Everything Beginners Need to Know About Commodity Investing

posted on 06-07-2019

By definition, a commodity is a product that tends to come from the earth or is grown. It varies only slightly in quality regardless of where it is purchased. For example, gold is gold and salt is salt. Across the globe, the quality is relatively unchanged, and in the commodities market the price is uniform.

There are a variety of commodities beyond the two mentioned above. The better-established ones involve such basic resources as iron ore, crude oil, ethanol, copper, wheat, and so on. In addition, commodity investors can also bet on the future direction of interest rates, various currencies and the S&P 500 Index itself.

How Commodities Work

The oldest of the eight commodity exchanges in the world is in Chicago, while the largest is in New York City. At these U.S. exchanges, traders execute investors’ orders from brokerage firms across the nation for what are called “futures contracts.” These are essentially promises to provide the product involved at a specific price and on a particular date in the future.

For example, say crude oil is priced at $80 per barrel. This is called the “spot price.” Some trades are made in the spot market and the purchaser takes immediate delivery.

For investors, however, there is the futures market. In that arena, and on this same day when the price is $80, we’ll assume that an investor pays $10,000 for the right to buy 1,000 barrels of crude for $95 per barrel at any time over the next 12 months. Much like the over/under odds posted for a sporting event, the future price of $95 is set at the time of the investment. Similarly, it is the one variable in this type of transaction and it is determined by the equilibrium that is created between the forces of supply and demand at the time the contract is written.

One year later -- or earlier, if the investor so elects -- he or she will earn that portion of the then market price that exceeds $95. At $105 per barrel, the investment would be recouped (because of the $10,000 price of the contract). Above that price, the transaction would produce a profit. Because of the leverage, the profit potential is significant, rising to 100%, for example, if the final price is $115.

Nevertheless, it cannot be overemphasized that the funds so invested are subject to one of the highest levels of risk in the business. If the price at the end of one year is under $95, and if the investor hasn’t already opted out at a higher amount, the entire initial investment of $10,000 is lost.

[InvestingAnswers Feature: The Absolute Worst Way to Invest in Commodities]

Many participants in this market are gambling on the outcome. Others, however, are seeking legitimate hedges against exposures they may have in other areas of their portfolios. An owner of an apartment complex, for example, might purchase a futures contract for heating oil to protect himself against the risk of a disastrous run-up in the price.

However, for most individuals -- and especially for investors new to the market -- who wish to include commodities among their investments, there are other, less risky ways to go about it.

Indirect Commodities Exposure

One way would involve a commodity mutual fund. This would provide the diversification that many individual investors would not be able to achieve on their own. In addition, the minimum initial investment required is generally considerably less.

Another option would be a commodity-indexed ETF (exchange traded fund). This is perhaps best thought of as a bundle of commodities that is priced like a common stock. Before ETFs, traders were limited to buying and selling futures contracts on the underlying commodities or buying and selling stocks of companies that produce commodities. With commodites ETFs, the investing process is a whole lot simpler.

[InvestingAnswers Feature: 7 ETFs for Profiting From Commodities]

In any event, if a fund is your desire, you can consider an array of choices ranging from those that focus on just a few commodities to those that offer a wider, more balanced exposure. An investment advisor should be able to match your needs to the appropriate investment.

However, as with the timing of any investment, the decision of if and when to participate in this market is yours to make. In this respect, a little knowledge of past history might be helpful, although there is no guarantee whatsoever that history will repeat itself.

Learn History's Lessons

The 11 years from 1992 through 2002 were atypical, as this was not a particularly good time to invest in commodities. The Dow Jones Industrial Average soared 168% during those years, while the indices that tracked commodity prices were relatively flat. What was most remarkable about this period was that inflation at the retail level, as measured by the U.S. Consumer Price Index (CPI), averaged only 2.44% per annum, the longest low stretch since World War II.

The next four years, through 2006, saw commodity price indices nearly double, however. All of this occurred despite the fact that prices at the retail level remained below 3% on average. This was a favorable time for commodities overall, as they solidly outperformed the stock market.

At that time, investors began to notice the increasing demand for certain commodities, especially crude oil, by the rapidly emerging economies of China and India.

#-ad_banner_2-# The trend became more obvious in 2007 and it nearly triggered a panic episode of investing. This was a classic case of what has been called irrational exuberance and its effect was to raise the commodities indices by approximately another 70% by the middle of 2008.

At that point of 2008, the global recession and attendant financial crises caused a drop in demand for products producing a severe decline in the indices. Gold, which is considered a safe haven in times of crisis, was a notable exception to the downtrend.

What might be learned from the history of these significant periods is that those who invest in the commodities market may be courting a fickle target, capable of both extraordinary returns and rapid disappointments.

The Associated Risks of Commodity Investing

As a generalization, the commodities market may be one of the most difficult fields for a new investor to grasp. For one thing, it has been described as a hedge against unanticipated inflation, which could be caused by brief wars, disruptions in weather patterns, currency devaluations or the sudden emergence of sovereign economies. The operative word "unanticipated" in this context tends to detract from its value as a reliable investment.

[InvestingAnswers Feature: 3 Simple Ways Everyone Can Hedge Against Inflation]

Furthermore, commodity prices are not only influenced by fundamental supply-and-demand factors, but also by the impact of the investors themselves, who are actually betting on the future price of each product. An irrational burst of exuberance or an excessive wave of pessimism can cause the volatility of the prices to range beyond realistic levels.

Nevertheless, despite these risk factors, there have been periods in the economic cycle when commodity investments have proven to be highly profitable.

If this is for you, great care is recommended in the timing of your initial move, the type of investment vehicle you choose and the degree of your exposure.

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