A commodity is a basic good used in commerce that is interchangeable with other goods of the same type. Traditional examples of commodities include grains, gold, beef, oil, and natural gas.
For investors, commodities can be an important way to diversify their portfolios beyond traditional securities. Because the prices of commodities tend to move in opposition to stocks, some investors also rely on commodities during periods of market volatility.
There is a growing appreciation of the role of commodities as an alternative asset class that offers diversification benefits to a portfolio. The rise in commodity prices over the last decade reflects fundamental supply and demand constraints, particularly significant demand growth from China and other emerging markets.
Types of Commodities
Commodities that are traded are typically sorted into four categories broad categories: metal, energy, livestock and meat, and agricultural.
Metals
Metals commodities include gold, silver, platinum, and copper. During periods of market volatility or bear markets, some investors may decide to invest in precious metals, particularly gold—because of its status as a reliable, dependable metal with real, conveyable value. Investors may also decide to invest in precious metals as a hedge against periods of high inflation or currency devaluation.
Energy commodities include crude oil, heating oil, natural gas, and gasoline. Global economic developments and reduced oil outputs from established oil wells around the world have historically led to rising oil prices, as demand for energy-related products has gone up at the same time that oil supplies have dwindled.
Energy
Investors who are interested in entering the commodities market in the energy sector should also be aware of how economic downturns, any shifts in production enforced by the Organization of the Petroleum Exporting Countries (OPEC), and new technological advances in alternative energy sources (wind power, solar energy, bio-fuel, etc.) that aim to replace crude oil as a primary source of energy, can all have a huge impact on the market prices for commodities in the energy sector.
Livestock and meat commodities include lean hogs, pork bellies, live cattle, and feeder cattle.
Agriculture
Agricultural commodities include corn, soybeans, wheat, rice, cocoa, coffee, cotton, and sugar. In the agricultural sector, grains can be very volatile during the summer months or during any period of weather-related transitions. For investors interested in the agricultural sector, population growth—combined with limited agricultural supply—can provide opportunities for profiting from rising agricultural commodity prices.
Using Futures to Invest in Commodities
One way to invest in commodities is through a futures contract. A futures contract is a legal agreement to buy or sell a particular commodity asset at a predetermined price at a specified time in the future. The buyer of a futures contract is taking on the obligation to buy and receive the underlying commodity when the futures contract expires.
The seller of the futures contract is taking on the obligation to provide and deliver the underlying commodity at the contract’s expiration date. Futures contracts are available for every category of commodity. Typically, there are two types of investors that participate in the futures markets for commodities: commercial or institutional users of the commodities and speculative investors.
Manufacturers and service providers use futures contracts as part of their budgeting process to normalize expenses and reduce cash flow-related headaches. Manufacturers and service providers that rely on commodities for their production process may take a position in the commodities markets as a way of reducing their risk of financial loss due to a change in price.
The airline sector is an example of a large industry that must secure massive amounts of fuel at stable prices for planning purposes. Because of this need, airline companies engage in hedging with futures contracts. Future contracts allow airline companies to purchase fuel at fixed rates for a specified period of time. This way, they can avoid any volatility in the market for crude oil and gasoline.
Farming cooperatives also utilize futures contracts. Without the ability to hedge with futures contracts, any volatility in the commodities market has the potential to bankrupt businesses that require a relative level of predictability in the prices of goods in order to manage their operating expenses.
Speculative investors also participate in the futures markets for commodities. Speculators are sophisticated investors or traders who purchase assets for short periods of time and employ certain strategies as a way of profiting from changes in the asset’s price. Speculative investors hope to profit from changes in the price of the futures contract. Because they do not rely on the actual goods they are speculating on in order to maintain their business operations (like an airline company actually relies on fuel), speculators typically close out their positions before the futures contract is due. As a result, they may never take actual delivery of the commodity itself.
If you do not have a broker that also trades futures contracts, you may be required to open a new brokerage account. Investors are also typically required to fill out a form that acknowledges that they understand the risks associated with futures trading.
Futures contracts will require a different minimum deposit depending on the broker, and the value of your account will increase or decrease with the value of the contract. If the value of the contract decreases, you may be subject to a margin call and required to deposit more money into your account in order to keep the position open. Due to the high level of leverage, small price movements in commodities can result in either large returns or large losses; a futures account can be wiped out or doubled in a matter of minutes.
There are many advantages of futures contracts as one method of participating in the commodities market. Analysis can be easier because it’s a pure-play on the underlying commodity. There’s also the potential for huge profits, and if you are able to open a minimum-deposit account, you can control full-size contracts (that otherwise may be difficult to afford). Finally, it’s easy to take long or short positions on futures contracts.
Livestock and Meat
Because the markets can be very volatile, direct investment in commodity futures contracts can be very risky, especially for inexperienced investors. The downside of there being a huge potential for profit is that losses also have the potential to be magnified; if a trade goes against you, you could lose your initial deposit (and more) before you have time to close your position.
Most futures contracts offer the possibility of purchasing options. Futures options can be a lower-risk way to enter the futures markets. One way of thinking about buying options is that it is similar to putting a deposit on something instead of purchasing it outright. With an option, you have the right–but not the obligation–to follow through on the transaction when the contract expires. Therefore, if the price of the futures contract doesn’t move in the direction you anticipated, you have limited your loss to the cost of the option you purchased.
Using Stocks to Invest in Commodities
Many investors who are interested in entering the market for a particular commodity will invest in stocks of companies that are related to a commodity in some way. For example, investors interested in the oil industry can invest in oil drilling companies, refineries, tanker companies, or diversified oil companies. For those interested in the gold sector, some options are purchasing stocks of mining companies, smelters, refineries, or any firm that deals with bullion.
Stocks are typically thought to be less prone to volatile price swings than futures contracts. Stocks can be easier to buy, hold, trade, and track. Plus, it is possible to narrow investments to a particular sector. Of course, investors need to do some research to help ensure that a particular company is both a good investment and commodity play.
Investors can also purchase options on stocks. Similar to options on futures contracts, options on stocks require a smaller investment than buying stocks directly. So, while your risk when investing in a stock option may be limited to the cost of the option, the price movement of a commodity may not directly mirror the price movement of the stock of a company with a related investment.
An advantage of investing in stocks in order to enter the commodities market is that trading is easier because most investors already have a brokerage account. Public information about a company’s financial situation is readily available for investors to access, and stocks are often highly liquid.
There are some relative disadvantages to investing in stocks as a way of gaining access to the commodities market. Stocks are never a pure-play on commodity prices. In addition, the price of a stock may be influenced by company-related factors that have nothing to do with the value of the related commodity that the investor is trying to track.
Risk associated with investing in commodities
Market risk: the value of assets in the Portfolio is typically dictated by a number of factors, including the confidence levels of the market in which they are traded.
Operational risk: material losses to the Portfolio may arise as a result of human error, system and/or process failures, inadequate procedures or controls.
Liquidity risk: the Portfolio may not always find another party willing to purchase an asset that the Portfolio wants to sell which could impact the Portfolio’s ability to meet redemption requests on demand.
Exchange rate risk: changes in exchange rates may reduce or increase the returns an investor might expect to receive independent of the performance of such assets. If applicable, investment techniques used to attempt to reduce the risk of currency movements (hedging) may not be effective. Hedging also involves additional risks associated with derivatives.
Custodian risk: insolvency, breaches of duty of care or misconduct of a custodian or sub-custodian responsible for the safekeeping of the Portfolio’s assets can result in loss to the Portfolio.
Derivatives risk: certain derivatives may result in losses greater than the amount originally invested.
Counterparty risk: a party that the Portfolio transacts with may fail to meet its obligations which could cause losses.