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.