Commodities are among the most valuable asset classes, along with stocks, bonds, real estate, and cryptocurrencies. This guide will describe what they are in detail, provide some examples of the most common types, and explain what causes their prices to fluctuate. You’ll also learn how commodity trading works and the vital investment approaches.
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What is a commodity?
Definition
They include:
✦ Agricultural products such as cotton or wool;
✦ Metals like gold, silver, or aluminum;
✦ Energy sources, namely oil, gas, and electricity.
These assets are generally traded between businesses to secure a price for a specific period or by individual investors to earn a profit.
Examples include raw materials and agricultural products like grains, coffee, meat, sugar, wool, metals like gold or silver, or energy like oil or coal. For instance, airline companies use gasoline to offer flight services, flour, pasta, cereal, and bread all need grains to produce, and buildings require electricity for heating.
Determining commodity prices
Commodities are raw materials that we come across in our daily lives. When prices of essential goods go up or down, it can directly impact the cost of our grocery shopping. If the price for grains like wheat is rising, this is likely to reflect in the commodity prices, like bread or flour cost. Likewise, an increase in the price of cotton will almost certainly have a direct effect on clothing costs.
However, they can also be sold and bought as an investment opportunity. Industries from clothing production (cotton) to airlines (oil) to packaged goods (plastic made out of coal, cellulose, salt, and crude oil) rely on these.
Companies buy commodities that need these essential goods for a fixed price in the long term. For example, in the production process, they invest through futures contracts. Additionally, individual traders also invest in commodities to make a hefty profit.
Due to the more intricate investment methods, higher risks, and research required, investing in these assets is more challenging than investing in stocks or bonds, and it is not always the best choice for novice investors.
Fungible and non-fungible
This asset class can be fungible, meaning traders can swap them if they are of the same grade. For example, beef cattle grown on a farm in Texas are similar in quality as beef cattle raised in Oklahoma. So, it doesn’t matter where the beef cattle comes from for the buyer. It can be interchangeable if it is of the same quality and serves an identical practical purpose.
In contrast, commodity assets like gold, diamonds, baseball cards, or a new digital asset class non-fungible tokens (NFTs), aren’t fungible. Each non-fungible unit has unique qualities and differs from each other.
We use commodities to produce groceries and heat our apartments, and unlike stocks or bonds, they are crucial products that affects the prices of everyday items or what we pay for services.
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Main types of commodities
Commodities are divided into two separate categories: soft and hard commodities.
These further diverge into four main sub-categories:
- agriculture (grains, cotton, coffee);
- livestock (meat);
- metals (gold, aluminum, copper, platinum);
- energy (renewables, oil, coal, electricity).
1. Soft commodities
These traditionally come from animal husbandry or farming, e.g., cotton or beef cattle.
Agriculture
Agriculture includes essential goods farmed and grown, such as corn, wheat, rice, coffee beans, cocoa beans, cotton, or sugar. In this sector, commodity prices can be highly volatile during summer, depending on the weather.
There is a rising demand for agricultural commodities, driven by population growth. It can provide opportunities for investors to make profit.
Livestock
Livestock is animals raised and farmed in agriculture to produce meat, eggs, fur, leather, or wool. It is a labor-intensive process where farmers grow animals for consumption or to make other products. For example, cattle, sheep, and goats fall under the livestock category.
2. Hard commodities
These require mining to obtain them, such as gold or oil.
Metals
The commodity category of metals includes goods like gold or silver and platinum, aluminum, or copper. Metals, particularly gold, can offer sustainable value and act as a hedge against inflation. This makes precious metals a safer and more reliable investment during bear or down markets.
Energy
Energy commodities include crude oil, petroleum, natural gas, and electricity.
Global economic factors can have a direct impact on price fluctuations. For example, there’s an ongoing trend of falling demand for traditional commodities like crude oil as primary energy sources. Therefore, investors are seeking new technological advances in alternative energy sources like solar, wind, or biofuel.
What are commodity futures?
Commodity futures are legal agreements that oblige two parties into a contract. An example would be selling an underlying product, e.g., barley, in the future for a fixed, already agreed-upon price.
Goods like metals, grains, cotton, or other assets, including the US and foreign currencies, are traded in the futures market. Execution of these contracts used to require physical presence in the Chicago Mercantile Exchange (CME) or the New York Mercantile Exchange (NYMEX). However, due to online trading, it has become decentralized and can happen from almost anywhere in the world.
What causes commodity prices to rise and fall?
Commodities are riskier than average investments, mainly because the prices can fluctuate due to unpredictable factors. Natural and man-made uncertainties like pandemics, epidemics, natural disasters, wars, and unusual weather patterns can affect supply and demand.
For example, the COVID-19 pandemic in 2020 caused oil prices to crash due to restrictions on travel and tourism. This event drastically increased supply and decreased demand, making the prices tumble.
As opposed to other asset classes, such as stocks or bonds, commodity prices tend to have a different pattern in correlation to the economic cycles. Where stocks gain value, commodities decrease in value, and vice versa. This makes them an excellent asset for diversifying portfolios and hedging against inflation.
Another factor is a country’s development and reliance on these goods. Depending on the transition phase of a country, it tends to have a varying relationship with commodities, as explained by UNCTAD’s Commodities and Development Report for 2023.
Conclusively, the supply and demand in the market drive the commodity price up and down in value. High demand and low supply equal higher prices, whereas low demand and high supply equal lower prices. For example, a significant disruption such as wildfires can lead to crop shortages.
But economic factors can also play a part: manufacturing, as a considerable part of China’s economy, increases their need for metal and steel compared to the rest of the world.
Commodities and the economic cycle
Commodity prices are cyclical and, in contrast to stocks or bonds, often increase and decrease in different economic cycles. This implies that the performance of commodities during economic recessions is the opposite of stocks or bonds.
The four economic cycles are expansion, peak, contraction, and through, forming a wave-like pattern, as seen below.
Note
When the economy starts to slow down, interest rates decrease to promote economic activity, which also helps with commodity performance. Moreover, the demand for tangible assets like gold often rises, and these goods protect investment portfolios from inflation.
Therefore, people looking to profit from their investment during all phases of the economic cycle or diversify their portfolio would invest in these assets. However, it is essential to note that there are no guarantees for this. Commodities can also act independently of the business cycle, making them a risky investment.
How to invest in commodities?
There are a few ways to invest in commodities. The most common is through futures contracts, exchange-traded funds (ETFs), Contract-for-Diffenece (CFD) instruments, or direct purchases.
Investors directly buy precious metals such as gold and silver, whereas goods like grains or oil are usually traded through futures contracts. In general, commodities sell on a futures market – suppliers negotiate directly with the buyers, agree on a fixed price, and set a date on when they will deliver these goods.
Examples of such investing are businesses buying essential goods for production, speculators seeking a profit, and individual consumers looking for a hedge against inflation.
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1. Bought directly
People can buy precious metals like gold or silver outright as physical assets. Investors looking to trade these items can be individual commodity buyers.
The general public can purchase commodities directly in numerous ways, like via online dealers or pawn shops. An individual buyer could buy large amounts of gold, keeping it in a safe place as a hedge against inflation. However, the risk of owning the physical asset is finding a safe place to store it.
2. Commodity futures
Two main types of investors buy commodities through futures contracts: business users wishing to secure prices and speculative investors who want to profit.
Trading through futures is the most common method of investing in commodities. However, it isn’t necessarily the most accessible way and comes with a high risk.
A futures contract can protect businesses, suppliers, and manufacturers against unexpected price changes. Manufacturers looking to secure their margins create future contracts with suppliers who guarantee a fixed price at a set time in the future, thus avoiding sudden price swings.
Example 1:
Mars Incorporated, a multinational confectionery manufacturer, owns multiple chocolate brands like Galaxy, M&M’s, Snickers, Twix, and Milky Way. They know they need bulk quantities of cocoa beans to produce chocolate bars. With this insight, they make the bulk purchase at today’s prices through futures contracts, meaning that the production costs of making chocolate will remain more stable and won’t be affected by price fluctuations.
Example 2:
A farmer is selling his corn in the futures market. He is in the seller position, gets a contract with the buyer for selling his corn at a set price rate, and promises to deliver the corn at a set time. This way, the farmer is guaranteed an order at a fixed price, so even if the price declines between the production and the sell-by date, he gets the same price.
Example 3:
Another example is airlines, which often use futures contracts to guarantee their fuel supply at a fixed rate to avoid any unexpected price increases in oil and gas.
Others who participate in exchanges in futures markets are speculative investors who trade commodities through futures contracts for short periods to generate profits from price changes. This strategy involves closing out their contracts before they are due, as they don’t need a commodity but only wish to profit from the price fluctuations. Trading this way is more challenging and requires a brokerage account and a minimum deposit.
A minimum deposit is required to cover the cost of the commodity price (value of the contract) decreases. If the price drops, investors may also need to deposit more money into the account to keep it open. Therefore, due to high volatility and several external factors, a futures contract can either gain significant returns or experience large losses over a short period.
3. Commodity stocks
Buying into related businesses is an alternative and easier way to invest in commodities. For example, people interested in purchasing gold could instead purchase stocks of mining companies or refineries. Similarly, for energy commodities like oil, investors can opt to buy stocks of refineries or tanker companies.
However, on top of the economic and other external factors impacting commodity prices, stocks also depend on company-related issues that have no direct link with these price changes. Therefore, investors need to know whether the commodity is a good investment and check whether the company is financially prosperous.
Still, there are quite a few favorable advantages to investing in commodities through stocks. Firstly, public information about a company is already available, and it is also easier to invest in stocks than in futures contracts. Moreover, stocks are generally less prone to price swings than futures contracts.
4. Commodity ETFs
Another way is to invest in commodity exchange-traded funds (ETFs). Most commodities, but not all of them, trade on commodities exchanges. There are a few najor exchanges: the Chicago Board of Trade (CBT), the New York Mercantile Exchange (NYMEX), and the London Metal Exchange (LME).
Some funds focus on the same single commodity and hold it in physical storage (physically-backed funds), funds that invest in futures contracts (futures-based funds), or funds that invest in commodity-related stocks (ETFs in commodity-related stocks).
There are four most common types of commodity ETFs:
- ETFs that invest in commodity-related stocks;
- Exchange-traded notes (ETNs);
- Physically backed funds;
- Futures-based funds.
Exchange-traded funds are an additional way to invest in commodities. Investors can benefit from price fluctuations in their prices to profit.
Some ETFs hold physical commodities, dealing with precious metals like gold. However, in most cases, the fund managers do not purchase the actual products either. Instead, they invest in companies dealing with a particular commodity, such as oil or gold, or futures contracts.
5. Commodity pools
Another way is to invest in commodity pools. These are investment structures where individual investors can combine their money to trade futures contracts under a single entity to gain more leverage and diversify the assets.
Commodity pools differ from traditional exchange-traded funds. Investors won’t own a share of an asset but buy into the right to sell it during a short time window, which can be even riskier than other ways of investing in commodities.
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Before you start investing
Commodities are one of the five major asset classes. However, they aren’t considered a good option for new or individual investors due to the high risk involved. They are affected by the economic cycle and unpredictable disruptions like natural disasters. Moreover, investing in them tends to be more complicated than buying stocks or bonds.
However, there are several upsides in buying commodities for businesses, suppliers, and individual investors.
Things to keep in mind when investing:
- When an individual investor trades these assets, it comes with the obligation to buy or sell the commodity futures without getting the asset. This trading model can be somewhat confusing and requires a thorough understanding of the risks involved;
- Commodities are generally invested through commodity futures by suppliers or manufacturers who want to secure the price of an asset for a period or by speculative investors to make a profit;
- They are riskier investments, as the performance of certain commodities can be unpredictable. Commodities are affected by economic cycles, human-made disruptions, and factors like natural disasters, floods, or draughts, which can suddenly impact prices. For instance, oil prices can be affected by political activity in the Middle East or crops impacted by wildfires in Australia;
- Including these assets in a broader portfolio are encouraged for portfolio diversification, as they tend to perform in opposite economic cycles to other asset classes like stocks and bonds;
- High earning potential but comes with a high risk-reward balance;
- Exchange-traded funds can provide lower risks than futures contracts, as futures are more speculative. What is more, the stakes are higher due to margin requirements;
- Despite high risks, commodities can act as a hedge against inflation. For example, in particular, precious metals like gold can be a solid investment in a market downturn;
- There are also certain ethical factors to consider.
In conclusion
Like any investment, commodities come with a high-risk-return tradeoff. Traders need to understand the market thoroughly and know what makes the prices go up or down.
It is essential to analyze how each commodity is affected separately. A study of a specific sector of a particular commodity is exceptionally beneficial when making the right decisions, as investing in these essential goods involves more than analyzing public information about business performance.
Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.
FAQs about commodities:
What are commodities?
Commodities are essential goods used to produce other goods or services. These are further used as inputs in manufacturing and are often interchangeable with similar merchandise.
What are the main types of commodities?
Commodities are divided into soft commodities and hard commodities. Soft commodities are traditionally grown or farmed, like cotton or beef cattle. On the other hand, hard commodities usually come from resource gathering, like mining, to obtain them, and include goods such as gold or oil.
How to invest in commodities?
The most common ways to invest in commodities include futures contracts, exchange-traded funds (ETFs), and direct purchases. Precious metals like gold or silver tend to be bought directly. On the other hand, agriculture and energy sources are usually traded on a futures market.
In which category do commodities belong?
Commodities belong to their own asset class next to stocks, bonds, cryptocurrencies, and real estate. They are further divided into soft and hard commodities.
