Investing In Commodities 101 — The Basics

Let’s go over the basics

What Are Commodities?

🧬 Simply put, commodities are raw materials that can be bought and sold. Much like how DNA represents the foundation of life, commodities represents the foundation of the global economy. They are fungible — standardised to a point where they are interchangeable with other goods of the same type no matter where it comes from.

Brief History

📜 Believe it or not, commodities trading is as old as human civilisation itself. The first commodities came from agricultural crop production and livestock. As these practices improved, supply levels reached a point where they needed to store excess supplies, which led farmers and merchants to wonder how they can make money with stored products. This led to the idea of futures agreements. The first ever recorded futures trade dates back to 17th century Japan with a rice exchange using rice tickets. However, there’s evidence that this kind of system was also used in China dating as far back as 6,000 years ago.

What Are The Different Types?

Commodities are generally categorised into four groups. Note that some commodities will have more liquidity (how easy it is to sell) than others because liquid commodities are trade at a higher volume (more people, more trades, more supply & demand) than illiquid ones. This means that you might not be able to get your trade in illiquid commodities executed immediately because there aren’t enough people who want it.

• 🔧 Metals. These include precious metals (like gold, silver, platinum and palladium) and industrial metals (like copper, aluminium (aluminum if you’re American or Canadian), zinc, tin, iron, steel and nickel).
• 🛢️ Energy. As its name suggests, these are energy sources, which include commodities like crude oil (which is then further sub-categorised, with West Texas Intermediate (WTI) and Brent Crude being the most popular), natural gas, gasoline, heating oil, and coal.
• 🌾 Agricultural. These include food crops like coffee, soybeans, cocoa, rice, wheat, corn, sugar, oats, barley, and even orange juice! There are also industrial products, like cotton, lumber, rubber, and wool.
• 🐄 Livestock & meat. Yes, you can even invest in livestock and meat! These include lean hogs, pork bellies, live cattle and feeder cattle.

Different Ways You Can Invest In Commodities

There are many ways in which you can invest in commodities. These are known as investment vehicles. Similar to actual vehicles like cars or buses, each one is different and have their own pros and cons.

• Physical. Depending on the commodity, you can buy and directly hold the physical goods. There’s no doubt to the ownership of these assets, and is reliable. You also may want to consider storing it securely in a warehouse or vault, rather than at home. Further, you may be faced with several fees, such as commission fees for the broker, storage, insurance, and delivery of the goods. Selling it may be a bit of an issue as you first need to identify a buyer, and that they may buy it back at below market prices. Note that not all commodities can be bought this way. For example, you can’t physically buy orange juice and store it for long periods of time!
• Commodity ETFs. These are commodity-backed Exchange-Traded Funds. Essentially, these are funds that buys commodities on your behalf when you buy shares in their fund. They’re traded on the stock exchange, which means you’ll be able to buy and sell these assets very easily. They’re also very popular since they’re convenient and you don’t have to bother dealing with the physical goods, and yet, still have exposure to actual commodity market prices. However, there are no assurances that you actually own the underlying goods. You also won’t be able to take delivery of your goods. Depending on which broker you go with, you may be charged with trading commissions. ETFs also charge an expense ratio, or management fee, that gets taken out of their total holdings and is then reflected on your account. Pay attention to the fund’s fine print and look at how closely it tracks actual market prices (spot prices) of the commodity.
• Commodity Stocks. These are shares of companies that deal with commodities, either in a manufacturing, mining, processing, or harvesting capacity. Like ETFs, they can be bought and sold easily on the stock exchange. There are no fees, apart from trading commissions depending on your broker. They might, however, pay you with dividends. They don’t necessarily follow the price of commodity you’re interested in since company performance and data and stock market movements need to be taken into account. Because of these extra factors, you may not get much exposure to market prices of the commodity. You may want to consider looking at the company’s annual reports, portfolio of the assets they have, whether or not they pay dividends, and potential expansion plans.
• Futures Contracts. A binding agreement between two parties where they agree to buy/sell the commodity at a specified time in the future with an agreed-upon price. These are traded on futures exchanges, so process-wise, they are relatively easy to buy/sell. When these contracts expire, some may want the delivery of the commodity, but most are usually settled in cash. If the commodity price increases above the agreed upon price, you profit. If not, then the seller profits. The main problem with futures contracts is that they are highly leveraged. This means that you are borrowing money so you only have to pay for a fraction of the total amount. Because you are using a significant amount of borrowed money, even small price changes in the commodity can either lead to massive profit, or massive losses beyond what you paid for, potentially leaving you in massive debt. They are certainly high-risk and not recommended for beginners. Further, fees associated with futures trading include broker commissions, exchange/clearing fees, and more. The key here is to be able to use technical and fundamental analyses to be able to understand and predict price movements ahead of time.

Example: Sarah enters into an agreement with James to buy 100 bushels of corn at $4 per bushel from James at a certain point in the future. If the price per bushel of corn increases to $5 the day the contract expires, James has lost $100 because he is obligated to sell at $4 as agreed in the futures contract, even though it’s $5 the day the contract expires. So, Sarah has profited $100.

• Commodity Options. Similar to futures, options allow you to buy a commodity for a fixed price by a date in the future. Unlike futures, options gives you the opportunity, but not the obligation, to buy/sell the goods. An option, as the name refers to. This means that you don’t have to buy/sell the goods if it isn’t favourable to you. However, to be able to do this, buyers will usually have to pay a premium/fee to do so. There are two kinds of options — call and put options. A call option is an offer to buy the goods for a certain price (includes the premium. The strike price is the price of the goods without the premium) at a certain date in the future. A put option is an offer to sell the goods for a fixed price (does not include the premium) at a certain date in the future. Commodity options contracts are traded on different commodity exchanges. On top of the premium the you pay, additional fees may include clearing and brokerage fees. Similar to futures, the key here is to be able to use technical and fundamental analyses to be able to understand and predict price movements ahead of time.

Call Option Example: Sarah opens a call option to buy a barrel of oil for $50 at a certain point in the future. The premium is added to the cost of the barrel of oil. If the barrel of oil rises to $55 when the contract expires, Sarah can exercise her right, the option, to buy it at $50, as was agreed in the contract. Sarah can then close the call option immediately to sell the barrel of oil for $55 and have a profit of $5 per barrel. Alternatively, if the barrel of oil fell to $45, Sarah doesn’t have to go through with the option and just loses the premium, or the extra “fee” to be able to buy the option.

Put Option Example: James opens a put option to sell a barrel of oil at $50 at a certain point in the future. If the price falls to $45 before the option expires, James can close his put option and profit $5 per barrel (minus the premium paid to open the put option) since he’s selling it at $50 and not the current price of $45, as was agreed. If James decides to wait until expiration of the options contract and the price rises to $55, the option becomes worthless and he just loses the premium paid to open it. Either the buyer or James can close the put option at anytime before it expires to either limit losses or lock in profits.

Here’s a picture of a field of wheat to give you a break. You’re almost there! Enjoy.

Who Typically Trades In Commodities?

• 🚜 Producers like farmers and miners. Example: A farmer decides to sell their crops early before they can be harvested in the futures market to get the best price they can get, acting as a safeguard in case crop prices fall.
• 🏭 Companies that need commodities as a resource. Example: following the farmer example above, food manufacturing companies buy crop resources early in the futures market to avoid market volatility and lock-in their production costs, in case crop prices rise when it’s harvest time.
• 🏦 Investors, both individual & institutional. This one is pretty self-explanatory. They might want to invest for the following reasons: protection/diversification of their portfolios, or speculation and profit.

Main Factors That Affect Commodity Prices

There are a number of factors that are involved. Each commodity will have a slightly different set of key factors that impact their own prices, but here are the general ones that they all share in common:

• 🏗 Supply & demand. Commodity prices are very much dictated by supply and demand. When production levels fall, prices tend to go up, and vice versa. Things to look out for:

🌏 Emerging markets. Significant improvements in the economy of developing countries potentially means higher demand for commodity resources and goods. Alternatively, better manufacturing capabilities means more of the commodity on the market (more about this here).

💸 Substitution effect. As the price for one particular commodity rises, consumers may switch to cheaper alternatives, increasing the latter’s demand & reducing the former. This can then turn into a cycle of supply and demand, where if demand for the pricier commodity drops, its price can also drop, which then means consumers go back to buying it, etc., (more about this here).

📈 Production levels. If production levels are low (i.e. low supply of the commodity in the market), prices tend to go up because there are more buyers than sellers. Vice versa, if production levels are high, prices tend to go down because there are lots of it on the market. This means that if there’s a disruption in either supply or demand (like a pandemic 👀), it will usually be reflected in the market (more about the impact of COVID on the commodities market here).

• 💵 The Value of the US Dollar. Because the US dollar is used as a benchmark for the pricing of commodities globally, both usually (not always) share an inverse relationship. Example: if the US dollar rises, commodity prices tend to fall because people buying with their currencies wouldn’t be able to buy as much as they did before the dollar rose. Vice versa, if the US dollar falls, commodity prices tend to rise because people buying with their currencies have more purchasing power and are able to buy more, thus raising the demand.
• 💣 Geopolitical (Un) Certainty. Commodity prices are affected during moments of turmoil, conflicts and crises. Depending on the commodity, this uncertainty creates volatility in the markets, and can negatively impact stocks and bonds, so investors tend to flock to gold to preserve their wealth. For commodity-producing regions, tension here can potentially impact supply and demand dynamics as mentioned above
• ☁️ Climate & Weather. This is especially true in the agricultural industry. Unfavourable weather conditions can lead to crop failures and therefore a shortage of supply, increase demand for heating oil and natural gas to heat homes and buildings and therefore increasing its price, and can potentially impact transport logistics moving commodities around, causing delays and pushing up costs (more about this here).

Why Should/Shouldn’t You Invest In Commodities?

🎯 It depends what your aims and goals are.

• 🛡️ Protection/Preservation. If you have an existing portfolio with stocks and/or bonds, or you’re looking to preserve your wealth to prevent the effects of inflation, commodities are something you might want to consider. This is because commodities tend to act in the opposite direction to stocks and bonds. So, if the stock market is doing badly, your entire portfolio won’t go down. Similarly, during times of inflation, currencies will lose their value, which means you’ll need to pay more for commodities like precious metals, and so their prices increase.
• 💰 Profit. If you’re looking to profit and time the market, commodities trading can be very risky due to volatility in the market. In this case, to minimise risk and losses, please do due diligence, research, and learn about the different kinds of fundamental and technical analyses so you can make informed investment moves. You’ll need to think carefully about exactly which commodity (or a basket of commodities — a mix of a number of different commodities) you’d like to invest in, which method of investment (whether it’s ETFs, physical, futures, etc.), the factors that affect prices and monitor them, the data that you’ll need, the type of trading strategy to use, and ways to minimise or manage your risk. If you are interested in having fundamental & technical analysis covered as topics, please reach out and let us know.

Thank you for reading! Let us know if you found this helpful. You can connect with us @VNewsletters, or check out our website for more information @ vaultcomms.com.