A Beginners Guide to Commodities -- How to Play 2011

Like many of you, I like to stick with the basics when it comes to investing (finding good companies with sound financial statements that appear undervalued). I don't know much about soybeans, oil, gold and other commodities, which is a pity since they were a great place to invest in 2010.

Lesson learned. I've spent a considerable amount of time getting up to speed on this important asset class, and am here to share what I've learned.

Supply and Demand -- On Steroids
Commodities are subject to the most basic law of economics: A shortage of any commodity brings rising prices, which stimulates production and supply, which brings prices back down, which in turn reins in production and supply, and so on. It's a never-ending cycle, and commodity investors simply look to gauge where we are in that cycle.

Unlike stock prices which tend to move in modest increments, swings in the balance of supply and demand can cause exaggerated moves in commodity prices. For example, a modest reduction in the global output of cotton led to a shortage in supplies, causing its price to nearly double in 2010. Conversely, there is so much natural gas in storage -- and underground -- that its price continues to fall.

How to Get Started
Want to own commodities? Just a few years ago, traders interested in investing in commodities were limited to buying and selling futures contracts on the underlying commodities. Due to the high amount of risk involved, it can be a dangerous place for most investors.

But all that has changed with the emergence of exchange-traded funds (ETFs). These are likely the best route for individual investors interested in commodities. If you're looking for broad-based exposure, check out the PowerShares DB Commodity Index ETF (NYSE: DBC), which tracks the value of a wide range of commodities. Or you can make a wager on virtually any specific commodity, including:

  • Natural Gas (NYSE: UNG)

  • SPDR Gold Trust (NYSE: GLD)

  • iShares Silver Trust Fund (NYSE: SLV)

  • PowerShares DB Agriculture Fund (NYSE: DBA)

  • iPath Dow Jones-UBS Copper Fund (NYSE: JJC)

  • iPath Dow Jones-UBS Sugar Fund (NYSE: SGG)

There are actually dozens of available funds. Just choose a favorite commodity, and you'll fund an ETF for it through a search engine.

The Best Places for 2011
So which commodities look appealing over the next few years? The answer lies in which commodity is much more likely to benefit from any supply/demand imbalances and avoid the landmines set by speculators.

We know a few things with certainty. Global food consumption is on the rise, and we're getting closer to the limits of arable land. That means agriculture prices could spike well higher if the global economy is heating up. And even as cars and trucks become more fuel-efficient, car ownership in places like China, India and Brazil continues to surge. Oil has rebounded to $90 a barrel, and some believe we'll soon see $100 oil.

Could $120 oil be in our future by 2012? The stars are indeed aligning.

Conversely, commodity investors could get burned if the Chinese economy slows down. China consumes so much of the world's aluminum, copper and other metals (up to 40% by some estimates thanks to a building boom), but concerns are building that China already has ample housing and doesn't need to keep building. China has plans to keep consuming steel as it builds a national railroad network, but even that building boom would sharply slow if the Chinese economy took a hit.

In an ideal world, we would have been talking about commodities a year ago. The sector has posted such a great run in 2010, that near-term gains may be much more muted. But the long-term outlook for many commodities remains quite bright, and if you have a multi-year time horizon, there's still time to get in on the action.

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