What’s a commodity?

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The word commodity comes to us from our friends in economics, and it refers to any product that is fungible. For example, if you buy a TV, it matters which specific TV you buy. Some are bigger, some have more features, or belong to a certain brand, so their price varies according to that. But one kilogram of sugar is about the same as another kilogram of sugar. You don’t really care which kilogram you get, because it’s going to be the same. Sugar is fungible, so it’s a commodity. 

Other well-known examples of commodities include gold, silver and oil, and importantly, many of the crops that farmers produce, including wheat, cocoa, soybeans, and corn. These are called commodity crops. Sugar is also one of these. 

All of these commodity crops are produced in order to be traded on markets. That means their prices are changing every single second as traders buy and sell them. These are called the spot prices, the price of the commodity right now. For example, the sugar price, on the commodities market, is decided by the Sugar No. 11 contract, which entitles the contract holder to receive about 112,000 pounds (around 50,000 kilograms) of raw cane sugar. 

Looking into the future

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Wait a second. So the price of sugar, cocoa and other commodities is changing every second? Why doesn’t the price of my candy bar change every time I go to the store? And does this mean farmers are constantly waiting for a better price before they sell their crops?

This is where we get into futures. As you could have guessed, it’s inconvenient for farmers and companies to have to keep paying different prices for products they know they’ll need. It makes for an unpredictable revenue stream. 

What they do instead is buy a futures contract, which is a legal agreement that allows someone to buy or sell a specific commodity at a fixed price at a specific time in the future. 

Let’s say you’re the candy company, and you know you’ll need 100,000 kilograms of cocoa next month to make all your chocolate bars. The cocoa crop so far has been good, with plenty of rain, so it’s likely farmers will have plenty of cocoa to sell, which could make prices cheaper than they are right now. On the other hand, the rain hasn’t stopped, and there is a chance that floods might destroy some of the harvest, which would lead to the cocoa price spiking. In either case, you don’t want to take any chances, so you buy a futures contract that lets you buy 100,000 kilograms for slightly more than the current price. You now have visibility into your expenses for the next month, and the farmer knows they’ll be able to sell their cocoa for a good price, even if they have plenty. 

Sidenote: because the futures contract price changes based on the value of something else, in our cocoa example, it’s called a derivative. 

That’s how your chocolate bar can stay roughly the same price: companies will often secure their commodity prices far in advance, making sure they can predict their expenses, and only adjust retail prices when necessary.

The investor’s game 

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There are two ways a futures contract can end: physical delivery or cash settlement. Physical delivery is exactly what it sounds like: you buy a contract for 100,000 kg of cocoa a month from now, and in a month, you get 100,000 kg of cocoa delivered. 

But what if you don’t really want all that cocoa? What if you just think the price is going to rise, so you buy a contract for a cheap price, and make money by selling it once the price rises? You could take all the cocoa and resell it. But that would take a lot of work, not to mention storage facilities and transportation. Instead, you can opt for cash settlement, where you just get paid the difference between the price you bought at and the current price. If the price goes down, you pay the seller the difference, and if it goes up, they pay you. 

This is where we get to the “everything is finance” part. It’s estimated that only 3% of contracts are actually settled by physical delivery. Almost all futures are actually settled by cash settlement, as they’re traded by investors and speculators who are trading the futures like they’re any stock or crypto coin. 

That trading can have an impact on the price of these very real commodities. While weather, crop abundance and real-world factors are incredibly important, they don’t always explain all the price movements. 

So the next time that chocolate bar gets more expensive, you might be able to blame traders.

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