Commodities, whether they are related to food, energy or metals, are an important part of everyday life. Anyone who drives a car can become significantly impacted by high crude oil prices. Anyone who eats might feel the impact of a drought on the soybean supply. Similarly, commodities can be an important way to diversify a portfolio beyond traditional securities – either for the long term, or as a place to park cash during unusually volatile or bearish stock markets. (Commodities traditionally move in opposition to stocks.)
It used to be that the average investor did not invest in commodities because doing so required significant amounts of time, money and expertise. Today, though, there are a number of different routes to the commodity markets, and some of these routes make it easy for even non-professional traders to participate.
Actually, commodities dealing is an old, old profession – far older than dealing in stocks and bonds. Ancient civilizations traded a wide array of commodities, from seashells to spices. Commodity trading was an essential business. The might of empires can be viewed as somewhat proportionate to their ability to create and manage complex trading systems and facilitate commodity exchange as these served as the wheels of commerce, economic development and taxation for a kingdom's treasuries. Although most of the principals were people who actually dealt with the physical goods (created or used them in some way), there were doubtless speculators around, eager to bet a drachma or two on how good the wheat harvest was going to be.
Where to Invest
Although many have merged or gone out of business, there are still multitudes of commodities exchanges around the world. Most carry a few different commodities, though some specialize in a single group. For instance, the London Metal Exchange only carries metal commodities, as its name implies.
In the U.S., the most popular exchanges include those run by CME Group, which resulted after the Chicago Mercantile Exchange and Chicago Board of Trade merged in 2006 (the New York Mercantile Exchange is among its operations), the Intercontinental Exchange in Atlanta and the Kansas City Board of Trade.
Commodity trading in the exchanges can require agreed-upon standards so that trades can be executed (without visual inspection). You don't want to buy 100 units of cattle only to find out that the cattle are sick, or discover that the sugar purchased is of inferior or unacceptable quality.
Basic economic principles of supply and demand typically drive the commodities markets: lower supply drives up demand, which equals higher prices, and vice versa. Major disruptions in supply, such as a widespread health scare among cattle, might lead to a spike in the generally stable and predictable demand for livestock, for example. On the demand side, global economic development and technological advances often have a less dramatic, but important effect on prices, too. Case in point: The emergence of China and India as significant manufacturing players has contributed to the declining availability of industrial metals, such as steel, for the rest of the world.
Types of Commodities
Today, tradeable commodities fall into four categories. They include:
- Metals (including gold, silver, platinum and copper)
- Energy (including crude oil, heating oil, natural gas and gasoline)
- Livestock and Meat (including lean hogs, pork bellies, live cattle and feeder cattle)
- Agricultural (including corn, soybeans, wheat, rice, cocoa, coffee, cotton and sugar)
Volatile or bearish stock markets typically find scared investors scrambling to transfer money to precious metals such as gold, which has historically been viewed as a reliable, dependable metal with conveyable value. Precious metals can also be used as a hedge against high inflation or periods of currency devaluation.
Energy plays are also common for commodities. Global economic developments and reduced oil outputs from wells around the world can lead to upward surges in oil prices, as investors weigh and assess limited oil supplies with ever-increasing energy demands. Economic downturns, production changes by the Organization of the Petroleum Exporting Countries (OPEC) and emerging technological advances (such as wind, solar and biofuel) that aim to supplant (or complement) crude oil as an energy purveyor should also be considered.
Grains and other agricultural products have a very active trading market. They can be extremely volatile during summer months or periods of weather transitions. Population growth, combined with limited agricultural supply, can provide opportunities to ride agricultural price increases.
How to Invest in Commodities
A popular way to invest in commodities is through a futures contract, which is an agreement to buy or sell, in the future, a specific quantity of a commodity at a specific price. Futures are available on every category of commodity.
Two types of investors participate in the futures markets:
- commercial or institutional users of the commodities
The first group, manufacturers and service providers, use futures as part of their budgeting process, to normalize expenses and reduce cash flow-related headaches. These hedgers may use the commodity markets to take a position that will reduce the 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: Via futures contracts, they purchase fuel at fixed rates (for a period of time) to avoid the market volatility of crude and gasoline, which would make their financial statements more volatile and riskier for investors. Farming cooperatives also utilize futures. Without futures and hedging, volatility in commodities could cause bankruptcies for businesses that require predictability in managing their expenses.
The second group, mainly individuals, are speculators who hope to profit from changes in the price of the futures contract. Speculators typically close out their positions before the contract is due and never take actual delivery of the commodity (e.g. grain, oil, etc.) itself.
Getting Into Futures
Investing in a commodity futures contract will require you to open up a new brokerage account, if you do not have a broker that also trades futures, and to fill out a form acknowledging that you understand the risks associated with futures trading.
Each commodity contract requires 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 goes down, you will be subject to a margin call and will be required to place more money into your account to keep the position open. Due to the huge amounts of leverage, small price movements can mean large returns or losses, and a futures account can be wiped out or doubled in a matter of minutes.
- It's a pure play on the underlying commodity.
Leverage allows for big profits if you are on the right side of the trade.
Minimum-deposit accounts control full-size contracts that you would normally not be able to afford.
- You can go long or short easily.
The futures markets can be very volatile and direct investment in these markets can be very risky, especially for inexperienced investors.
Leverage magnifies both gains and losses.
- A trade can go against you quickly and you could lose your initial deposit (and more) before you are able to close your position.
Most futures contracts will also have options associated with them. Buying options on futures contracts is a little like just putting a deposit on something, rather than purchasing it outright; you have the right, but not the obligation, to follow through on the transaction. So, if the price of the contract doesn't move in the direction you anticipated, you have limited your loss to the cost of the option. As derivatives, options and usually do not move point-for-point with the futures contract.
Many investors use stocks of companies in industries related to a commodity in some way. For example, those wishing to play oil could elect from drillers, refiners, tanker companies or diversified oil companies. Those bitten by the gold bug could purchase mining companies, smelters or refiners – any firm that deals with bullion.
Equities are less prone to volatile price swings than futures. Stocks are easy to buy, hold, trade and track, and it is possible to play a particular sector. Of course, investors need to do some research to help ensure that a particular company is a good investment as well as a good commodity play.
Stock options, which require a smaller investment than buying stocks directly, are another way to invest in commodities. While risk is limited to the cost of the option, the price movement will not usually directly mirror the underlying stock.
Investors usually already have a brokerage account, so trading is easier.
Public information on a company's financial situation is readily available.
- The stocks are often highly liquid.
A stock is not a pure play on commodity prices.
- Its price may be influenced by company-specific factors as well as market conditions.
Exchange Traded Funds and Exchange Traded Notes
Commodity ETFs usually track the price of a particular commodity or group of commodities that comprise an index by using futures contracts, although a few back the ETF with the actual commodity held in storage.
ETNs are unsecured debt designed to mimic the price fluctuation of a particular commodity or commodity index, and are backed by the issuer. A special brokerage account is not required to invest in ETFs or ETNs.
Because they trade like stocks, there are no management or redemption fees to worry about.
- They provide an easy way to participate in the price fluctuation of a commodity or basket of commodities.
A big move in the commodity may not be reflected point-for-point by the underlying ETF or ETN.
Not all commodities have an ETF or ETN associated with them.
- ETNs have credit risk associated with the issuer.
Mutual Funds and Index Funds
While mutual funds cannot invest directly in commodities, they can invest in stocks of companies involved in commodity-related industries, such as energy, agriculture or mining. Like the stocks they invest in, the fund shares may be affected by factors other than commodity prices, including stock market fluctuations and company-specific risks.
A small number of commodity index mutual funds invest in futures contracts and commodity-linked derivative investments, thus providing more direct exposure to commodity prices.
Professional money management
- Because most commodity mutual funds invest in stocks, they are not a pure play on commodity prices.
A commodity pool operator (CPO) is a person or limited partnership that gathers money from investors, combines it into one pool and invests it in futures contracts and options. CPOs do need to provide a risk disclosure document to investors, and they must distribute periodic account statements as well as annual financial reports. They are also required to keep strict records of all investors, transactions and pools they may be running.
CPOs will employ a commodity trading advisor (CTA) to advise them with the trading decisions for the pool. CTAs must be registered with the Commodity Futures Trading Commission (CFTC) and are required to go through an FBI background check before they can provide investment advice. They usually have a system to trade futures and use it to advise commodity-pool trades.
A pooled structure provides more money for a manager to work with.
- Closed funds require all investors to put in the same amount of money.
It may be difficult to evaluate past performance, and you may want to look at the CTA's risk-adjusted return from previous investments.
- Investors should also read CTA disclosure documents and understand the trading program, which may be susceptible to drawdowns.
The Bottom Line
There are a variety of commodity investments for novice and experienced traders to consider. Although commodity futures contracts provide the most direct way to participate in price movements, other types of investments with varying risk and investment profiles also provide opportunities. Commodities can quickly become risky investment propositions because they can be affected by eventualities that are difficult, if not impossible, to predict: unusual weather patterns, epidemics, and disasters both natural and man-made. Therefore, it may be a good idea to not allocate more than 10% of a portfolio to commodities.