Investing in commodities is one of the purest lessons in supply and demand
Commodities are the products (in raw form) that allow the creation of other products. Examples of commodities include a barrel of crude oil, the price of natural gas, an ounce of gold, and the cost of a bushel of soybeans.
To be a commodity, an item has to meet three conditions.
- It must be available in a standard, repeatable unit of measurement (i.e. a barrel of oil). For agricultural and industrial commodities, the unit must be in its raw state.
- It must be considered usable upon delivery.
- It must have enough price movement to justify creating a market.
Markets typically group commodities into four broad categories: Metals, Energy, Livestock and Meat and Agricultural Products. However, in recent years, this list has grown to include items like bandwidth and cryptocurrency. In fact, the New York Mercantile Exchange, the largest futures exchange in the nation, writes, “A market will flourish for almost any commodity as long as there is an active pool of buyers and sellers.”
In this article, we’ll explain why commodities are important not just to investors but to the broader economy. We’ll also explain different ways for investors to trade commodities and answer the question investors may have about the safety of commodity investing.
Why Are Commodities So Sensitive to Supply and Demand?
One of the first lessons of basic economics is the correlation between supply and demand. In the investment world there are few investments that illustrate this principle as clearly as commodities. The price of commodities illustrates the supply and demand dynamic. This is because, while some investments require sophisticated analysis, commodities are things that are part of the daily fabric of a consumer’s life.
When crude prices rise or fall, consumers know that they can expect companies to pass along those prices at the gas pump. A hard freeze in Florida may mean higher prices for fresh citrus in the winter. When a drought or flooding affects farmers crops in the Midwest, consumers know that they will be paying more for consumer staples.
But as was stated above, commodities can take many forms. Gold and other precious metals rise in value when speculators fear a falling dollar and hyperinflation. The central banks of some countries have made major investments in gold as a hedge against currency prices.
The price of commodities can also affect the global economy and the stock market in particular. For example, when crude oil prices begin to rise, it puts pressure on different stock sectors, because higher energy costs to consumers and businesses erode consumer confidence. Conversely when oil prices are falling, and subsequently the price at the pump is lower, consumer confidence begins to soar. Consumer confidence a key economic indicators analysts view it as a leading indicator of economic activity in a country.
What are Different Ways for Investors to Trade Commodities?
There are several ways for investors of all risk tolerances to invest in commodities:
- Trading on the Spot Market – This is the most direct way for investors to trade commodities. In this kind of transaction a buyer and seller complete their transaction immediately based on the current price of the commodity.
While the actual cash and commodity does not change hands immediately, the buyer and seller agree to the spot price. For highly liquid commodities (i.e. when there is a heavy volume of buy and sell orders) a commodity’s spot price may change in a matter of seconds.
- Trading on the Futures Market - A more common way to invest in commodities is through the futures market by writing up a futures contract. Because commodities are subject to price volatility, futures contracts allow buyers and sellers to determine a pre-determined price for the future delivery of the commodity.
A futures contract contains standardized product specifications for different commodities. But the idea is that a crude oil contract that expires in May will have the same specifications for the underlying commodity as one that expires in September.
Futures contracts attract two kinds of traders: hedgers and speculators. Hedgers are generally from the producer side. They are looking to protect themselves, or their company, from the potential of higher costs, which could mean an increased cost of goods sold which could in turn negatively affect their profit margins.
A good example of would be when an appliance manufacturer like Whirlpool Corporation (NYSE: WHR) saw their raw material costs skyrocket after the Trump administration imposed tariffs on foreign steel and aluminum. Hedgers, such as farmers who need to have a market that will take physical possession of their goods, rely on hedging as a buffer against the volatility of commodities, specifically soft commodities like perishable items that are subject to varying risk factors.
Speculators on the other hand are only interested in the future price direction as a means of collecting a profit. Day traders are a good example of investors who may speculate in the currency markets because they are looking to turn a quick profit from the price volatility.
- Trading Options Contracts - For many speculators a popular way to invest in commodity futures is with an options contract. Like a futures contract, an options contract is an arrangement between buyers and sellers to purchase or sell a commodity for an agreed upon price on or before the expiration date of the contract.
However, with an options contract, neither the buyer or the seller has any intention of taking physical possession of the commodity and are only seeking to profit from going long or short on the price movement of the underlying asset. Plus, with an options contract the buyer has the right, but not the obligation to execute the trade. They can choose to not exercise the option in which case the only money they lose is the price of the contract.
Both the spot market and futures market are examples of “pure play” where a buyer and seller are investing solely in a single commodity. There are other options for trading commodities that may be more attractive to investors with a lower risk tolerance.
- Investing in stocks of companies that produce the commodities – For a crude oil play, investors can select to buy the stock of a driller, refinery, tanker company or oil company. This is also a way for investors to get involved with precious metals. For example, investing in gold is often considered a hedge against a weak currency.
A speculator could buy stock in a mining company, gold refinery, or smelter. Equities are less volatile than futures contracts and stocks may be easier for investors to buy and sell. However, by investing in the company and not just the commodity, the price can be affected by issues unrelated to the underlying commodity.
- Investing in Exchange-Traded Funds (ETFs) or Exchange-Traded Notes (ETNs) – A commodity ETF tracks the price of a single commodity or an index of commodities by investing in a collection of futures contracts. This provides elements of a pure play, since the investment is being made in the commodity not the company. However, large price moves may not be reflected immediately in the ETF or ETN.
Yet another option is to trade commodities through mutual funds or index funds. This spreads out the risk even further by allowing investors to invest in multiple commodity producers instead of just one. Investing in mutual funds or index funds is also a good way to gain exposure to emerging markets which may have growing economies due to their increased need for commodities.
Is it Safe to Invest in Commodities?
Commodity trading is safe because it’s regulated. Commodities are regulated through the Commodity Futures Trading Commission (CFTC) to “ensure the competitiveness, efficiency, and integrity of the commodities futures markets and protects against manipulation, abusive trading and fraud.”
In the United States, commodities are also traded on one of six major commodity exchanges. The largest is the New York Mercantile Exchange (NYMEX). The other exchanges are the Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CME Group), the Chicago Board of Options Exchange (CBOE), the Kansas City Board of Trade, and the Minneapolis Grain Exchange.
These exchanges do not set the prices of commodities. Those are still determined by supply and demand. The exchanges match buyers with sellers through open-outcry options. The trades, once confirmed, are guaranteed using good-faith deposits (called margins) that ensure each party has the required funds to handle potential losses.
Having said that, like any type of investment, any form of commodities trading has risk. However because commodities trading tends to have a high level of both stable supply and steady demand, commodities exchanges facilitate efficient and competitive trading between producers, manufacturers, and other companies.
Some Final Thoughts on Commodities
Trading commodities is one of the purest forms of investing. But while it can be easy for investors to understand the principles of supply and demand that shape the price direction of commodities, they are one of the most volatile of all asset classes.
Examples of commodities include crude oil, natural gas, precious metals. In general, if a commodity is perishable it is considered a soft commodity unlike commodities such as gold and silver which have to be mined or otherwise extracted.
Commodities can be traded in many ways to help investors manage risk. And although no asset class is without risk, commodities are a highly regulated industry with prominent exchanges to help ensure efficient and competitive trading.