All About Investing In Commodities


What Are Commodities?

Well, commodities refer to natural resources that fall into the three major classifications of agriculture, energy and metals.

The word commodity means it is a useful or valuable thing and commocategodities is an appropriate term because it has a global market.  Commodities are physical and tangible assets. They include metals such as gold, silver and copper, fuel materials like crude oil and gas, and the ‘soft’ commodities such as wheat, sugar, coffee and cocoa beans.

Why do we need the commodity market?

Commodities, being useful, are needed by modern societies of different countries.  As such, these demands greatly influence the prices and cause them to fluctuate.  The commodity market is the center that helps to maintain price stability through forwarding or futures trading.  A forward or futures contract allows a supplier to lock in on the price of the commodity months before they can be delivered to the buyer.  Their buyer, on the other hand, can already fix the future price for the end consumers.

How it’s done?

Geographically, most commodities have limited supply production availability. Only certain countries, regions and companies have economic access to these resources.  However, practically all societies have a demand for these materials.  This has given birth to a large global market for commodities.  This market enables commodities to be efficiently distributed from the most economic sources to where they are needed.

In investment lingo, commodities fall under the fifth asset class in terms of conventionality.  They stand behind the first four classes namely: cash, fixed interest securities, equities and property.

So let’s get to work!

The Commodities Sector

The commodities sector is quite independent of stock and currency markets and it has no direct correlation at all.  The implication is that in case the equity market plummets, the commodity prices would not necessarily go down with it.

Another distinct qualities of commodities are their uniformity and fungibility.  Since the commodities are not uniquely identifiable, they are easily interchangeable with their own kind.  Gold is gold and crude oil is crude oil regardless of the country where they were mined.

How can we promise the quality of commodities?

Although there are some differences in their quality, particularly in oil and agricultural products, they are graded and classified.  Grading and classifying them in specific types ensures that their characteristics remain tolerably uniform and therefore, fungible.

This solves the dilemma of having to inspect the whole batch of products.  It is precisely because of this non-inspection aspect that the large commodity markets can exist today.  Thousands of traders and speculators pin their trust on the integrity of these markets.

Gold 

Gold has been the standard for value for thousands of years. However, gold is back in the spotlight due to the recent performance of precious metals , their viability as investments, and inflationary worries.  Institutional and private investors are once again discussing the merits of this investment category.

Market’s development impacts the price:

Not with standing the sell-offs of the recent past, commodity prices have almost tripled over the last ten years. This is according to the Index Mundi commodity price index.  They should know because much of their successes were derived from this emerging market’s development.

Commodities, to summarize, can then be described as follows:

  • They are natural resources
  • They are needed by most nations or regions
  • They are sourced economically from limited locations
  • They incur large price fluctuations
  • They are generally uniform and fungible

Types Of Commodities

Commodities include the following:

  • Agricultural – (ex. cocoa, coffee, corn, cotton, feeder cattle, hogs, live cattle, lumber, milk, oats, orange juice, palm oil, pork bellies (bacon), rapeseed, rough rice, rubber, soybeans, soybean meal, soybean oil, sugar, wheat, wool)
  • Energy – (ex. crude oil, ethanol, natural gas, heating oil, gasoline, propane, purified terephthalic acid)
  • Metals – (ex. copper, lead, zinc, tin, aluminum, aluminum alloy, nickel, cobalt, molybdenum, recycled steel)
  • Precious metals – (ex. gold, platinum, palladium, silver)

What Are The Investment Characteristics Of Commodities?

Commodity prices are highly affected by the law of supply and demand just because they are mostly consumables. Low supply and increased demands raise commodity prices. High supply and low demand lower commodity prices.  Since the demand and supply scale constantly changes, so do commodity prices.

Here’s why:

The prices of many commodities, especially agricultural products, are affected by the natural seasons.  For example, corn normally peaks during March and April before the planting season but dips in September.  Weather and lifestyle seasons also affect the demand.  For instance, natural gas peaks during winter months because it is used mostly to heat homes.  Crude oil prices tend to go up during vacation season because many families take time to travel.

It sounds simple. And it is.

Diversity is another main advantage of investing in commodities.  With stocks and bonds, general prices rise or fall at the same time affecting your entire portfolio.  Commodity prices, on the other hand, rise or fall at different times.  By carefully tracking the seasons, you could adjust your investment strategies appropriately.

Also, Commodities remain strong even in bad economic times; therefore they afford the investor a natural protection.  Most commodities are necessities and their demand does not diminish even in a bad economy.  Because of this, prices are more buoyant and can remain springy even when demand falters.

Natural Hedge

Commodities are also natural hedges versus inflation. Why?

In fact, when commodity prices rise, it could mean that inflation is starting.  If a rapid inflation is reasonably expected, commodity prices are more likely to go up even faster.  In times like this, people normally move their funds to options that offer protection for their assets, like real estate. However, moving them to commodities is much more convenient than investing them in properties.

Think about it this way:

This was the scene in 2008 when the real estate bubble exploded and prices began plummeting.  Mortgaged-backed bonds and other securities that were dependent on mortgage income quickly lost their value due to loan defaults.  This triggered a domino effect on the economy.  It substantially depressed consumer confidence and spending which caused the economy worsen further. This in turn, adversely affected the prices of stocks enough to bring the market down.

The result:

As people began moving their money out of stocks, bonds and expectedly, real estate, they turned to the commodities market.  This pushed the prices of the commodities upward and pushed the prices of stocks even lower.  This was because the profits of most companies are decreased when commodities are more expensive.

For instance:

During the summer and spring of 2008 when oil prices rose to 150%.  This naturally increased the operating costs of many companies since just about everyone depends on oil one way or another.

What Are The Risks Of Investing In Commodities?

Volatility 

The commodities market is highly volatile because it is influenced by supply and demand.  Supply and demand, on the other hand, are dependent on many factors that are as unpredictable as the weather. Natural and geopolitical factors, ease of finding new sources, delivery time  – all these things directly affect supply and demand.

crude-oil-prices-20-years

Leverage and speculation 

Because they are traded using futures contracts, traders often use high leverage ratios, even as high as ten to one.  This causes many traders to become jittery and react accordingly if there is news that prices may rise or fall greatly.  Hence, a forecast of a construction boom may cause metal prices to go up. An escalation of conflict in the Middle East would cause oil prices to spike.

Take a look:

When Hurricane Katrina damaged oil refineries in the Gulf of Mexico, rumors of oil shortage went around.  Gasoline prices naturally went up.  The jump of oil prices from $100 per barrel to $150 per barrel in 2008 was mostly due to speculation.

Geopolitical risks 

Events in major supplier countries can cause prices to swing wildly from day-to-day.  Oil prices shift very quickly on rumors of wars whether in Nigeria, Kuwait or Iraq.

Government policies.

A government may act to control extraction of these natural resources by take-over, nationalization, area protection or increase in taxes and permit fees.  In 2006, Bolivia nationalized the natural gas industry and banished foreign companies who were extracting and processing gas.

Foreign exchange or currency risk. 

The value of the currency of the buyer may decline against the value of the currency of the supplier.  This will cause prices to increase on the part of the buyer.  Anytime the value of the US dollar depreciates against major currencies, an oil price hike is bound to happen.

What Are The Ways To Invest In Commodities?

The three common ways to invest in commodities are:

  • Buy them directly in their physical form
  • Invest in shares in commodity companies
  • Buy indirectly thru a fund or investment trust

Direct / Physical Form

Buying direct or investing physically means buying and then holding the commodity. It presents a storage problem but many solutions are available.

For example:

there are several bullion firms that offer not only online gold dealing but also storage of the asset.  Buying real gold gives you an easy access to the precious metal.  Remember to buy only from reputable companies for your security.  Check the website of the World Gold Council for a list of these companies.

And remember:

When you buy physical assets like commodities, it means real direct exposure to the goods.  There are added costs to these such as storage, insurance, security, buying and selling fees, etc.  This means that as an investor, you need to buy them at a good price.  It may be difficult if you are not buying mega bulk quantities.  You may have little or no haggling advantage if you are just buying a small quantity.

Shares In Commodity Companies

The second option for investing in commodities is to invest in commodity companies.

How?

You can deal in oil and gas by simply buying shares in companies such as ExxonMobil, BP, Royal Dutch Shell or Tullow Oil.  The same applies to other commodities although your options might not be as wide in your country.  Your investments will also be subject to the movement of the stock market and changes in the prices of the commodities.

An investment fund is the most convenient way to access the commodity market.  These funds also allow you a degree of diversity because they are invested in a variety of commodities.  Other funds are invested in commodity-producing companies.

It’s that simple

Also, passive funds have gained popularity recently.  ETPs (exchange traded products) has become a feasible way to access commodities directly or indirectly.

Fund / Investment Trust (ETFs)

There is also commodity exchanged traded funds (ETFs) that are equity-based and exchange traded commodities (ETCs).

ETFs invest in shares of commodity companies while ETFs give investors exposure to commodities in the form of shares.  ETCs track the price movement of an individual commodity and/or a commodity basket.  They can either be physically backed by the holdings of the commodity or they can use swaps with other financial institutions.

A word of caution:

However, EFTs only monitor particular indices such as oil futures.  With this, there is little room to move.  ETCs allow investors to ‘short’ or ‘leverage’ their investments, affording more space to maneuver.  They can take bets on the prices either rising of falling.  Being careful is the key because although there could be potential gains, there could also be possible losses.

How Can You Make Money From Commodity Trading?

The main strategy is still the same:  buy low and sell high although not necessarily in that order.

Here’s how it goes:

The only difference is the time – you have to do it in a short period.  The reason for this is that commodity prices continually move.  They do not trend upward or downward as in the case of stocks. Higher prices tend to increase the supply and lower the demand for all commodities.  Lower prices tend to decrease the supply and increase the demand.  Therefore, the upper and lower limits of commodity prices are rigidly curbed.  So in the case of commodities, the buy-and-hold method is not a wise move to make a profit.

This also means that it is not usually profitable to buy the commodity itself. 

The exception is if you actually intend to receive it physically and use it for your business. You can buy gold, for example, and hold on to it for a long time.  The price may go up for a time but it will fall again sooner or later and will naturally increase along with inflation.  Another disadvantage of holding the commodity is that it becomes difficult to resell for a profit.

And let’s not forget:

An investment in commodities does not earn you interests or dividends unless you invest in a company that pays dividends.  In effect, you are actually betting your money on the profitability of the company and not of the commodity.  This is dependent on how the company is effectively managed, its business proficiency and how it rationalizes expenses.  The company may also be exposed to extensive geopolitical pressure and currency risks if it operates abroad.  This is a common situation in third-world countries where many of the commodity companies operate in.

Timing is everything

Timing is everything if you want to make substantial profits in trading commodities.

Here’s the secret:
The best financial instrument available for trading commodities is a futures contract.  It is a standard forward contract traded on several exchanges that already pre-setthe quantity of the commodity, the selling price, and the delivery date.  The futures contract’s expiration is normally the same as the delivery date. Also, traders use technical analysis tools such as support and resistance levels, historical graphs, trend lines and more technical indicators that can help them to get the right decision.

A trader that sells a futures contract assumes a short position and obligates the commodity seller to deliver on time.  A trader that buys a futures contract assumes a long position.  He obligates the contract buyer to accept delivery according to the terms of the contract.

Most speculators close out their positions before the futures contract expires.

They simply offset their contract with another contract that has the same terms. The short seller buys back the contract before the delivery date while the long buyer sells the contract.  Offsetting relieves the trader of making or taking delivery of the commodity.  Closing the position at a higher price than when it was opened generates profits for the trader.

So to profit from trading in commodities, you need to forecast the market accurately to a certain degree.  Buying low and selling high should be done before the contract expires.  This is much difficult to achieve than investing in undervalued stocks or in companies with high growth potential. In this scenario, the buy and hold strategy works but sadly, in commodities, it is not applicable.

To sum up:

To be so successful, you must have an in-depth knowledge of both the commodity and the market.  It also means you must monitor any development that may affect the supply and demand of the commodity.  Remember that your commodity’s price is highly dependent on the law of supply and demand.

What Other Things Should You Be Aware Of

As a private investor, your commodities portfolio can be very useful in the long term. It is a good diversifier, inflation protection and a great stake in specific industries or regions.  However, you should know whether or not your investments are being exposed to the underlying commodity.  You should also look at the profile of the rest of your portfolio.  For example, oil and gas companies are mostly good options.

To diversify your assets, you may consider direct investment in a physical commodity such as precious metals.  To mitigate risks, you might invest in a fund.  An index tracker fund is a good way to lower your cost and spread your risk.

Note: 

We exert all effort to keep our beginner’s guide relevant and up-to-date.  However, in the dynamic world of finance and investing, some elements may become irrelevant or incongruous with the present situation. We advise you to double-check the facts before you make any important financial decisions.

Play