When learning about the trade and finance industry, you will likely run into terms like commodity and commodity financing. These terms are significant to how the economy works and how goods and services are priced for the market.
What Is It?
A commodity is a basic good used in commerce and can be easily exchanged for another good of the same type. Common commodity examples include beef, gold, and oil. Commodity financing, therefore, is funding used to facilitate the movement of goods globally. This funding is typically loans from banks or private companies with terms of less than a year, but long-term financing examples are found in the oil and gas trade.
What Are the Loan Types?
You can find commodity financing through revolving credit facilities, letters of credit, and open credit. A revolving credit facility is usually used by major trading firms and is a line of credit from a consortium of lenders. A firm can use the RCF multiple times as long as the total outstanding amount does not exceed the limit the lenders set. Letters of credit, L/C, are the most common form of commodity funding. This form of financing involves the buyer’s bank sending a letter to the seller’s bank guaranteeing payment once the goods are received. Open credit arrangements are usually only made between buyers and sellers with a history of successful L/C deals and offer no protection if your counterparty fails to deliver.
How Do They Work?
When you use financing to pay for commodity trading, you essentially buy another shipment of goods while awaiting payment for prior shipments. While many transactions are for short-term sales, there are two types of long-term commodity and trade financing: prepayment and pre-export financing. Prepayment is a way to provide producers upfront cash and wait for the funding to be repaid with goods as they are produced. It is usually used in the oil and gas industries. Pre-export financing covers production costs while waiting for repayment from the sale of future goods.
Commodity financing can be tricky to understand, especially if you are entering the commodity trading industry. Understanding there are both long and short-term financing options depending on the commodities and deals you are working with is essential to seeking suitable funding for your needs. Establishing working relationships with lenders and trade partners is an excellent way to secure the financing you need for trade and earn a positive reputation with investors.