What are Commodities?
Commodities are basic goods used for both consumption and production but also for physical exchanges and trading derivatives contracts.
Different Classes of Commodities
The term “commodities” refers to a categorization of raw materials meant to be consumed, but over time has become the terminology to refer to underlying assets within financial products.
Nowadays, commodities are frequently traded in derivative instruments and various other speculative investments.
Commodities can be further split into being either “hard” or “soft”.
- Hard commodities must be mined or drilled, e.g. metals and energy
- Soft commodities can be farmed or ranched, e.g. agricultural goods and livestock
Examples of frequently traded types of assets are listed below.
- Crude Oil
- Natural Gas
- Heating Oil
- Agricultural Goods
- Live Cattle
- Lean Hogs
- Feeder Cattle
- Pork Cutouts
Commodities Futures Contracts
Investing or trading around commodities isn’t as simple as, for example, buying a shipment of corn and then selling it to the next willing investor.
Instead, commodities are bought and sold through a number of different securities, and while they can be physically bought and sold, they are most commonly traded through derivatives contracts.
The most commonly used method of investing in commodities is a futures contract, which gives the investor the obligation to buy or sell a commodity at a predetermined price on a specified date in the future.
Note that the “obligation” is not a discretionary choice, but rather a mandatory agreement between two parties to fulfill their agreed-upon tasks.
For example, if you purchased a futures contract for gold at $1,800/oz in 90 days, you would make a profit if the price of gold rises above $1,800 after that 90-day period.
Derivatives can be complex instruments that are often less accessible to retail investors than more common securities such as equities and money market instruments.
Because of this, many investors prefer to invest in shares of companies that are involved in the production of a commodity they wish to invest in.
For example, if you wanted to invest in platinum without entering a futures contract or purchasing physical platinum, you could invest in shares of a mining company like Sibanye-Stillwater (SBSW) or Anglo American Platinum (ANGPY), giving you access to similar returns as the metals that the companies mine.
Another highly liquid method of investing in commodities, ETFs provide investors exposure to a professionally managed portfolio of commodities-oriented futures, stocks, and physical assets.
For example, if an investor wanted broad exposure to agricultural commodities, investing in the iShares MSCI Global Agriculture Producers ETF (VEGI) would be an option.
Why? Such an index would provide exposure to shares of companies that produce agricultural chemicals, machinery, and other goods involved in the process of producing agricultural commodities.
These are similar to ETFs in the sense that they consist of a pool of capital that is invested into commodities-related securities.
However, these funds are not publicly traded, and investors who wish to gain exposure to them must be approved by the fund’s managers.
Commodity pools often use more complex securities and strategies than ETFs do, which creates the potential for higher returns at the expense of higher fees (and higher risk).
Of course, investors can also simply purchase the commodity they’re interested in investing in its physical form. Instead of purchasing a derivatives contract for gold, for example, an investor can purchase bullion, coins, bars, and other physical forms of gold. This method is especially common for most metals, but can also be used for certain soft commodities, as well.
Commodities Compared to Other Asset Classes
Commodities typically move independently of stocks and bonds.
The biggest underlying difference between commodities and other asset classes is the presence of a cash flow-generating asset.
For example, equities feature the company as an underlying asset, and when a company makes a profit, it is generating cash flows. With fixed income, the underlying asset involves the company paying off its debt, so investors are receiving cash flows in the form of interest payments.
Commodities, however, derive value solely from what the market is willing to pay, meaning that supply and demand determine the price of a commodity.
With equities, investors can make calculated decisions based on their projections of the company’s future cash flows, and if it’s a company they believe will generate strong cash flows for an extended period of time, they may hold onto the security for years to come.
Since a commodity does not generate cash flows, it is much harder to make long-term projections on its price movements, as this would involve making educated guesses on where supply and demand will land over an extended period of time.
Russia-Ukraine Conflict Example
For example, following Russia’s invasion of Ukraine, the price of wheat skyrocketed.
The rapid rise in prices was due to the fact that both Russia and Ukraine are two of the world’s largest wheat producers, and since wheat would no longer be flowing out of the region like it once did, the supply of wheat dropped and the price rose.
Participants in Commodities Market
Commodities investors typically fall into two categories:
- Manufacturers: Those who manufacture or use the commodity
- Speculators: Those who speculate over the commodity price (e.g. portfolio hedging)
Producers and manufacturers will often invest in the same commodities they use or produce as a hedge against any fluctuations in price.
- Manufacturer Example: For example, computer chip producers may be inclined to purchase gold futures due to gold being a key input into their products. If they believe the price of gold will rise in the future, they can purchase a gold futures contract and purchase gold for a previously agreed-upon price. Moreover, if the price of gold does in fact rise, the producer will have successfully purchased the gold at a lower price than what the market is offering at the time.
- Speculator Example: The other portion of the market consists of speculators, i.e. those that are investing for the potential to make a profit. Thus, they are speculating on the price of the commodity they’ve invested in. For example, if an institutional or retail investor believes the price of natural gas will increase in the future, they could purchase futures contracts, ETFs, or stocks in order to gain exposure. If the price of natural gas increases, the speculator will have earned a profit.