We have already covered three of the major asset classes to date; Stocks, Bonds, and Real Estate. Today, we turn the spotlight on commodities. What are commodities and why should you know about them? In this post, we will cover the different types of commodities, along with their place in your portfolio.
What Are Commodities?
Let’s start with a definition. Investopedia defines a commodity as “a basic good used in commerce that is interchangeable with other goods of the same type. Commodities are most often used as inputs in the production of other goods or services”.
Commodities are usually consumed or used to create a product. Common commodities are oil, gold, pork and grain. They can be traded, but to do so, they must meet certain standards. Without standards, it would be impossible to put a fair price on a specific commodity as they are usually bought unseen.
Types of Commodities
Commodities can be sorted into four broad types. They are Metals, Livestock/Meat, Agricultural and Energy.
Metals include gold, silver, steel, platinum and copper. They are used in manufacturing industries across the world and can also be used to diversify an investment portfolio. Gold, in particular, is used as a safe-haven asset. Traditionally when uncertainty or fear is prevalent in the economy, the price of gold will rise. This is due to the fact that it has an underlying value. After all, the US Dollar was based on the value of gold until the 1970s.
Livestock/Meat are traded all around the world for human and animal consumption. Cattle, pork bellies and butter are all in this category.
Agricultural commodities include sugar, coffee, corn and wheat. Due to the nature of their production, the prices can be highly sensitive to adverse weather conditions. Poor farming conditions can reduce the yield, thereby driving up prices.
Energy includes oil, natural gas and gasoline. Due to the finite nature of these commodities (oil in particular), the prices tend to trend upwards over time as the resources dwindle. Increased demand coupled with reduced supply usually leads to increased prices, but new technologies such as solar and wind energy have the potential to reduce our reliance on fossil fuels.
How Are Commodities Traded?
Commodities are usually traded via a futures contract. A futures contract is an agreement to buy or sell a specific amount of a commodity at a predetermined price on a specific date. The buyer agrees to buy at the specific price and the seller agrees to sell at that specific price when the contract expires. It is the seller’s responsibility to ensure he has the required amount of the underlying commodity to deliver upon expiry of the contract.
The futures contract will not only stipulate the quantity, but it will also define the quality of the goods.
Who Trades Commodities?
Commodities are traded by two groups of people. The first group are speculators who try to profit from the price movements in the commodity markets. The second group is the producers and buyers.
Speculators have no intention of receiving the goods when they buy a contract, and they do not possess the goods when selling a contract. They are only concerned with making money on the price movements. Commodities can be volatile and the large price movements coupled with the high liquidity makes them an attractive choice for speculators.
The Producers and Buyers are the people who produce the commodities and the people who use them in their business. This group trade commodities in the traditional way. Rather than trying to profit from price changes, this group try to hedge against potential price movements. A farmer (producer) can use a futures contract to lock in a specific price for the crop he is currently growing. If the price decreases before his harvest, he will be protected. If the price rises, his loss on the futures contract will be offset by his gain due to the price rise.
A brewery (buyer) can also take advantage of the futures contract. He can lock in a specific price from the farmer and be protected against rising prices. If prices fall, he will lose money on the futures contract but will have saved the equivalent amount due to the lower prices.
Do Commodities Have a Place in Your Portfolio?
Commodity prices tend to increase with inflation, so they can provide a hedge against rising inflation. Other than that, commodity trading is best left to the speculators and producers and buyers.
The only exception to this is precious metals. As they act as a safe-haven asset, there is some diversification benefit to having some in your portfolio. A small position in gold can offset your losses in stocks or bonds when the market or economy is performing poorly. Likewise, gold tends to rise on major world events (terrorism, economic crash etc.) so can help to protect you in those scenarios.
Commodities can also be invested in through ETFs (Exchange Traded Funds) but unless you have a knowledgeable insight into specific commodity classes I would suggest avoiding these.
As always with trades and investments, do your research before taking a position.
The Stoic Trader