Why Would You Want To Invest In Commodities Anyway?

10 mins

Why Would You Want To Invest In Commodities Anyway?

Basics of commodity trading

Finance can be abstract: shares and debt aren’t especially tangible purchases. For those of you that prefer actual things – welcome to commodities!

What are commodities? Commodities are the raw materials that run the world. We can split them into four categories. Energy commodities keep the lights on – think: oil and gas. Precious metals like gold, silver, and platinum store value; while industrial metals like copper, aluminum, and steel are essential to manufacturers. Finally, agricultural commodities keep our bellies full – whether pigs and cows or corn, soybeans, wheat, and sugar.

What am I gonna do with soybeans? Buy and sell them – commodities have a vital purpose in the economy and folks trades these materials every day. There’s a vibrant market, with prices fluctuating as farmers and miners negotiate with wholesalers and factories.

These people need their fix and you had better give it to them. Commodity markets are wide open to individual investors like you to trade these goods yourself. And you needn’t ever touch a soybean. Clever financial products let you bet on their price from afar.

Why should I invest? Historically, commodities have had a low correlation to other assets – meaning they can diversify your portfolio and help guard against a collapse in the stock or bond markets. Commodities can also protect you from the worst of inflation. Gains in the cost of living on pumped-up fuel prices, for example, won’t sting so much if you’re already invested in oil.

It’s not all plain-sailing: commodities are very volatile, with big falls in price common. But that volatility brings the prospect of high returns too – it’s a gamble, but you could win.

In this pack, we’ve dug out everything you need to know about commodities trading: from what drives prices, to the nitty-gritty of how to get invested. First off, let’s look at exactly how this market works.

A primer on futures contracts

How does commodity investing work? Manufacturers, farmers, and miners buy or sell goods in such large quantities that price fluctuations can prevent them from planning for the future.

So traders invented futures contracts. You can get the full lowdown on how these work in our Futures & Options Pack, but for a quick refresher: a futures contract is a commitment to buy or sell something in the future at a certain date and price. A contract could specify that on November 20th you’re going to buy 1,000 barrels of oil for $70 per barrel – come November 20th, the contract settles and you’re given a bunch of oil.

These futures contracts guarantee the price way in advance of the actual transaction date, offering stability to industry.

Commodities can be bought and sold in their physical form, but the industrial scales involved can make it hard for small investors to get a look in. So the side benefit of futures is they allow people like you to invest in things like copper or wheat.

How? Futures are available to buy and sell, so you can speculate on the price. Say the price of coffee is $1 per pound, and you think it’ll soar to $2 by year’s end – you could buy a futures contract for coffee that settles in December at $1.50. Come November, if coffee’s trading at $1.75 per pound, your futures contract becomes rather valuable. Starbucks will collect that coffee contract for their next brew, and serve you a tidy profit (though they can’t guarantee to spell your name right on the cup).

The jargon of futures pricing

What does futures pricing look like? Brace for jargon. Commodities investors talk about the “futures curve” mapping out the prices today for contracts that settle on different dates in the future. Normally, the curve slopes upwards: the price of oil two months from now would be greater than its “spot price” today. That’s because the seller of the contract has to be paid for the storage of the commodity for those two months, and compensated for having to wait two months for their cash. In these situations, traders say the curve is… normal (they’re an imaginative bunch).

But when it’s cheaper to have the commodity delivered two months from now than to get it today, we have the opposite inverted curve sloping downwards. A temporary shortage of beef, for instance, would drive up the price for today’s cows while leaving the price of future cows the same.

futures curve

And how do these prices change over time? Futures contracts let you buy something for a set price in the future – but that doesn’t mean that the price you’re paying today for a January 21st delivery is the actual price you would pay on January 21st (think about how pre-order prices for games or books sometimes differ from release day prices). If the curve is normal, the futures price might be higher than the expected “buy-it-now” price for January 21st. If that’s the case, we say the market is in contango – people expect the price of the futures contracts to fall over time to meet the expected “buy-it-now” price.

The opposite is when the market’s in backwardation. That’s where the futures price is below the expected “buy-it-now” price for January 21st, which signifies that people think the price of the futures contracts will rise over time: they think the price in a month is going to be even higher than the futures contracts are suggesting it is. Markets that are in backwardation are perfect for long-term investors, because they’re holding onto an asset that’s increasing in value.

backwardation

Be warned: traders sometimes use these terms interchangeably. The two concepts are subtly different: normal and inverted refer to today’s snapshot expectation of the future, reflected in the cost of futures contracts for different dates to come, whereas contango and backwardation are analyses of how prices of the underlying commodity will actually move over time.

Now you know the jargon, let’s get to the fun – how to actually trade commodities.

How to trade commodities

How can I get involved? The simplest way could be to buy some yourself – though a bag of flour from your supermarket might not cut it. Storage sucks for agricultural and energy commodities (you probably don’t want a pile of coal under your couch) and to trade at scale (wheat futures are sold in 50 ton lots) you’ll need to buy into proper warehousing and an enviable logistics operation. It’s an option for precious metals, though: keeping gold bars under your mattress isn’t the worst idea in the world – just don’t tell anyone.

You can track the price of a commodity without owning it directly. Some exchange-traded funds (ETFs) buy and sell the physical assets, and you can invest to part-own the goods. Exchange-traded commodities (ETCs) are a bit different: you own an IOU note from the issuer, not their underlying gold. That makes them riskier – the issuer could default and leave you with nothing – but ETCs track the commodity’s price better than an ETF can. ETFs have to buy and sell the actual asset (or its futures contracts) so the price sometimes deviates from the actual spot price.

What if I want to do it myself? You can directly buy futures contracts, but this is pretty risky. You’re exposed to huge volatility, and the leverage on offer for commodity trading is a dangerous temptation. Leverage is where you borrow money to trade with – that can magnify your gains, but also magnify your losses to a devastating extent. Remember: never risk more than you can afford to lose.

You could also trade options on the futures contracts: rather than promising to buy oil next month, you buy an option – the right, but not the obligation – to buy an oil contract next month at a price agreed now. A cheap and feisty way to enter the market, we do a deepdive in our Futures & Options Pack.

Finally, you could invest in commodity firms by buying shares in metal miners, oil extractors, or dairy farmers. That is straightforward and less volatile, but you’ll be exposed to more than just the commodity price – losing money because your particular oil firm reported weak profits is a drag when the price of oil is soaring.

But to trade, you need to understand what moves the price and we have you covered.

What changes commodity prices

What affects energy commodity prices? The alpha and omega of markets: supply and demand. For energy commodities like oil, both can change rapidly and explosively. Demand climbs as economies grow – as oil fuels everything from construction to cars – and weakens during recessions. There are also seasonal fluctuations in demand for heating. Use of both oil and gas goes up when it’s winter in the northern hemisphere (where 90% of people live).

On the supply side of the equation, because so much oil comes from volatile regions in the Middle East, politics affects its price. War or international embargo can curb supply for years, driving the price up.

Oil supply is tightly controlled by OPEC, a group of major oil-producing countries led by Saudi Arabia. They meet regularly to agree how much to produce – and the outcomes of the meetings are closely watched by energy traders. More recently, the US has flooded the market with shale oil (oil extracted from shale formations), becoming the world’s top oil producer.

Like with all markets, remember that oil prices will rise on unexpected disruptions. A long-foreshadowed war, like Kuwait in the 90s, will be reflected in higher prices long before any bullets are fired. Oil prices actually dropped by half once that conflict finally kicked off.

How about metals? Precious metals are seen as a safe store of value, particularly when investors become concerned about rising inflation. Traders fled to gold in the early stages of the 2008 financial crisis, as the global financial system teetered. Later in the crisis however, when it looked like the economy could be entering a long depression – and raising the specter of deflation – the gold price lost its shine.

Other metals like nickel and cobalt can see spikes in demand when new technology requires them – because nickel is crucial in batteries, it could benefit from an electric-car boom. And the price of steel has been driven higher by the construction boom in emerging markets like India and China – a skyscraper a day keeps the steelmaker in pay…

And agriculture? Weather can washout agricultural supplies – or leave you high and dry. We need food, so a constrained supply shoots up prices with everyone jostling for bread. But you can beat that inflation with commodity trading: when the price of wheat soars, so does your grocery bill; but your wheat trades beforehand can see you come out on top. And a warming climate could throw many commodity prices into flux – check out our Climate Change Pack for more on that. Disease can blight a nation too: Canada’s early-2000s mad cow disease scare drove a stampede of bullish demand for US beef.

The rules of investing reign eternal: do your research, build a sensible and diverse portfolio, then pray. If all else fails, at least you’ll have a big pile of soybeans to dive into.

In this Pack you learned:

  • Commodities trade through futures contracts, which let you fix a deal to buy or sell in advance
  • Contango means people expect the futures contracts to fall in value, backwardation means people expect them to gain in value
  • You can trade commodities by buying futures contracts, or with exchange-traded funds
  • Commodity prices are affected by everything from a geopolitical fracas to extreme weather
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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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