Commodities, tangible raw materials traded globally, play a vital role in financial markets. This comprehensive guide explores what commodities are, their categories, price determinants, reasons for investment, investment methods, associated risks, and how commodities differ from stocks.
What are Commodities?
Commodities are interchangeable goods used as inputs in the production of other goods and services. For example, an ear of corn grown by one farmer can be considered the same as an ear of corn grown by another farmer. This interchangeability makes commodities tradable on exchanges where buyers and sellers come together to negotiate prices. Key characteristics of commodities include being raw materials, interchangeable, used in manufacturing, and tradable on exchanges with fluctuating market-driven prices.
Categories of Commodities
Commodities are generally grouped into two overarching categories:
Hard Commodities: Natural resource-based materials that must be mined or extracted like metals, oil, and gas. Examples include gold, silver, crude oil, natural gas, and platinum.
Soft Commodities: Grown agricultural products like crops and livestock. Examples include corn, wheat, coffee, sugar, lean hogs, and live cattle.
Additionally, commodities can be grouped into more specific subcategories:
Energy: Crude oil, heating oil, gasoline, natural gas
Precious Metals: Gold, silver, platinum
Industrial Metals: Copper, aluminum, nickel, lead, zinc
Livestock: Live cattle, lean hogs, feeder cattle
Grains: Corn, soybeans, wheat
Softs: Cocoa, coffee, cotton, sugar, orange juice
What Drives Commodity Prices?
Commodity prices are primarily determined by the core economic principles of supply and demand. However, other complex factors influence commodity markets, including supply shocks, changes in demand, US dollar valuations, government policies, central bank actions, and speculation. Real-world developments across economics, politics, demographics, and investor speculation contribute to price volatility.
Investing in Commodities
While buying physical commodities is an option, most individual investors gain exposure through tradable securities with a commodity linkage:
Commodity ETFs: Offer a basket of commodity futures or physical commodities within a single exchange-traded fund. Examples include the United States Oil Fund (USO) and the SPDR Gold Shares ETF (GLD).
Commodity Mutual Funds: Professionally managed pooled funds providing exposure to a mix of commodities. Ideal for those wanting active management.
Commodity Stocks: Shares of publicly traded companies that produce or supply commodities. Examples are oil and gas drillers like Exxon Mobil (XOM) and miners like Rio Tinto (RIO).
Commodity Futures: Exchange-traded derivatives contracts that track physical commodity prices. Recommended only for very experienced traders.
Indirect investing through funds and commodity stocks moderates volatility compared to futures contracts, making them better suited to casual retail investors. Thorough due diligence is vital before selecting any commodity investment vehicle.
READ ALSO: High-Yield Dividend Growth Stocks in the S&P 500
Why Invest in Commodities?
Several compelling reasons drive capital allocation to commodities, including acting as an inflation hedge, providing diversification due to unique supply-demand dynamics, improving risk-adjusted returns, and presenting growth opportunities amid emerging trends like decarbonization and electrification. However, due to their inherent turbulence, commodities should constitute a smaller allocation in a diversified portfolio.
Risks of Trading Commodities
While commodities present portfolio diversification and inflation-fighting benefits, they carry significant risk exposure, including severe price volatility, complex factors driving prices, leverage risk with futures, indirect investment tracking errors, and geopolitical instability. Careful research, prudent position sizing, diverse allocation, and continuous monitoring help buffer against commodities investing pitfalls.
How Do Commodities and Stocks Compare?
Stocks and commodities have some distinct differences, such as ownership representation, valuation drivers, volatility levels, and usage. However, they also have key associations, as many natural resource and material companies’ stock valuations correlate strongly with underlying commodity prices. Prudent investors often allocate capital across both asset classes to optimize portfolio diversification and risk-adjusted returns.
Ways to Gain Exposure to Commodities
While direct physical commodity investment is an option, individual investors primarily access commodities through liquid securities such as:
Commodity ETFs: Offering diversified exposure to commodity futures or physical commodities, examples being iShares S&P GSCI Commodity-Indexed Trust ETF (GSG) and Aberdeen Standard Physical Precious Metals Basket ETF (GLTR).
Commodity Stocks: Shares of publicly traded commodity producers, influenced by underlying commodity prices, examples include Chevron Corporation (CVX) and Barrick Gold Corporation (GOLD).
Commodity Mutual Funds: Professionally managed portfolios investing in commodity derivatives and stocks.
Commodity Futures: Exchange-traded derivatives offering leverage but requiring extensive risk management.
For most individual investors, funds and stocks provide better risk moderation compared to futures.
Investing in Gold and Precious Metals
Precious metals, serving as safe-haven assets and industrial materials, present unique demand profiles. Exposure options include Gold and Silver ETFs, mining stocks, futures and options, and physical bullion. Thorough analysis of relative valuations, mining economics, demand changes, and monetary policies is crucial.
Investing in Energy Commodities
Oil, gasoline, natural gas, and diesel play vital roles across various sectors. Major exposure options include Energy ETFs, Master Limited Partnerships (MLPs), and exploration & production stocks. Evaluation of petroleum demand growth, OPEC policies, geopolitics, and environmental, social, and governance (ESG) considerations is necessary.
Investing in Agricultural Commodities
Crops and livestock form the foundation of the global food supply chain. Exposure avenues include Agriculture ETFs, grain stocks, and crop & livestock futures. Analyzing planting acreages, crop conditions, weather models, population growth forecasts, and changing diets is crucial for informed decisions.
Risks Associated With Commodities
While commodities offer inflation and diversification advantages, significant risks include severe volatility, global conflicts impacting prices, weather-related disruptions affecting agriculture, and concentration risk when not diversifying across commodities. Continuous tracking, prudent position sizing, diverse allocation, and pre-defined strategies are essential for managing these risks.
To Recap
While commodities are volatile, they serve critical roles in meeting the raw material needs of the economy. Strategically allocating capital across commodities such as precious metals, agriculture, livestock, and energy allows investors to benefit from diversification and inflation-buffering qualities. Maintaining an allocation target between 5-10% is recommended for most individual investors, considering the inherent volatility of commodities. Utilizing the tips outlined and maintaining prudent position sizing facilitates success.
FAQs on Investing in Commodities
Here are answers to some frequently asked questions about getting started with commodity investing:
What percentage of my portfolio should I allocate to commodities?
Most financial advisors suggest limiting overall commodities exposure to between 5-10% of your total portfolio given the volatility.
What is the best commodity to buy right now?
Opportunities exist in energy commodities like crude oil and natural gas, safe-haven commodities like gold and silver, and industrial metals like copper and lithium vital to the green energy transition.
What is the least risky way to invest in commodities?
Commodity ETFs provide exposure to baskets of commodity futures or physical commodities, moderating risk substantially compared to trading futures contracts directly.
How do beginners invest small amounts in commodities?
Online brokers enable easy access to commodity ETFs and stocks of commodity producers with no minimum investment amounts.
In another related article, Hot Silver Stocks Poised for Growth in 2024
