If you are thinking of investing in commodities this article looks at the different types of commodities and the key features of the commodities markets. It also explains the commodities futures market and describes the different ways of investing in commodities.
What is a commodity?
A commodity is a physical good such as an agricultural product used in food production, like wheat; or a raw material used in the construction industry, like copper. Whatever the particular commodity, each has a similar value whatever its place of origin.
So, if you invest in a bar of gold bullion, it will be just as valuable if it came from South Africa, Russia or the USA. The market for commodities is truly global.
Examples of commodities
There are several different examples of commodities which can be broadly categorised as either hard commodities or soft commodities. We can also include Oil & Gas as an energy commodity.
Hard commodities include:
- Non-precious metals: copper, lead, nickel, and aluminium
- Precious metals: gold, platinum, palladium and silver
Soft commodities include:
- Agricultural commodities: cocoa, sugar, wheat and coffee.
What are the key features of the commodities markets?
The commodities markets play a critical role in our everyday lives. From the cost of a cup of coffee, to the price of a gallon of petrol to the raw materials used in manufacturing mobile phones, commodities permeate every aspect of society.
Commodity markets tend to be high-risk, unpredictable and characterised by volatile movement in prices as many different variables can influence supply and demand.
For example, soft commodities can perish or hard commodities can be stolen and war can interrupt the availability of oil & gas.
Commodities can be differentiated from other asset classes in many ways including:
1. The need for secure storage
Across the world commodities are stored in warehouses and vaults so that they are available to duty warranted buyers or to ensure that perishable commodities are in held in appropriate conditions.
2. The cost of delivery and security
Oil tankers can sink or get hijacked; silver and copper have to be moved to locations where it is needed in the manufacturing process and criminal activity is always a concern. Insuring against these events can add a substantial premium to the end price of the commodity.
3. The impact of politics:
Political problems and global conflict can have a significant effect on commodity prices. For example, the gulf war resulted in a threefold increase in the price of oil.
4. The weather
Increasingly extreme weather conditions can lead to flooding or drought and either event can impact the supply of agricultural commodities and eventually lead to an unexpected hike in prices.
5. Act as an economic hedge
Investing in commodities can help investors manage economic uncertainties. For example, during periods of high inflation, many investors turn to gold, which is seen as a hedge against inflation and is viewed as a sensible way of protecting capital.
Alternatively, investing in a base metal commodity like copper is often used as a proxy to benefit from growth in the global economy.
6. Zero income
While shares provide dividends and bonds or bank deposit accounts offer interest, buying a commodity like gold or silver does not and is usually held for capital growth only.
What are the different ways of investing in commodities?
Investing in commodities requires a reasonably high level of sophistication and knowledge as it is a complex and very diverse asset class.
Retail investors usually prefer to invest in the listed shares of individual precious metal explorers, miners and producing companies, as these tend to be more accessible and easier to understand. Whatever the investor preference, there are many opportunities in this sector.
Apart from investing in individual listed companies, the commodity markets can be split into two distinct categories: wholesale and retail:
Wholesale commodity markets:
Globally, many Exchanges specialise in trading commodities. These Exchanges are used by large volume buyers and sellers to trade significant quantities of specific commodities.
Examples of these Exchanges include the London Metals Exchange (LME); the New York Metals Exchange (NYMX); and the Chicago Mercantile Exchange (CME).
Retail commodity markets:
Retail investors can usually invest in a particular commodity such as gold, platinum, oil, and copper either directly or through a fund.
This can include physical trades such a buying and storing gold coins or commodity funds such Exchange-Traded Products which track the price of individual commodities or baskets of commodities.
What are commodity futures markets?
Commodities provide traders with excellent profit-making opportunities as commodity markets tend to be volatile and active. One way to trade commodities is through commodity futures.
A commodities future contract is an agreement to purchase a commodity from a supplier on a specific day at a specific price. This procedure was devised to manage agricultural production and helped mitigate large price swings created by planting and harvesting cycles.
Futures contracts allows buyers and sellers to trade in agricultural commodities and defer the delivery date. In this way, arable farmers or coffee growers can agree to sell their crops before harvesting and deliver them afterwards.
Today, all futures contracts traded at futures exchanges and are often done so to make a profit. For example, where a trader believes that the price of a barrel of oil will increase before the futures contract expiry date, then they could buy the contract by making an initial margin payment and subsequently sell the contract at either a profit or loss.
Where can you learn more about individual commodities?
The commodities market is diverse, complex and all-encompassing. If you would like to learn more about individual commodities, whether it’s investing in commodities or understanding the mining process, then please follow the links below for more background information:
- Investing in gold and the gold mining process.
- Investing in silver and the silver mining process.
- Investing in oil and how the oil and gas industry works.
- Investing in copper and the copper mining process.
- Investing in diamonds and how the diamond market works.
- Investing in platinum and the platinum mining process.
- Investing in potash and how potash mining works.
- Investing in rare earth metals and mining for rare earth elements.
