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How to Invest in Commodities? Full Guide For Investors

As a private investor, your commodities portfolio can be very useful, especially in uncertainty times. The commodity market is the center that helps to maintain price stability through forwarding or futures trading.So what are commodities and how can you invest in?
Author: Baruch Mann (Silvermann)
Baruch Mann (Silvermann)

Writer, Contributor

Experience

Baruch Mann (Silvermann) is an experienced investor, financial expert and founder of The Smart Investor. Above all, he is passionate about teaching people how to manage their money and helping millions on their journey to a better financial future.

Review & Fact Check: Baruch Mann (Silvermann)

Baruch Mann (Silvermann)

Financial Expert, The Smart Investor CEO

Experience

Baruch Mann (Silvermann) is a financial expert and founder of The Smart Investor. Above all, he is passionate about teaching people how to manage their money and helping millions on their journey to a better financial future.
Author: Baruch Mann (Silvermann)
Baruch Mann (Silvermann)

Writer, Contributor

Experience

Baruch Mann (Silvermann) is an experienced investor, financial expert and founder of The Smart Investor. Above all, he is passionate about teaching people how to manage their money and helping millions on their journey to a better financial future.

Review & Fact Check: Baruch Mann (Silvermann)

Baruch Mann (Silvermann)

Financial Expert, The Smart Investor CEO

Experience

Baruch Mann (Silvermann) is a financial expert and founder of The Smart Investor. Above all, he is passionate about teaching people how to manage their money and helping millions on their journey to a better financial future.

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Table Of Content

As commodity prices rise, investors' attention is drawn to this alternative asset class to traditional stocks and bonds.

Commodities are raw materials that are consumed or used to manufacture other products. Commodities come in a variety of forms, ranging from orange juice to cotton, oil and gas to gold.

Commodity demand is rising as the US economy recovers from pandemic-induced shutdowns and spending rises across the board. This is a significant change from last year, when commodity prices fell and oil prices fell.

With the economy flush with fiscal and monetary stimulus, some commodities, such as gold, may be reflecting increased inflation concerns. Other commodities, such as copper, are experiencing structural demand shifts, because the metal is used in products such as electric vehicles and other infrastructure built to combat climate change.

The amount of official reserve assets held in Gold have increased to $494 billion as of 2020, according to data from the FED. The reserve assets held in gold increased from $134 billion in 2005 to $433 billion in 2012. However, the reserves fell by $118 billion in 2013 to $315, then to a further $277 billion in 2015. The government then increased the reserve assets held in gold from 2016 to 2020, when the reserves attained a 20-year peak of $494 billion in asset reserves.

Chart: U.S. Official Reserve Assets Held in Gold 2000-2020 (in billion U.S. dollars)

What Are Commodities?

Well, commodities refer to natural resources that fall into the three major classifications of agriculture, energy and metals. Commodities are physical and tangible assets. They include metals such as gold, silver and copper, fuel materials like crude oil and gas, and the ‘soft’ commodities such as wheat, sugar, coffee and cocoa beans.

Commodities can then be described as follows:

  • They are natural resources
  • They are needed by most nations or regions
  • They are sourced economically from limited locations
  • They incur large price fluctuations
  • They are generally uniform and fungible

Commodities can be an important way for investors to diversify their portfolios beyond traditional securities. Because commodity prices tend to move in the opposite direction of stock prices, some investors rely on commodities during periods of market volatility. Commodities trading used to take a significant amount of time, money, and expertise, and it was primarily limited to professional traders. Today, there are more ways to participate in commodity markets.

Commodities include the following:

  • Agricultural – (ex. cocoa, coffee, corn, cotton, feeder cattle, hogs, live cattle, lumber, milk, oats, orange juice, palm oil, pork bellies (bacon), rapeseed, rough rice, rubber, soybeans, soybean meal, soybean oil, sugar, wheat, wool)
  • Energy – (ex. crude oil, ethanol, natural gas, heating oil, gasoline, propane, purified terephthalic acid)
  • Metals – (ex. copper, lead, zinc, tin, aluminum, aluminum alloy, nickel, cobalt, molybdenum, recycled steel)
  • Precious metals – (ex. gold, platinum, palladium, silver)

How's The Commodity Market Work?

Commodities, being useful, are needed by modern societies of different countries.  As such, these demands greatly influence the prices and cause them to fluctuate.  The commodity market is the center that helps to maintain price stability through forwarding or futures trading.

A forward or futures contract allows a supplier to lock in on the price of the commodity months before they can be delivered to the buyer.  Their buyer, on the other hand, can already fix the future price for the end consumers.

Geographically, most commodities have limited supply production availability. Only certain countries, regions and companies have economic access to these resources.  However, practically all societies have a demand for these materials.  This has given birth to a large global market for commodities.  This market enables commodities to be efficiently distributed from the most economic sources to where they are needed.

US Gold production has declined from 256 metric tons in 2004 to 190 metric tons in 2020, based on data from the US Geological Survey. The production levels have been fluctuating over the years, with the production falling from 237 metric tons in 2017 to 190 metric in 2020.Chart: U.S. Gold Mine Production 2005-2020 (in metric tons)

In investment lingo, commodities fall under the fifth asset class in terms of conventionality.  They stand behind the first four classes namely: cash, fixed interest securities, equities, and property investment.

Commodities Vs Stocks Investing

Inventing in either commodities or stocks depends on individual general knowledge of the investment opportunity at hand. Since commodities tend to be highly volatile, most investors tend to speculate on the price change of the underlying asset. However, stock investors mainly focus on investing in a company in the long term to earn dividends or profit from stock appreciation. The impact of investing in stock is to get part ownership of the issuer.

In contrast, in the commodity market, investors own a contract with the right to either buy or sell a specific good at a future date at a stated price regardless of the current market prices.  An investment in commodities does not earn your interests or dividends unless you invest in a company that pays dividends.  In effect, you are actually betting your money on the profitability of the company and not of the commodity.

This is dependent on how the company is effectively managed, its business proficiency and how it rationalizes expenses.  The company may also be exposed to extensive geopolitical pressure and currency risks if it operates abroad.  This is a common situation in third-world countries where many of the commodity companies operate in.

How are Commodities Different From Other Investment Assets? 

Investing in commodities can be confusing than other investment assets because of the concept called future contracts. The contract gives the investors the right to buy or sell the future without receiving the underlying physical product. That means the trade locks in the price of the product the investors can engage in despite the prevailing market prices of the underlying assets.

Besides, investing in commodities is bargaining on the cost of given raw materials, often priced in bulk, for instance, cotton, sugar, oil, gas, cattle, lumber, etc.

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How Commodity Prices are Determined?

Commodity prices are highly affected by the law of supply and demand just because they are mostly consumables. Low supply and increased demands raise commodity prices. High supply and low demand lower commodity prices.  Since the demand and supply scale constantly changes, so do commodity prices.

The prices of many commodities, especially agricultural products, are affected by the natural seasons.  For example, corn normally peaks during March and April before the planting season but dips in September.  Weather and lifestyle seasons also affect demand.  For instance, natural gas peaks during winter months because it is used mostly to heat homes.  Crude oil prices tend to go up during the vacation season because many families take time to travel.

Diversity is another main advantage of investing in commodities.  With stocks and bonds, general prices rise or fall at the same time affecting your entire portfolio.  Commodity prices, on the other hand, rise or fall at different times.  By carefully tracking the seasons, you could adjust your investment strategies appropriately.

Also, Commodities remain strong even in bad economic times; therefore they afford the investor natural protection.  Most commodities are necessities and their demand does not diminish even in a bad economy.  Because of this, prices are more buoyant and can remain springy even when demand falters.

Benefits

Let’s take a look at the benefits of investing in commodities:

Commodities, especially precious metals, are natural hedges versus inflation. The dramatic increase in inflation over the last four months has put a strain on paychecks and generally given people the blues. And, as recent reports show, it is playing a role in undermining consumer confidence and the economic recovery.

In fact, when commodity prices rise, it could mean that inflation is starting.  If a rapid inflation is reasonably expected, commodity prices are more likely to go up even faster.  In times like this, people normally move their funds to options that offer protection for their assets, like real estate. However, moving them to commodities is much more convenient than investing them in properties.

inflation in the US - graph

Commodities and commodity stocks have historically provided returns that differ from other stocks and bonds. A portfolio comprised of assets that do not move in lockstep can assist you in better managing market volatility. Diversification, on the other hand, does not guarantee a profit or protect against loss.

Individual commodity prices can fluctuate due to supply and demand, exchange rates, inflation, and the overall health of the economy. Increased demand from massive global infrastructure projects has had a significant impact on commodity prices in recent years. Commodity price increases have generally boosted the stocks of companies in related industries.

Risks

Here are the most important risks you should consider:

The commodities market is highly volatile because it is influenced by supply and demand. Supply and demand, on the other hand, are dependent on many factors that are as unpredictable as the weather. Natural and geopolitical factors, ease of finding new sources, delivery time – all these things directly affect supply and demand.

Events in major supplier countries can cause prices to swing wildly from day-to-day. Oil prices shift very quickly on rumors of wars whether in Nigeria, Kuwait or Iraq.

The value of the currency of the buyer may decline against the value of the currency of the supplier. This will cause prices to increase on the part of the buyer. Anytime the value of the US dollar depreciates against major currencies, an oil price hike is bound to happen.

Because they are traded using futures contracts, traders often use high leverage ratios, even as high as ten to one. This causes many traders to become jittery and react accordingly if there is news that prices may rise or fall greatly. Hence, a forecast of a construction boom may cause metal prices to go up. An escalation of conflict in the Middle East would cause oil prices to spike.

A government may act to control extraction of these natural resources by take-over, nationalization, area protection or increase in taxes and permit fees. In 2006, Bolivia nationalized the natural gas industry and banished foreign companies who were extracting and processing gas.. 

What Are The Ways To Invest In Commodities?

The three common ways to invest in commodities are:

  • Buy them directly in their physical form
  • Invest in shares in commodity companies
  • Buy indirectly thru a fund or investment trust

Direct / Physical Form

Buying direct or investing physically means buying and then holding the commodity, and it's mainly popular in precious metals such as gold, silver and platinum. It presents a storage problem but many solutions are available.

There are several bullion firms that offer not only online gold dealing but also storage of the asset.  Buying real gold gives you easy access to the precious metal.  Remember to buy only from reputable companies for your security. Check our our best gold dealers list.

When you buy physical assets like commodities, it means real direct exposure to the goods.  There are added costs to these such as storage, insurance, security, buying and selling fees, etc.  This means that as an investor, you need to buy them at a good price.  It may be difficult if you are not buying mega bulk quantities.  You may have little or no haggling advantage if you are just buying a small quantity.

The amount of official reserve assets held in Gold have increased to $494 billion as of 2020, according to data from the FED. The reserve assets held in gold increased from $134 billion in 2005 to $433 billion in 2012. However, the reserves fell by $118 billion in 2013 to $315, then to a further $277 billion in 2015. The government then increased the reserve assets held in gold from 2016 to 2020, when the reserves attained a 20-year peak of $494 billion in asset reserves.

Chart: U.S. Official Reserve Assets Held in Gold 2000-2020 (in billion U.S. dollars)

Shares In Commodity Companies

The second option for investing in commodities is to invest in commodity companies.

You can deal in oil, gold and gas by simply buying shares in companies such as ExxonMobil, BP, Royal Dutch Shell or Tullow Oil.  The same applies to other commodities although your options might not be as wide in your country.  Your investments will also be subject to the movement of the stock market and changes in the prices of the commodities.

An investment fund is the most convenient way to access the commodity market.  These funds also allow you a degree of diversity because they are invested in a variety of commodities.  Other funds are invested in commodity-producing companies.

Also, passive funds have gained popularity recently.  ETPs (exchange-traded products) has become a feasible way to access commodities directly or indirectly.

Commodity Fund / Investment Trust (ETFs)

There is also commodity exchanged traded funds (ETFs) that are equity-based and exchange traded commodities (ETCs).

ETFs invest in shares of commodity companies while ETFs give investors exposure to commodities in the form of shares.  ETCs track the price movement of an individual commodity and/or a commodity basket.  They can either be physically backed by the holdings of the commodity or they can use swaps with other financial institutions.

Some commodity ETFs invest in commodity futures contracts – a futures contract is an agreement to buy or sell a specific commodity at a predetermined price at a future date. The iShares S&P GSCI Commodity-Indexed Trust (GSG) is an exchange-traded fund that tracks the S&P GSCI, formerly the Goldman Sachs Commodity Index, which includes several commodity futures markets.

However, EFTs only monitor particular indices such as oil futures.  With this, there is little room to move.  ETCs allow investors to ‘short’ or ‘leverage’ their investments, affording more space to maneuver.  They can take bets on the prices either rising of falling.  Being careful is the key because although there could be potential gains, there could also be possible losses.

Commodity Trading Vs Investing

The main strategy is still the same:  buy low and sell high although not necessarily in that order.

Here’s how it goes:

The only difference is the time – you have to do it in a short period.  The reason for this is that commodity prices continually move.  They do not trend upward or downward as in the case of stocks. Higher prices tend to increase the supply and lower the demand for all commodities.  Lower prices tend to decrease the supply and increase the demand.  Therefore, the upper and lower limits of commodity prices are rigidly curbed.  So in the case of commodities, the buy-and-hold method is not a wise move to make a profit.

This also means that it is not usually profitable to buy the commodity itself.

The exception is if you actually intend to receive it physically and use it for your business. You can buy gold, for example, and hold on to it for a long time.  The price may go up for a time but it will fall again sooner or later and will naturally increase along with inflation.  Another disadvantage of holding the commodity is that it becomes difficult to resell for a profit.

Commodity Futures Contracts

Timing is everything if you want to make substantial profits in trading commodities.

Here’s the secret: The best financial instrument available for trading commodities is a futures contract.  It is a standard forward contract traded on several exchanges that already pre-setthe quantity of the commodity, the selling price, and the delivery date.  The futures contract’s expiration is normally the same as the delivery date. Also, traders use technical analysis tools such as support and resistance levels, historical graphs, trend lines and more technical indicators that can help them to get the right decision.

A trader that sells a futures contract assumes a short position and obligates the commodity seller to deliver on time.  A trader that buys a futures contract assumes a long position.  He obligates the contract buyer to accept delivery according to the terms of the contract.

Most speculators close out their positions before the futures contract expires.

They simply offset their contract with another contract that has the same terms. The short seller buys back the contract before the delivery date while the long buyer sells the contract.  Offsetting relieves the trader of making or taking delivery of the commodity.  Closing the position at a higher price than when it was opened generates profits for the trader.

Should I Trade Commodities?

So to profit from trading in commodities, you need to forecast the market accurately to a certain degree.  Buying low and selling high should be done before the contract expires.  This is much difficult to achieve than investing in undervalued stocks or in companies with high growth potential. In this scenario, the buy and hold strategy works but sadly, in commodities, it is not applicable.

To be so successful, you must have an in-depth knowledge of both the commodity and the market.  It also means you must monitor any development that may affect the supply and demand of the commodity.  Remember that your commodity’s price is highly dependent on the law of supply and demand.

Should I Invest in Commodities?

As a private investor, your commodities portfolio can be very useful in the long term. It is a good diversifier, inflation protection and a great stake in specific industries or regions.  However, you should know whether or not your investments are being exposed to the underlying commodity.  You should also look at the profile of the rest of your portfolio.  For example, oil and gas companies are mostly good options.

To diversify your assets, you may consider direct investment in a physical commodity such as precious metals.  To mitigate risks, you might invest in a fund.  An index tracker fund is a good way to lower your cost and spread your risk.

 

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FAQs

You can start investing in commodities by buying commodity futures contracts or ETPs tracking a specific commodity index. This kind of investment is highly volatile and technical, hence not beginner-friendly. The alternative is to invest in physical commodities like gold bullions or silver coins.

Here, prices are pretty stable, but you may incur holding costs such as insurance and storage. Also, you can invest in commodities by buying mutual funds that allow investors to invest in commodity products like oil or energy. 

There are many lucrative commodities you can invest in in the market. You should look for commodities that have a stable track record of stability in the market.

For example, precious metals like gold bullions have a long history of stability. When investing in EFPs, watch for commodities that pull together several assets in one pool, called commodity pool. These commodities will help you reduce your risk exposure than directly investing in a single product. Some of the best EFPs in this group include BDRYUGA, or GRN

In the time of economic uncertainties, investing in commodities offer investors protection against price erosion. As a result, a large percentage of these investments tend to be bullish. Since they have a low correlation to stocks, they offer a better diversification portfolio.

This is good for investors because not all commodities prices will receive the full blow, unlike other investments like stocks. In addition, some commodities have been performing way better than other securities over a long period.

Investing in commodities can be confusing than other investment assets because of the concept called future contracts. The contract gives the investors the right to buy or sell the future without receiving the underlying physical product.

That means the trade locks in the price of the product the investors can engage in despite the prevailing market prices of the underlying assets. Besides, investing in commodities is bargaining on the cost of given raw materials, often priced in bulk, for instance, cotton, sugar, oil, gas, cattle, lumber, etc. 

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