COMMODITIES 101

Commodities

What You Need to Know

Interested in learning about commodities? Confused by talk about contango and crack spreads? yallacompare is here to help…

Let’s start with the basics:

A commodity is any physical substance which is interchangeable with another product of the same type and which investors buy or sell, usually through futures contracts.

The key categories of commodities available for futures trading are:

1. Energy e.g. crude oil, heating oil, natural gas and gasoline
2. Metals e.g. gold, silver, platinum and copper
3. Livestock and Meat e.g. lean hogs, pork bellies, live cattle and feeder cattle
4. Agricultural e.g. corn, soybeans, wheat, rice, cocoa, coffee, cotton and sugar
5. Interest Bearing Assets e.g. T-bills, bonds, notes

The key to understanding what makes a commodity a commodity is the term fungibility, which basically means that one product is the same as another. Gold for example is the same in China as it is in New York, provided it has the same purity. Your copper is the same as my copper and both sell for USD x per ton. Look at the list of categories above and you’ll see that all the listed commodities are fungible.

It is fungibility that lets us trade huge quantities of these commodities at a single price – because there is no differentiation between products, it’s easy to understand the market and prices move in direct response to expected supply and demand. That’s it. No brands, no intellectual property, no innovation — just simple supply and demand!

Commodities markets, both in the past and today, have tremendous economic impact on nations and individuals. Their history is still pretty unknown, but it has been suggested that rice futures may have been traded in China as long as 6,000 years ago. Shortages on critical commodities have sparked wars throughout history whilst oversupplies can have a devastating impact on a region by devaluing the prices of core commodities.

Investors tend to break commodities down into two categories; hard and soft. Typically, soft commodities are grown whilst hard commodities are mined or extracted. Hard commodities are generally easier to handle because soft commodities are often subject to spoilage, which can create added volatility.

There are also what’s called ‘emerging commodities’ which are expected to develop into booming markets in 5-10 years. These include wind, solar, water and pollution rights.

Now for the million dollar question. Why invest in commodities?

Put simply, commodities exposure will increase your returns while lowering your risk. You see, historical data shows us that picking stocks doesn’t actually have much of an impact on your portfolio’s performance, provided you make reasonable choices. What really matters is the markets you pick, rather than the stocks you choose. In other words, asset allocation is key!

So what’s asset allocation?

Asset allocation is how you invest your portfolio in different parts of the market such as cash, stocks, bonds, commodities, property etc. Each of these assets tends to perform differently – some are more risky and volatile, others more stable, some rise when the economy does well, others fall and so on.

A key goal in a smart asset allocation plan is to create a diversified portfolio. That way, if part of your portfolio hits a rough patch, the other part may perform well – and this is where investing in commodities is a smart choice because when stocks and bonds head south, commodities tend to head north. Commodities are the only asset class that is negatively correlated to bonds, making them a powerful tool for diversification.

To conclude…

The commodities markets are present both challenges and opportunities with over 30 tradable commodities to choose from, deciding whether to trade crude oil or gold, sugar or palladium, natural gas or soybeans is complicated alone. And if you do, what’s the best way to invest in them? Through dedicated futures markets, equity markets or physical purchase?
There are lots of options to choose from and lots of variables to keep track of but one thing is clear – the commodities universe is huge, the investment opportunities plentiful and by exploring this asset class, you will get a great glimpse of how global capital markets operate and understand how to capitalize on this information to generate profits.