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Commodities


What are commodities?

A commodity is something that is traded around the world in a standardised form. For example, gold and wheat are commodities because no matter where they are mined or grown, the end product is basically the same. This means they can be traded worldwide at a standardised price.

Commodities come out of the earth and normally take the form of raw materials, agricultural goods and fuel. Because of this there's a limit to how much of a particular commodity can be supplied, which can lead to big swings in price (i.e. high 'volatility') if actual (or anticipated) demand is higher or lower than the supply.


Ways to get a return

Because commodities are physical items that are traded, investment returns can only come from a change in a commodity's price - there's no prospect of an income.

A commodity's price is very sensitive to the supply of and demand for that commodity. Suppose bad weather hits corn crops, reducing worldwide production. If the world's population continues to demand the same amount of corn as normal then there'll be a shortage (assuming supply normally equals demand), causing the corn price to rise until demand once again equals supply due to people buying less. Successful commodity investing means trying to predict what will happen to the future supply and demand of a commodity.

Futures However, you may have noticed one problem with all this. Suppose you want to invest in 1 tonne of wheat because you think the price will rise over the next year, where will you store it and will it last a year before turning bad? Because of these impracticalities it's rare to buy an actual commodity when investing. The two most common routes are using futures contracts or shares. Although you can't buy shares in commodities themselves, you can buy them in companies which produce commodities or are related to commodity production, e.g. gold mining companies for gold and companies that produce fertiliser for agricultural commodities. While such companies don't track a particular commodity's price, they tend move in the same direction (i.e. they're correlated).

Commodity futures contracts between two people require one to buy and the other to sell a specific amount of a commodity on a specific date in future at an agreed price. It's not just investors who use them, commodity producers e.g. farmers can use them to fix the price they'll get for their crops long before harvest, protecting (i.e. 'hedging') them from subsequent price fluctuations.

While some futures require the physical commodity to be delivered, others simply require cash to be passed from one party to the other equal to the profit/loss made.

The current price (known as the 'spot' price) of commodity X is £80 per tonne. Mrs Foresight enters into a futures contract to buy 10 tonnes of X in six months time at £90 per tonne, because she believes the price will be higher. When the contract is due the spot price of X is £100 per tonne, giving her a £10 per tonne profit, equal to £100 overall (10 x £10). Had the spot price fallen to £60 per tonne, she would have lost £30 per tonne, equal to £300 overall.

Futures prices can be useful as they indicate where the market thinks the spot price of a commodity will go in future. They are also used to construct the commodity indices used by investors to track commodity performance, often by buying the futures contracts expiring soonest and then rolling the money into the following month's contract just before expiry. However, there's a potential glitch with this. The following month's contract price is often a little higher (ignoring changes to the spot price) reflecting the cost of storing the commodity, insurance and financing etc. This is called 'contango'. The potential impact of contango means an Index could lose out every month when money is rolled over, perhaps totalling several percent or more over a year. If you buy an investment that tracks a commodity Index, be aware of this.


What types are there?

Hard Commodities

Hard commodities are generally those that are mined from beneath the ground. As a result, it can take a lot of cash and several years to increase supply due to the logistics of setting up a new mine or drilling operation. The main types are:

OilGasIndustrial MetalsPrecious Metals

Oil is one of the most important, and often volatile, commodities. Crude oil, which is priced per 'barrel' (42 US gallons) is primarily refined into the fuel that powers our cars, trains and planes etc. but is also used in the manufacture of other products such as plastics, asphalt and lubricants.

The world's capacity to produce oil is relatively fixed in the short term and even the discovery of new oil fields may not be enough to satisfy eventual demand if emerging countries such as China and India one day consume the same amount of oil per person as the US. However, while very long term supply could be scarce, supply currently more or less matches global demand at 85 million barrels a day.

If current supply pretty much matches demand, why does the price vary so much?

  • Events such as wars, political unrest and natural disasters can temporarily hit production, reducing supply.
  • A group ('cartel') of oil producers (mostly Middle Eastern) called OPEC sometimes reduces supply to try and prop up (or increase) oil prices for the benefit of its members.
  • Some believe that a flood of financial speculators buying futures in the expectation of oil price rises can actually result in oil price rises.

It's also widely held that the cost to extract oil from the ground is increasing, which naturally results in a rising oil price over time.

Soft Commodities

Soft commodities are generally those that are grown, i.e. agricultural produce. The main types are:

GrainsOther CropsLivestock

Grains are primarily needed to feed humans, livestock and poultry. They're one of the most important foodstuffs in the world.

Popular grains include:

  • Corn - as well as a foodstuff, it's also used to produce ethanol, an alternative to fossil fuel.
  • Wheat - primarily used to make flour.
  • Rice - the staple diet for billions of people around the world.
  • Soybeans - very versatile, can be used to produce many food types and oil.

Factors influencing the demand and supply (hence price) of grains include climate, demand for alternative fuels and the attractiveness for farmers to grow grains in preference to other crops (i.e. relative prices).


Tax

Gains on commodities are subject to capital gains tax.


How can I buy commodities?

With the exception of precious metals, it's really not practical to buy the commodity itself when investing. Most investors therefore use one of the following routes when investing in commodities, including precious metals too:

Futures

While it's possible for private investors to buy commodities futures through a commodity broker, it's now more popular to use 'spread-betting' brokers. This approach allows you to bet on the price movements of commodity futures. Gains are tax-free but tread carefully, as you could lose a lot more than your initial stake if the price plummets.

Shares

Rather than buy commodities themselves or futures, you could buy shares in companies than produce commodities or provide products/services to commodity producers. For example, shares in a gold mining company for exposure to gold and shares in a fertiliser company for exposure to grains. However, be aware that it's not uncommon for such shares to rise or fall by a greater degree than the commodity itself.

Funds

There are several types of fund that offer exposure to commodities:

Unit TrustsInvestment TrustsETFsPension

There are several unit trusts investing in hard commodities. Some may have a strong bias towards certain hard commodities over others, so it's important to check.

Commodity unit trusts buy shares in commodity companies, not futures, so expect volatility to be higher than the commodity prices themselves.


Commodities Jargon

Here's some of the more common commodities jargon you might come across:

JargonMeaning
BackwardationWhen the price for immediate delivery of a commodity is higher than the price of delivery for a future date.
Brent CrudeThe name given to oil produced in the North Sea and also a benchmark used for oil pricing.
ContangoWhen the price for immediate delivery of a commodity is lower than the price of delivery for a future date (due to storage costs, insurance and financing etc.)
Hard CommoditiesCommodities that are mined from beneath the ground, e.g. oil.
Soft CommoditiesCommodities that are grown, e.g. corn.
Spot PriceThe cash market price for a physical commodity that is available for immediate delivery.