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Commodities – What are They and How to Start Investing?

Commodities
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Commodity futures are a staple of speculative trading. You are probably already aware of many different types of commodities but how can you trade them? In this article, we will cover how to invest in commodities and the wide range of them available in the futures market.

Table of Contents:

What are Commodities?

Generally, the best way to describe a commodity is as a naturally occurring or an agricultural product that you can physically trade. In effect, they’re raw material. The term encompasses many different things from precious metals such as gold to specific products such as coffee, wheat, corn.

Exchanges generally sort commodities into specific groups based on common characteristics. These include:

  • Energies
  • Crops
  • Livestock
  • Base (or industrial) metals
  • Precious metals

That is not the complete list, of course, just some of the most popular ones. There are many more to choose from.

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Characteristics of the Commodities Market

The broad characteristics of the commodities market have been mostly the same for hundreds of years. We can go as far back as the 19th century. Back then, farmers in America began to use what we now term “forward contracts.” They were useful for selling crops like wheat and corn. The buyer and seller agreed on the delivery of a specific commodity at a specific price on a future date. In order to reduce the risk to the buyer, the contract also included a partial payment. Today we refer to it as “margin”, with the balance on delivery. In effect, this lowered the risk of non-delivery. Meanwhile, the seller had an incentive to follow through with the agreed transaction. 

Introducing organizations such as the Chicago Board of Trade allowed these “forward contracts” to be traded in a controlled and regulated environment. Even today the exchanges are central to the overall system. They provide a platform on which to trade the full range of commodity futures. The exchange regulations and structure provide confidence and certainty for both buyers and sellers. This ultimately reduces the so-called systemic risk for both parties.

How do Commodities Work?

In the minds of many people, there is a big difference between stocks/shares and commodities. In reality the difference is minimal. You are simply buying and selling individual “items” whether these are precious metals, shares, coffee, oil or gas. While some of the more traditional commodities markets may still offer a physical area in which to trade, the vast majority of exchanges today are “virtual.” They also arrange the physical delivery itself away from the exchange. 

It is safe to say that the trading of commodity futures is an integral element of the commodities market. Both speculators and those looking for physical delivery/receipt of specific commodities. While many people frown upon the activities of some speculators, it is the speculators that add a huge degree of liquidity to these very active markets. In essence, a commodities futures exchange is an information exchange. All of the buyers, sellers, traders and speculators come together to create a “fair price.”

The top five commodity exchanges in the world

  • London Metal Exchange – the world’s largest exchange for options in metals
  • Climax Exchange (Netherlands) – popular for energy contracts and environmental commodities
  • Chicago Mercantile Exchange – providing futures and options on a range of commodities
  • New York Mercantile Exchange – physically the largest commodity futures exchange in the world
  • Dubai Mercantile Exchange – the largest energy futures exchange in the Middle East

The London Metal Exchange accounts for more than 75% of worldwide non-ferrous metal futures. When you really think about it, this shows the huge size of these exchanges. Some of these exchanges have histories going back hundreds of years.

Types of Commodities

Today the commodity market covers a wide array of assets. Some are for business purposes while others are for speculative investing. We can probably consolidate these groups into seven categories. These are are:

Agricultural

Often described as “grains, food and fibre” the agricultural commodities market is absolutely huge. It takes in corn to oats, soybeans to soybean oil, wheat to milk, cocoa to coffee, sugar and much more. We are talking about huge contracts of up to 50 tons for corn, 60,000 lbs for soybean oil and 10 tons for cocoa.

Livestock & meat

The livestock/meat commodities market is very active and tends to revolve around a relatively small number of commodities. These include feeder cattle, lean hogs, live cattle, and pork bellies. This area of the commodities market is often sensitive to consumer trends as well as animal disease outbreaks. While it may look like a boring subject, livestock/meat futures can be a lot more volatile than you might think!

Energy

The energy commodities market is one of the most active. It includes everything from crude oil to natural gas, heating oil to propane, and much more. The price of oil always takes the headlines with an interesting two-way pull. On one hand, OPEC is controlling member output to support the oil price. On the other hand, there is a rising demand to switch to green technology/fuel which is reducing demand for oil. 

Just ask Elon Musk about the switch to green technology. He has created an electric car company now valued at $270 billion, which still makes a relatively small profit. With a 20% stake worth over $50 billion and a bonus scheme which could net him a further $55 billion. Not bad for a man who took over the company because he was the last founder standing!

Forest products

While you might assume that the forest product commodities market is fair game for lumberjacks but nobody else, think again! Trading hardwood pulp, softwood pulp, and random length lumber is a lot more popular than you might think. Still not very popular overall though.

Base metals

The London Metal Exchange dominates the metals commodity market. Traders deal in the likes of lead, zinc, tin, copper, aluminum, aluminum alloys, nickel, cobalt, molybdenum, and various types of steel. These prices are led by economic trends across the world. These can heavily impact construction and therefore demand for the likes of aluminium and steel.

Precious metals

Gold is one of the most popular. precious metals. Did you know the World Gold Council estimates there are less than 200,000 metric tonnes of gold in the world? Palladium is actually more expensive than gold. The former coming in at $2.200 an ounce against the gold price of approaching $1900 an ounce. Traders and investors often use gold as a hedge against challenging economic times. Traders don’t typically hold precious metal futures to expiry.

Other

There are numerous other commodity futures markets around the world. The list includes palm oil, rubber, wool, amber and many other commodities. There will be an array of other commodities which have active local markets but are not suitable for international trade.

How to Invest in Commodities

Now it is time to look at ways to invest in commodities. Thankfully, there are many different ways to do so. These include futures, ETFs, stocks, mutual and index funds not to mention commodity pools. So, let’s get down to business!

An example of futures commodity trading

Oil, gold, and coffee are probably three of the most popular commodity markets today. We will use crude oil to demonstrate the make-up of a futures contract.

Crude Oil Specifications

Product symbolCL
Contract size1,000 barrels (approx. 136 metric tons)
Price fluctuation$10.00 per contract ($0.01 per barrel)
Trading monthsMonthly contracts listed for the current year and the next 10 calendar years and 2 additional contract months. List monthly contracts for a new calendar year and 2 additional contract months following the termination of trading in the December contract of the current year.
Termination of TradingTrading terminates 3 business days before the twenty-fifth calendar day of the month prior to the contract month. If the twenty-fifth calendar day is not a business day, trading terminates 3 business day before the business day preceding the twenty-fifth calendar day.
Trading hoursSunday – Friday: 6:00 p.m. – 5:00 p.m. (5:00 p.m. – 4:00 p.m. CT) with a 60-minute break each day beginning at 5:00 p.m. (4:00 p.m. CT)
Source: CME

Contract size

When dealing with crude oil futures each contract equates to 1,000 barrels of crude oil. Each futures contract for different commodities will have different contract sizes which you need to be aware of. One contract does not equal one barrel. In order to gain exposure to 1,000 barrels of crude oil you simply buy one contract. In the example above we have acquired two contracts which equate to 2,000 barrels of crude oil.

Futures price per barrel

When you look at commodities futures the price quoted is for delivery at the end of the contract. In this instance we are paying $40 per barrel of crude oil for delivery in October 2020. 

Initial margin requirement

Let us say we acquire 2 crude oil contracts (equivalent to 2,000 barrels). At $40 a barrel that equates to an investment of $80,000. One of the main attractions of futures contracts is that you only pay a relatively small percentage of the value of each contract. This is known as the initial margin. It tends to be anywhere between 3% and 12% of the value of each contract. It will vary between different markets and different commodities. In our example, to simplify the figures, we will be using an initial margin of 10%.

Maintenance margin requirement

As you will see from the figures above, the initial margin requirement for each crude oil futures contract is $4,000. That is 10% of the value of each contract ($40,000). There is also an additional margin to take into consideration which is known as maintenance margin. If the balance of your initial margin account (10% of the value of each contract plus any cash deposits) falls below the maintenance margin then there will be a “margin call”. The maintenance margin is set by the futures exchange and in this instance is $3,000 per contract.

Margin call

If the balance of your initial margin account was to fall below the maintenance margin requirement then you would need to deposit additional funds. Enough to take the balance back up to the initial margin. In the above example, the initial margin is $4,000 per contract. So, if the contract margin fell to $3,000 there would be no margin call. If the value fell to $2500 then you would be obliged to deposit $1500. That’s what you need to take your margin account balance back up to the initial margin. Note that the additional deposit must be sufficient to take your margin account balance up to $4,000, not $3,000.

The double-edged sword of leverage

As you are only required to put down 10% of the value of each oil futures contract you are effectively given leverage of times 10. For every thousand dollars in margin you put down this equates to a $10,000 contract value. In the above example, we were able to acquire two oil futures contracts with a value of $80,000 for a down payment of just $8,000. The price of the two contracts increased to $90,000 thereby creating a $10,000 profit. In summary:-

  • The value of the contract increased from $80,000 to $90,000 or 12.5%
  • The futures investment in this case increased from an initial $8,000 up to $18,000 (adjusting for the second margin call) thereby creating a $10,000 profit or 125% gain.

While the leverage effect of dealing on margin is very useful when the price is going up, it also multiplies your losses by times 10 on the downside. If for example there was a short-term dip in the value of the contract, even if you were correct on the longer term trend, but you were unable to pay the additional margin then you would need to sell at a loss. Timing is crucial!

Different Investment Types

Investing in Commodities With Futures

Those who choose to invest in commodity futures tend to come in two distinct categories:

  • Commercial investors
  • Speculative investors

Commercial investors use the futures market to guarantee a constant supply of a particular product such as crude oil. If for example they acquired contracts for the crude oil futures October 2020 then they would take delivery of the physical product when the futures contract expired. When it comes to speculative investors, they would look to close out their futures contracts before expiry. As a consequence, they would not take physical delivery of the commodity in question.

It is worth noting that the vast majority of futures contracts are closed before expiry therefore no physical commodity changes hands. However, it would be wrong to give the impression that the commodities futures market is purely for speculative purposes. It plays a very important role for commercial entities that require such products as crude oil for their businesses.

Investing in Commodities With ETFs

Exchange Traded Funds (ETFs) are extremely popular and offer a way for investors to buy and sell shares in investment vehicles with exposure to particular areas of the market. For example, commodity ETFs will use a mixture of physical storage and futures contracts to create exposure to either an individual commodity or a basket of similar qualities. For example, you may have an ETF which focuses on agricultural produce or perhaps precious metals or even natural resources. 

Unlike mutual/index funds, ETFs are tradable on the stock market during normal market hours as opposed to end of day price fixing for mutual/index funds. This is a very important factor because if for example a particular commodity was in freefall then this would impact the value of the ETF investment vehicle. With a commodity focused ETF you could sell your shares as soon as the news began to emerge but with a commodity focused mutual/index fund you would need to wait until the end of the day – at which point even more damage could have been done to your investment.

ETFs are also a very useful means of diversifying your portfolio into the world of commodities. Even if you have relatively little experience in this area. These are managed funds. For all intents and purposes, you are buying a share of the underlying fund. However, you have no direct input on investment decisions. When you also consider the value of commodity futures contracts, margin requirements and the cost of physical storage, this type of investment vehicle offers a very cost-effective means of gaining exposure to commodities of your choice.

Investing in Commodities With Stocks

There are many examples of stocks that offer exposure to individual/baskets of commodities. For example, Rio Tinto Group is an Anglo/Australian multinational mining company. They have particular exposure to iron ore, copper, diamonds, gold, and uranium. This is one of many huge multinational mining companies that offer a means of introducing commodity exposure to your portfolio. There are other huge companies to keep an eye on. ExxonMobil is an interesting oil price play. Southern Copper Corp is self-explanatory. As well as many others focused on agricultural commodities. 

One of the few downsides to investing in commodities with stocks is that picking individual companies also introduces a degree of dependence on the directors managing the company. It may therefore be sensible to spread any investment funds earmarked for one commodity across a number of companies. This would diversify the management risk of investing individually in each company. However, it will still give you significant exposure to the commodity/commodities of your choice. Aside from the fact that companies listed on a stock exchange can be traded during normal market hours, the larger commodity-based companies tend to be extremely liquid.

Other Factors to Consider

There’s also the double-edged sword of no expiry date for direct investment in listed companies. However, at best you will pay significantly more margin and at worst need to cover 100% of an investment.

It is also worth taking into account the fact that many of the commodity-based companies have managed to create very strong income streams and are often able to pay out attractive dividends (together with scope for capital gain). Compare and contrast this against futures contracts, with no dividend payments, and for example technology companies where the emphasis is usually on capital appreciation. In many cases, with for example gold, exposure to some commodities can offer something of an insurance policy/hedge against a difficult wider economy.

Investing in Commodities With Mutual and Index Funds

Mutual and index funds are not normally listed on stock markets, or acquired through normal brokers, with dealings done directly with the management company. As with EFTs, mutual and index funds are a huge part of investment markets offering exposure to different sectors, different countries, different indexes and also different commodities. They are managed in a similar fashion to EFTs using a mixture of commodity futures and physical storing of commodities to gain exposure to specific areas of the market.

As we touched on above, while you wouldn’t normally pay commission when investing in a mutual/index fund the price is fixed at the end of each day. As a consequence, if for example a particular commodity such as oil, gold, etc was in freefall during the day you would not be able to sell your mutual/index fund units until the end of the day when the price was fixed. Therefore, it is fair to say that mutual/index funds are perhaps more appropriate for those with a long-term investment horizon.

Investing in Commodities With Commodity Pools

A commodity pool is best described as a private investment structure where the contributions of individual investors are pooled together to increase leverage. Individual funds tend to focus on specific commodities or a particular basket of connected commodities. They are often referred to as “managed futures funds” and the fact that they are private entities can often mean the general public have limited access to this particular area of the market. You often find that brokers will have contacts in the commodities market which may include access to commodity pools.

When we refer to leverage this can give the impression of a highly speculative investment strategy. While an integral part of the commodity pool investments is the leveraging of combined investor contributions, all transactions are carried out within a defined risk profile. You tend to find that commodity pools are managed by experts in particular fields which removes the decision-making process from individual investors. The liquidity of a commodity pool will depend upon the size and the number of investors in these private vehicles. They won’t be as liquid as listed shares, ETFs or mutual/index funds.

Advantages and Disadvantages of Investing in Commodities

In this section we will take a look at the general advantages and disadvantages of investing in commodities and then look at this from a commodities futures point of view. 

Advantages of Investing in Commodities

There are numerous advantages of investing in commodities which include:

Hedge against inflation

Many commodities can offer a hedge against high inflation with gold historically seen as a safe haven by many. The fact that many commodities are valued in dollars also adds to this hedge value because the dollar is often seen as the currency of choice in times of high inflation.

Portfolio diversification

When investing in commodities, directly or indirectly, this offers a very useful form of portfolio diversification. Not only does it help to balance long-term returns but it can reduce volatility.

Potential high returns

There is an argument to suggest that the ability to invest directly into commodities reduces traditional risks associated with equities, such as management risk. As a consequence, there is the potential for increased returns.

Disadvantages of Investing in Commodities

As with any type of investment there are some disadvantages to investing in commodities such as:-

Potentially high risk

As direct investment in commodities is a pure commodities play some areas of the market could be deemed potentially high risk.

Close correlation with worldwide economy

On the flipside of the argument suggesting that commodities are a hedge against inflation, they are also very closely correlated to the worldwide economy. In the event of a downturn, such as the one in 2008/9, this would lead to reduced demand for the likes of oil and other commodities.

Physical delivery 

There are additional costs associated with the physical delivery of commodities although in reality the vast majority of commodities futures contracts are closed before expiry.

Advantages of Investing in Commodities Futures

The commodities futures market offers the ability to create exposure to an array of different commodities with various advantages such as:-

Investment leverage

The leverage available through commodities futures, where you deal on margin, can be very advantageous if the underlying commodity price performs as expected.

Less manipulation

There is an argument to suggest that commodity prices are less open to manipulation because they are based on a simple supply/demand formula. Even though we have seen instances of market manipulation in the commodities sector this argument is generally correct.

Diversification

Commodities futures offer a very interesting form of diversification especially when acquired aside a traditional portfolio.

Hedge against price movements

The ability to acquire commodities futures for delivery in the future offers an invaluable hedge against price movements especially for commercial investors.

Market liquidity

Commodities markets such as oil, gold and agricultural products are extremely liquid and very secure. This creates an environment in which large trades can be transacted with relatively little impact on short-term pricing.

Disadvantages of Investing in Commodities Futures

There are always advantages and disadvantages with any type of investment therefore it is important to beware of the disadvantages when investing in commodities futures:-

Investment leverage

While we have listed investment leverage as an advantage it can also be a disadvantage if the underlying commodities price doesn’t go the way you expected. For example, when dealing on 10% margin your position is leveraged by 10 times – on the upside and the downside.

Limited life

As commodity futures contracts have a fixed expiry there is a limited window of opportunity in which to make money. If the underlying price of the commodity goes against you in the short-term there may be limited time for recovery.

Sensitive to economic activity

While the sensitivity of some commodities prices to worldwide economic activity can be an advantage, it can also be a disadvantage if economies are struggling. Using the example of oil, in the event of a worldwide economic downturn there will be a natural reduction in demand for oil thereby impacting the price.

Sensitive to political activity

You may also find that some commodities are sensitive to quasi-political activity such as for example OPEC agreeing to increased oil production for members. This is just one example which shows the potential influence of parties with their own agenda.

Sensitive to weather

The success and yield of various crops around the world is often heavily influenced by the weather. As a consequence, the price of some commodities will be sensitive to weather patterns and long-term climate change.

These are examples of some of the advantages and disadvantages when investing directly into commodities and in particular when it is via the futures market.

Who Invests in Commodities?

The commodities market is host to a number of different investors such as buyers, producers, speculators and those looking to hedge. As a consequence these markets are extremely liquid and able to accommodate large transactions without duly impacting the underlying commodities price. This is the perfect environment for institutions and hedge fund investors looking to take huge positions in individual commodities.

Buyers and Producers

The commodities futures market offers the opportunity for buyers and producers across many different business settings to protect themselves from future price fluctuations. The ability to buy and sell commodities at a guaranteed price for delivery in the future allows businesses to plan ahead with a degree of certainty. For example, if we look at the oil futures market we can see there are contracts expiring at the end of each month – staggered 12 months into the future. As a consequence, those companies dependent upon the price of oil can plan their physical deliveries each month for the next 12 months through the futures market.

This ability to plan ahead 12 months in advance, whether through monthly or quarterly commodities futures, allows companies to flatten out the price volatility curve thereby giving the end consumer a more stable price. If those businesses dependent upon individual commodities had reduced visibility going forward there would be much more volatility in the price of their end products. There is also the knock-on effect to other businesses such as haulage companies which require a degree of stability in the price of petroleum/gasoline to structure their client contracts going forward.

Speculators

If you follow the investment markets you will often see speculators criticised in the press for influencing prices in their search for short-term profits. The reality is that speculators create a huge element of the liquidity in major commodity futures markets often taking advantage of overbought and oversold positions. Many will also look to arbitrage between individual markets where the price of futures in specific commodities may be slightly out of sync. So in many ways, speculators help to ensure a fair price in stocks, indexes and commodities and “correct” overbought and oversold positions.

While buyers and producers of individual commodity futures will often hold their positions until expiry. Then they either deliver or take delivery of the physical commodities. It is very different for speculators. For them, it is rare to hold their commodities futures positions until expiry. The vast majority of commodities futures contracts are closed before expiry. The role of commodities futures speculators is often misunderstood. As we touched on above, they are a vital element of any commodity market.

Hedgers

While the role of those looking to hedge their positions is also often misunderstood it is no different from consumers purchasing house insurance. The purchase of house insurance allows you to protect the value of home and the goods within even though the majority of house insurance policies will never be used. In its most basic form hedging is the use of financial instruments to reduce risk exposure by offsetting an existing position.

A perfect example of hedging would be that of a farmer who grows wheat to sell into the marketplace. It takes on average about 7 to 8 months for a wheat crop to reach maturity during which time there may be significant volatility in the price of wheat. However, by hedging their future crop in the commodities market the farmer could sell wheat futures contracts to cover their full crop at a fixed price for delivery on a fixed date. So in theory, as the farmers plant their wheat crop they already know the price they will receive when the crop is finally harvested.

It would be nearly impossible to run a farming business without futures contracts. Once you have committed to planting a crop you would have no idea what price you would receive when harvested. How could you plan ahead without a degree of certainty?

Are Commodities for Beginners?

While there are numerous ways to invest in commodities, by far and away the most popular is via futures contracts. As you are dealing on margin (between 3% and 12%) the leverage on a commodities future could be anywhere up to 30 times. It is all good and well leveraging your profits to this degree but on the flipside of the coin you could very quickly see huge losses emerge on relatively small commodity price movements. There are other less volatile ways to invest in commodity markets such as ETFs, mutual funds, index trackers and even individual companies. It is fair to say that commodities futures should be researched in detail before even contemplating an investment.

What are the Most Traded Commodities?

While the full list of commodities tradable on markets around the world is huge, we will now take a look at the top 10 commodities traded in 2019:-

  1. Crude oil
  2. Coffee
  3. Natural gas
  4. Gold
  5. Brent oil
  6. Silver
  7. Sugar
  8. Corn
  9. Wheat
  10. Cotton

It can be difficult to get an idea of the size of these huge commodities markets but for example in 2019 global demand for crude oil was 100 million barrels a day. While demand is expected to fall to around 91 million barrels per day in 2020 this is an absolutely huge market. World coffee production in the financial year 2019/20 is projected to be around 167 million bags, valuing the global coffee market at approaching $30 billion. 

When you consider the above figures relate to physical delivery of these commodities, and the fact the majority of futures contracts will be closed before expiry, the volume and value of individual commodity futures markets will be many times the physical market value. 

Final Thoughts

In reality worldwide commodity markets influence each and every business sector across the globe. They also try to affect the price that consumers pay for goods and services. It is only when you look into these markets that you start appreciating their influence and size. Many businesses would struggle to survive without the ability to buy and sell commodiy futures. As a business dependent on a particular commodity, or one supplying a commodity to the market, it would be impossible to operate day by day with volatile price fluctuations.

The more you look into the world of commodities and commodities futures the more questions this will prompt. What are the biggest futures markets? What is the most valuable commodity? Are commodity markets purely for speculators? The list is endless.

F.A.Q

Is it risky to invest in a commodity?

Commodities markets offer an investment platform for buyers and producers at one end of the spectrum, and speculators at the other end. So in reality the commodities market can be as risky or relatively safe as you make it. Buying and selling futures to protect positions or taking a gamble on short-term price movements provides huge liquidity in the more popular commodity markets. The existence of leverage, by trading on the margin, attracts many speculators but as we know leverage is a double edged sword.

What is the most valuable commodity?

In terms of commodity futures transactions, crude oil is the most heavily traded commodity even though demand has fallen dramatically in recent years. Coffee, natural gas and gold are extremely popular with huge volumes of commodity futures dealt each year.

How much do commodity traders make?

It is very difficult to say with any certainty what commodity traders earn each year as many will be paid a basic salary and huge bonuses for successful trading. However, a report by HC Insider in 2013 found that commodity traders with less than three years experience were able to secure a basic salary of between $100,000 and $150,000 a year. Those with more than five years experience could expect a basic salary of between $200,000 and $350,000 a year. Keep in mind that this is not indicative of potential future profits.

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