How do I invest in commodities?
Commodities are everywhere you look. From wheat and corn to oil, natural gas, and precious metals, raw materials are an important part of the average consumer’s day-to-day life. Their price changes are important to everyone too. What’s happening in the commodities markets impacts what you pay at the gas pump, to buy groceries to feed your family, or to build or renovate a home.
Naturally, when something is so crucial to financial markets and the economy, investors find ways to exploit price changes in these crucial products for a profit. Whether you’re talking about soybeans or gold, there’s a host of investors ready to pounce when they see a good deal.
But should you be investing in commodities? If so, how do you gain access to commodity markets?
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Understanding Commodities Markets
Commodity markets are where commodities of all types are traded.
Before considering investing in these assets, it’s important to understand the different types of commodities because they each behave differently in the market.
Types of Commodities
While there are several different commodities on the market today, they all fall into three different categories, including:
Energy commodities are products that make travel possible. They also provide the energy used to heat homes in the summer and cool them in the winter, cook food, or run an impact wrench when making those exciting renovations to your home.
Some of the hottest commodities in the energy category include crude oil, natural gas, electricity, gasoline, and diesel fuel. However, any commodity that results in an energy transfer when used is included in this category.
Energy commodities are often used as a hedge against inflation. After all, when inflation is on the rise, the price of energy is generally rising as well, resulting in higher prices for the commodities that make the production of that energy possible.
One of the first examples of commodities many people think about is gold. However, all metals fall into this category, whether they be precious metals like gold and silver or other useful metals like copper, aluminum, and steel.
Metals are most often used in two ways:
- Inflation Hedge. As with energy commodities, the cost of metals will generally increase in line with inflation. That’s especially the case when it comes to metals like copper and steel that are used in the construction industry.
- Safe Havens. Metals, especially precious metals, are commonly used as safe-haven investments. When a correction or bear market sets in on Wall Street, investors tend to ditch their holdings in the stock market and nest their money in gold, silver, and other safe-haven investment options.
Soft commodities, also called agricultural commodities, represent resources that can be grown, whether the end product is designed to be eaten or not.
For example, edible crops like corn, wheat, and sugar, as well as inedible crops like cotton all fall into the soft commodities category.
Soft commodities are most commonly used as a hedge against inflation as well. After all, if prices are rising across the board, prices for a can of coffee beans, a cotton T-shirt, or a bag of sugar are also likely to be headed up.
How the Commodities Market Works
Commodities markets aren’t what you might picture. There’s no massive marketplace where merchants are selling corn, wheat, oil, and gold to the highest bidder. In fact, in commodities markets, physical commodities aren’t traded at all.
Instead, these assets are traded through derivative investments known as commodity futures, which is why many call the commodities market the futures market. So, what exactly are futures, and why are commodities traded using them?
Futures are contracts that were designed to lock in commodity prices, both for the producers and for the buyers. When a futures contract is purchased, it designates a specific amount of a specific commodity for delivery at a future date at a predetermined price.
This helps both the buyer and the seller:
Benefits to the Seller
Futures contracts give sellers a way to lock in a specific price months or even years prior to the production of the commodity. As a result, the seller knows exactly how much money they will make per pound or barrel of the commodity they produce before making the investment into production.
This is important because prices of commodities are known to be volatile, meaning that they tend to rise and fall relatively rapidly. By alleviating the risk of a sudden collapse in the price of a commodity, futures offer producers a sense of stability.
Benefits to the Buyer
Futures also give the buyer a way to lock in prices. Buyers generally either resell the commodities purchased or use them in products they’ll sell in the future. Futures contracts give them the ability to lock in the core cost of their raw materials.
For example, a clothing company that mass produces cotton T-shirts can lock in the price of the cotton it uses through commodity futures. As a result, the clothing company won’t have to worry about a sudden spike in cotton prices when they need to order their raw materials.
As another example, one of the biggest costs to airlines is the jet fuel they use. To alleviate volatility-related risks resulting in increased fuel costs, these companies often lock in jet fuel prices in advance through the use of futures contracts.
Meet the Speculator
The commodities futures market isn’t just for big companies that need massive shipments of basic materials and want to lock in prices at a future date. Commodity traders, known as speculators, make futures trading their life’s work, exploiting the fluctuations of prices in the market for a profit.
Speculators aren’t interested in the production of commodities, nor do they intend to hold futures contracts to expiration and accept the delivery of these raw materials. Instead, they simply buy and sell contracts, making a profit as the prices of the underlying commodities rise and fall.
Originally, speculators were known as locals. These deep-pocketed traders helped to provide liquidity when either producers had no interest in selling a specific commodity or buyers had no interest in buying.
Today, locals don’t play much of a role in the commodities market. Instead, institutional investors provide liquidity by purchasing massive blocks of commodities in an attempt to generate a return when the prices rise.
Another major change that has taken place over the past several decades is the availability of the commodities futures market to the average investor. Today, speculators with varying goals and financial capabilities trade in the futures market from the comfort of their own homes, lending a hand to liquidity and taking advantage of volatility.
Uses of Commodities as an Investment
There are three key reasons investors are interested in commodities. They include:
Commodities are the basic building blocks of just about every product on the market. When inflation is on the rise, these products tend to rise in value as well. As a result, they are often used as a hedge against inflation.
Energy, soft commodities, and metals are some of the top picks among investors looking for assets to hedge against inflation.
Commodities, specifically precious metals, have long been used as safe havens. That’s because precious metals have maintained an inverse correlation with the stock market throughout history.
When stocks are rising, investors tend to sell large portions of their precious metals holdings in order to free up money to take advantage of the rising prices of equities. As a result, precious metals tend to fall in value as demand slips.
On the other side of the coin, when the stock market goes through a correction or a bear market, leading to widespread declines, investors generally liquidate large portions of their equity holdings and park those funds in safe havens like gold and silver. This leads to an increase in demand for precious metals, driving up their prices.
While inflation hedges and safe havens are important to the average investor, they’re not of the slightest bit of concern for most short-term traders. Traders don’t hold assets long enough to worry about bear markets, corrections, or inflation. Instead, they practice technical analysis in an attempt to predict the direction of prices in the short term, resulting in opportunities to turn a profit.
All commodities on the market can offer compelling trading opportunities from time to time, making the market a hotbed for short-term speculators looking to exploit the rapid price changes.
Should You Invest in Commodities?
Most financial advisors point to diversification as a source of protection, with some recommending investing a small percentage of your allocation to commodities.
However, the allocation to commodities in your investment portfolio should change from time to time based on your investment strategy, which should take the following into account:
- United States Inflation Data. In times of economic expansion, inflation tends to pick up, meaning that the dollar will lose purchasing power. Commodities should be given a larger portion of allocation during high inflation or hyperinflation periods in which inflation rises faster than 2% annually.
- Economic and Stock Market Conditions. The state of the stock market and broader economy should also play a role in the amount you invest in commodities. During market corrections or bear markets, it’s a good idea to increase your safe-haven holdings and allow the storm to pass. However, when market conditions are positive, less allocation should go to precious metals and safe havens, giving you more of an opportunity to profit from growth in equities.
How to Access the Commodities Market
While the futures market is one of the most popular places to begin trading commodities, it’s not your only point of access to this asset class. There are five common ways to invest in commodities, meaning that there are four alternatives for investors not interested in actively trading futures contracts directly.
Exchange-Traded Funds (ETFs)
One of the most common ways investors gain access to commodities is through the stock market. Exchange-traded funds (ETFs) pool money from a large group of investors that’s then used to invest based on the prospectus they follow.
There are two different types of commodity ETFs:
- Futures Funds. There are several funds out there that invest in commodity futures. These are the most difficult types of commodity funds to trade (more on this below).
- Equity Funds. Instead of investing in commodities directly through futures, equity funds invest in the companies that produce the commodities, such as mining companies and oil exploration companies.
Challenges With Commodity Futures ETFs
ETFs that invest in commodity producers are just like other ETFs focused on investing in stocks. However, those that invest in futures contracts come with some challenges that make them a bit confusing for investors. Here’s what you need to know:
1. Based on Futures
When investing in stocks, you buy shares at the current market value. If the price increases you generate a profit, and if the price falls your investment will end in a loss. It’s all pretty straightforward.
Futures are a bit different. Instead of paying the current market price, you’re paying a future price. So, even if the value of the commodity you invest in rises, the investment could generate a loss.
For example, let’s say you invest in an ETF that focuses on oil futures. When you invest, the value of oil might be $100 per barrel — but the ETF isn’t investing at current oil prices. Instead, the ETF pays $103 per barrel for a futures contract for the delivery of oil in three months.
If, in three months, the price of oil has risen by $2 to $102 per barrel, you might think the profit on your investment would be $2 per contract. But because the ETF invested at $103 per barrel, even though the price of oil rose, the investment actually lost $1 per contract. In this example, the price of oil didn’t rise enough to meet up with the purchase price on the futures contract.
2. Term Structure Adds to the Confusion
When the price of a commodity in the future is more expensive than the current price, the term structure is said to be in “contango.” When the future price is lower than the current price, it is said to be in “backwardation.”
When it comes to energy and soft commodities — those that are driven primarily by supply and demand — contango and backwardation can lead to wide variations in how a commodity and its futures trade, making trading ETFs that focus on futures for these assets confusing.
Precious metals ETFs are more predictable because their term structure is largely determined by interest rates.
Mutual funds work like exchange-traded funds, pooling money from a large group of investors and investing into stocks based on their prospectus. There are several mutual funds designed to give investors access to the commodity space.
The vast majority of these funds don’t invest in futures contracts. Instead, they make investments in stocks that represent companies involved in commodity production. Mining companies, farms, and other materials companies fall into this category.
If you’d rather focus on making individual stock picks and want to find opportunities in the commodities space, you’re in luck. There are several quality stocks on the market that represent mining, oil exploration, and other basic materials companies.
As with any stock, commodity stocks aren’t all created equal. Especially when choosing individual stocks to invest in, it’s crucial to do your research and get a good understanding of what you’re buying before you dive in.
Index funds are another great option for investors who want widespread exposure to commodities but don’t want to take on the daunting task of researching each stock or commodity individually.
Some of the strongest commodity indexes on the market include the Bloomberg Commodity Index and the Dow Jones Commodity Index.
By investing in index funds that track these commodity benchmarks, you’ll gain widespread exposure without having to devote significant time to researching every investment involved in your portfolio.
Pros and Cons of Investing In & Trading Commodities
Before you start investing in or trading commodities, it’s important to consider the pros and cons associated with these assets. Some of the most significant include:
- Some Commodities Act as Safe Havens. Safe havens are an important part of just about any allocation strategy. They help to limit volatility and add stability. Moreover, when market downturns take place, they tend to rise in value, ultimately limiting drawdowns. Precious metals are some of the most prized safe havens on the market today.
- Growth. As the human population and consumption grows, it only makes sense that demand for commodities will grow as well. Because the price of commodities is largely dependent on the balance between supply and demand, this growth in demand has led to and will likely continue to lead to long-term growth in value.
- Inflation Protection. Naturally, when prices of products overall are on the rise, prices of the basic materials that make those products possible will increase too. While inflation may lead to the dollar losing value, commodities generally dampen the blow by growing in value during times of inflation.
- Volatility. While precious metals act as safe havens that help to reduce overall volatility in a balanced portfolio, the vast majority of commodities are known for experiencing rapid price movements. Some experts have suggested that commodity prices are twice as volatile as stock prices and four times as volatile as bonds.
- No Income. When investing in and trading commodities, your return is based on the growth in the price of that commodity. Other assets, like stocks and bonds, often pay dividends or coupon rates, offering income along with price appreciation and expanding earnings potential. Commodities don’t pay dividends, interest, or any other form of income to the investor.
Commodities are an important part of your life, even if you’ve never realized it before, and make a fine addition to your investment portfolio. While it’s not a good idea for everyone to trade commodities futures because of their high-risk nature, investments in precious metals help balance the risk you take on in your portfolio overall.
Wise decisions when investing in other commodities have the potential to yield significant returns in the long run. But due to the highly volatile activity that takes place in the commodities market, it’s important that you do your research before making your move.