What are softs?

In finance, soft commodities, or ‘softs’ refer to agricultural products that are grown rather than mined. They include natural, cultivated products like coffee, cocoa, sugar, corn, wheat, soybeans, fruit, cotton, rice, and livestock. Soft commodities are essential to global trade and play a vital role in industries like food production and textiles.

Soft commodities are sometimes referred to as tropical commodities or food and fiber commodities.

The role of softs in global commodity markets

Soft commodities play an important role in global commodity markets, influencing everything from food prices to manufacturing costs and international trade. These raw materials are essential to everyday life and traded extensively worldwide. 

The prices of soft commodities are influenced by supply and demand dynamics. Factors like weather conditions, crop yields, and geopolitical tensions can all contribute to significant price volatility. For example, a drought in a major coffee-growing region may reduce the supply of coffee beans, driving up prices. Conversely, an exceptionally abundant harvest can create a surplus that lowers prices.

These price fluctuations can have a ripple effect across the global economy. Producers and businesses may face increased costs, which can be passed on to consumers. For example, an increase in the cost of crops like wheat or corn could result in higher prices for staple foods like bread or cereal.

In financial markets, soft commodities are also used as an investment tool. Traders and investors may use soft commodities to hedge against inflation or manage currency risk.

How soft commodities impact supply chains

Soft commodities are a major part of numerous industries, making them an essential part of global supply chains. Disruptions in their availability – whether due to weather events, geopolitical instability, or supply-demand imbalances – can create knock-on effects throughout the supply chain, delaying production and increasing costs for downstream businesses.

For example, a poor cocoa harvest in West Africa or a drought affecting wheat production may result in price increases and supply shortages. Industries that rely on these materials may face higher costs, inventory shortages, and logistical disruptions, all of which can impact profitability and operations.

This volatility can make supply chain management more complex, as companies must anticipate and mitigate potential price fluctuations and disruptions. To manage these risks, businesses often use financial instruments, like futures contracts, to lock in prices and mitigate the impact of supply challenges.

Differences between soft commodities and hard commodities

The primary difference between soft and hard commodities is that soft commodities are grown or cultivated, while hard commodities are mined or extracted. Here’s a closer look at their key differences.

Soft commodities

Soft commodities include agricultural products like coffee, cocoa, orange juice, sugar, canola, lumber, livestock, and cotton. These commodities are primarily used in industries like food, beverage, and textiles.

Soft commodity prices are influenced by external factors like weather, pests, soil health, and geopolitical issues, which can lead to higher price volatility compared to hard commodities. Since these products are essential for everyday needs like food and clothing, price changes in soft commodities often have a direct impact on consumer prices.

Hard commodities

Hard commodities include natural resources like gold, silver, copper, oil, coal, and natural gas, which are vital to industries like construction, energy, electronics, and manufacturing. These materials are extracted from geological deposits through mining or drilling.

Compared to soft commodities, hard commodities tend to experience less volatility because their production is generally more stable and less reliant on environmental conditions. While their prices can fluctuate due to factors like market demand or geopolitical events, they tend to influence broader economic activity rather than directly affecting consumer prices.

How are softs traded in the commodity markets?

Soft commodities are primarily traded through futures and options contracts. These derivatives are widely used by companies and investors to manage risk or speculate on price movements.

Futures

Futures are one of the most common methods for trading commodities. These standardized contracts allow buyers and sellers to lock in a price for a commodity to be delivered at a future date. Farmers, producers, and commercial users often use futures to hedge against price fluctuations, helping to secure predictable revenues or costs for their crops or goods.

Speculative investors seeking to potentially profit from changes in commodity prices also often trade futures. The soft commodities most actively traded via futures include coffee, cocoa, sugar, and cotton.

Options

Options give buyers the right, but not the obligation, to buy or sell a futures contract at a specific price before a set date. They’re often used by businesses to manage downside risk while retaining the ability to potentially benefit from favorable future prices. Unlike futures, options don’t require the holder to execute the contract unless it's advantageous.

For example, a cotton producer concerned about a potential drop in cotton prices might purchase a put option to guarantee a minimum selling price. If market prices fall below that level, the producer has the option to sell their cotton at the predetermined price, helping mitigate potential losses.

The importance of softs for B2B industries

Soft commodities play an important role in B2B industries, providing raw materials for production and influencing cost management strategies.

Raw materials for manufacturing

Soft commodities provide essential raw materials for industries like food and beverage, textiles, and cosmetics. Companies such as coffee roasters, textile producers, and chocolate manufacturers depend on a reliable supply of goods like coffee beans, cocoa, and cotton to create and distribute their products. Any disruptions in the availability or pricing of these materials can impact production timelines and product availability.

Cost management

The price volatility of soft commodities can pose a challenge for cost management in many B2B industries. For example, sudden increases in the price of wheat or sugar can affect budgets and pricing strategies for food manufacturers. To address these fluctuations, companies may employ risk management tools like futures and options contracts to help stabilize costs and protect profit margins. These strategies can help companies maintain more predictable operating expenses, even in volatile market conditions.

Soft commodities and their influence on market volatility

Soft commodities tend to be more volatile than other asset classes as their prices are sensitive to external factors like weather, geopolitics, and global trade dynamics. These factors can lead to significant price fluctuations that impact industries and markets worldwide.

Weather & climate

The production of soft commodities is heavily dependent on a country’s environmental conditions. Adverse weather events, like droughts, floods, or unseasonal rainfall, may reduce crop yields and lead to supply shortages and price increases. Conversely, favorable conditions and bumper harvests can create surpluses, driving prices down.

Geopolitics and trade

Political instability and trade policies can also increase volatility in soft commodities. Export bans or sanctions on major producing regions can disrupt global supply chains, limiting access to specific commodities and causing price increases. For example, restrictions on soybean exports from a major supplier could affect the global livestock industry, which relies on soybeans for animal feed.

The inherent volatility of soft commodities can create challenges for businesses and investors, such as unpredictable costs and supply chain disruptions that may affect profit margins. To address these challenges, industries and investors often use strategies like hedging through futures and options, or working with a physical commodities broker, to manage price risk and secure reliable access to essential raw materials, helping mitigate financial impact.

Benefits of investing in soft commodities

Investing in soft commodities may offer benefits, such as:

• Diversification: Soft commodities often have a low correlation with traditional assets like stocks and bonds, making them a potential tool for diversifying investment portfolios and reducing overall risk exposure.
• Hedging: Soft commodities are frequently used as a hedge against inflation, as their prices tend to rise during periods of increasing costs. Businesses also use soft commodities to stabilize operating costs and mitigate the impact of price fluctuations.
• Potential for returns: Soft commodities can present opportunities for returns in volatile markets, particularly for those who monitor and respond to changing supply and demand dynamics.

How commodity markets handle soft commodity fluctuations

Soft commodity prices are highly volatile and unpredictable, which can create challenges for companies and investors. To manage risk and maintain stability amidst price fluctuations, hedging strategies are widely used.

Hedging involves offsetting potential losses in one market with gains in another. Two of the most common tools for hedging soft commodities are futures and options contracts.

Futures contracts

Futures allow buyers and sellers to lock in prices for specific commodities to be delivered at a future date, providing greater predictability for businesses.

For example, a coffee producer may secure a price for their coffee beans early in the growing season, reducing the uncertainty of future market conditions. This means that, even if market prices decline by the time of harvest, the producer can still achieve predictable revenues.

Similarly, a dairy processor might use dairy commodities services to manage price risks in milk and other dairy inputs. By locking in prices with futures contracts, they can better predict costs and protect their profit margins against sudden price increases.

Options contracts

Options offer more flexibility by giving holders the right, but not the obligation, to buy or sell commodities at a predetermined price. This allows businesses to mitigate downside risk while retaining the potential to benefit from favorable price movements.

For example, a confectionary manufacturer concerned about rising sugar prices might purchase call options. This allows the company to secure a maximum purchase price for sugar while retaining the flexibility to benefit if prices decrease. If sugar prices rise, the company can exercise the option and buy sugar at the predetermined price, helping protect against unexpected cost increases