Is it Safe to Invest in Commodities?

Posted on Friday, March 8th, 2019 MarketBeat Staff

Summary- In any economics class, one of the first lessons is supply and demand. In the investment world, there are few investments that illustrate this principle as clearly as commodities. This is because, while some investments require sophisticated analysis, commodities are things that are part of the daily fabric of a consumer’s life. When crude prices rise or fall, consumers know that they can expect those prices to be passed along at the gas pump. A hard freeze in Florida may mean higher prices for fresh citrus in the winter. When a drought or flooding affects farmers crops in the Midwest, consumers know that they will be paying more for consumer staples.

Commodities are the products (in raw form) that allow other products to be created. And while commodities are most frequently thought about in terms of items that make up consumable goods, there is a growing market for commodities such as bandwidth and cryptocurrencies. If there is a physical item that can be easily and consistently measured – and there is a large market of buyers and sellers – it can be traded as a commodity.

Commodities can be traded as pure plays. The most common example of this is through futures trading. Trading futures and options gives investors the opportunity to agree upon a price for a particular commodity at a particular date. Hedgers use futures contracts as a means of achieving a higher degree of price certainty. Many hedgers are producers of goods that rely on the underlying commodity and want to manage their costs. Another trader of futures contracts is the speculator – such as a day trader - who has no interest in owning the commodity but is seeking to profit from the price volatility.

Although commodities are most often traded with futures contracts, it is possible to trade commodities in other ways such as buying stock in a commodity producing company, through commodity ETFs or ETNs, or through mutual funds and index funds. Commodities can provide a degree of diversification to a portfolio, but like any investment, they do involve some level of risk.

Introduction

Commodities have been around since the dawn of time and trading commodities are one of the oldest and purest forms of investing. Every day, investors can see the price of a barrel of oil, a bushel of wheat, or an ounce of gold. Those are just a few examples of commodities that investors can buy and sell on futures exchanges.

Following Warren Buffett’s advice to know what you’re investing in, it’s easy for investors to understand the fundamentals behind commodities. From the gasoline we put in our cars to our morning cup of coffee, it’s easy to understand how certain commodities are affected by the laws of supply and demand.

In this article, we’ll break down what commodities are, why they are important not just to investors but to the broader economy. We’ll also explain different ways for investors to trade commodities and answer the question investors may have about the safety of commodity investing.

What are commodities?

A commodity is a product that is directly involved in the creation of another product. A barrel of crude oil, the price of natural gas, and the cost of a bushel of soybeans are examples of commodities. Commodities are grouped into four broad categories: Metals, Energy, Livestock and Meat and Agricultural Products. In recent years, items like bandwidth and cryptocurrency have been listed as commodities. The New York Mercantile Exchange, the largest futures exchange in the nation, writes, “A market will flourish for almost any commodity as long as there is an active pool of buyers and sellers.”

To be a commodity, an item has to meet three conditions.

  1. It must be available in a standard, repeatable unit of measurement (i.e. a barrel of oil). For agricultural and industrial commodities, the unit must be in its raw state.
  2. It must be considered usable upon delivery.
  3. It must have enough price movement to justify creating a market.

Why do commodities matter?

Commodities are raw materials that are used every day by millions, if not billions of consumers. Commodities are priced based on supply and demand. One example of a commodity that is in the news almost every day is crude oil. A hurricane that shuts down oil refineries will lead to higher gasoline prices. When the economy is in a recession and unemployment is rising, demand for gasoline may go down, which can leave the market oversupplied with crude oil.

Another example is the fresh citrus that arrives in January of February. The price – and the availability of those oranges and grapefruits – can be affected by something as simple as a brief cold snap. Less supply means higher prices.

But as was stated above, commodities can take many forms. Gold and other precious metals have risen in value as speculators bid up the price over fears of a falling dollar and hyperinflation.  The central banks of some countries have made major investments in gold as a hedge against currency prices.

The price of commodities can also have an effect on the global economy and the stock market in particular. For example, when crude oil prices begin to rise, it puts pressure on different stock sectors, because higher energy costs to consumers and businesses erode consumer confidence. Conversely when oil prices are falling, and subsequently the price at the pump is lower, consumer confidence begins to soar. Consumer confidence is one of the key economic indicators and is generally considered a leading indicator of economic activity in a country.

What are different ways commodities are traded?

The most direct way for trading commodities is on what is called the spot market (or cash market). This is a transaction where the buyer and seller complete their transaction immediately based on the current price of the commodity. While the actual cash and commodity may not change possession immediately, the buyer and seller are agreeing to what is called the spot price. For highly liquid commodities (i.e. when there is a heavy volume of buy and sell orders) a commodity’s spot price may change in a matter of seconds.

However, a more common way to invest in commodities is through the futures market by writing up a futures contract. Because commodities are subject to price volatility, futures contracts allow buyers and sellers to determine a pre-determined price for the future delivery of the commodity. A futures contract contains standardized product specifications for different commodities, but the idea is that a crude oil contract that expires in May will have the same specifications for the underlying commodity as one that expires in September.

Futures contracts attract two kinds of traders: hedgers and speculators. Hedgers are generally from the producer side. They are looking to protect themselves, or their company, from the potential of higher costs, which could mean an increased cost of goods sold which could in turn negatively affect their profit margins. A good example would be when an appliance manufacturer like Whirlpool Corporation saw its raw material costs skyrocket after the Trump administration imposed tariffs on foreign steel and aluminum.  Hedgers, such as farmers who need to have a market that will take physical possession of their goods, rely on hedging as a buffer against the volatility of commodities, specifically soft commodities like perishable items that are subject to varying risk factors.

Speculators, on the other hand, are only interested in the future price direction as a means of collecting a profit. Day traders are a good example of investors who may speculate in the currency markets because they are looking to turn a quick profit from the price volatility.

For many speculators, a popular way to invest in commodity futures is with an options contract. Like a futures contract, an options contract is an arrangement between buyers and sellers to purchase or sell a commodity for an agreed upon price on or before the expiration date of the contract. However, with an options contract, neither the buyer or the seller has any intention of taking physical possession of the commodity and are only seeking to profit from going long or short on the price movement of the underlying asset. Plus, with an options contract, the buyer has the right, but not the obligation to execute the trade. They can choose to not exercise the option in which case the only money they lose is the price of the contract.

Both the spot market and futures market are examples of “pure play” where a buyer and seller are investing solely in a single commodity. There are other options for trading commodities that may be more attractive to investors with lower risk tolerance.

Investing in stocks of companies that produce the commodities – For a crude oil play, investors can select to buy the stock of a driller, refinery, tanker company or oil company. This is also a way for investors to get involved with precious metals. For example, investing in gold is often considered a hedge against a weak currency. A speculator could buy stock in a mining company, gold refinery, or smelter. Equities are less volatile than futures contracts and stocks may be easier for investors to buy and sell. However, by investing in the company and not just the commodity, the price can be affected by issues unrelated to the underlying commodity.

Another option for trading commodities is through Exchange-Traded Funds (ETFs) or Exchange-Traded Notes (ETNs). A commodity ETF tracks the price of a single commodity or an index of commodities by investing in a collection of futures contracts. This provides elements of a pure play since the investment is being made in the commodity, not the company. However, large price moves may not be reflected immediately in the ETF or ETN.

Yet another option is to trade commodities through mutual funds or index funds. This spreads out the risk even further by allowing investors to invest in multiple commodity producers instead of just one. Investing in mutual funds or index funds is also a good way to gain exposure to emerging markets which may have growing economies due to their increased need for commodities.

Is it safe to invest in commodities?

The short answer is yes. Commodities are regulated through the Commodity Futures Trading Commission (CFTC) to "ensure the competitiveness, efficiency, and integrity of the commodities futures markets and protects against manipulation, abusive trading, and fraud."

In the United States, commodities are also traded on one of six major commodity exchanges. The largest is the New York Mercantile Exchange (NYMEX). The other exchanges are the Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CME Group), the Chicago Board of Options Exchange (CBOE), the Kansas City Board of Trade, and the Minneapolis Grain Exchange. These exchanges do not set the prices of commodities. Those are still determined by supply and demand. The exchanges match buyers with sellers through open-outcry options. The trades, once confirmed, are guaranteed using good-faith deposits (called margins) that ensure each party has the required funds to handle potential losses.

Like any type of investment, any form of commodities trading has risk. However because commodities trading tends to have a high level of both stable supply and steady demand, commodities exchanges facilitate efficient and competitive trading between producers, manufacturers and other companies.

The final word on commodities

Trading commodities are one of the purest forms of investing. But while it can be easy for investors to understand the principles of supply and demand that shape the price direction of commodities, they are one of the most volatile of all asset classes.

Examples of commodities include crude oil, natural gas, precious metals. In general, if a commodity is perishable it is considered a soft commodity unlike commodities such as gold and silver which have to be mined or otherwise extracted.

Commodities can be traded in many ways to help investors manage risk. And although no asset class is without risk, commodities are a highly regulated industry with prominent exchanges to help ensure efficient and competitive trading.


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