Investing in commodities

Commodities are integral to and are the fundamental drivers of the global economy. The dynamic nature of their prices offers investors distinct opportunities to realise profits. Trading in commodities is far older than you might imagine, going as far back as 4500 BCE. However, commodities entail a higher degree of risk when compared to traditional assets such as stocks and bonds. This makes them quite unpopular amongst investors, except the more experienced ones. (Thaxton, 2023; Rodeck & Curry, 2022)

While commodities such as gold, oil and gas frequently take the spotlight, orange juice and uranium have been talking points in investor circles of late. Orange juice prices, traded as a frozen concentrate, increased by almost 80% last year, on the back of harsh climate and crop disease (Trading Economics, 2024; Meredith, 2023). The demand for Uranium too, has experienced quite the surge as well, amidst conversations around it being the best solution towards energy security. (Roy & Dareen, 2023; Jain, 2023)

This article is an attempt to understand the commodity market and how commodities are traded.

What is the commodity market?

Commodity markets have experienced significant evolution, especially in the past century, since their early origins. Substantial technological advancements, supported by the exploration of new sources of raw materials, have positively impacted supply. Consumption, especially in energy and metals, has surged, largely driven by the increasing demand from emerging economies (Baffes, et al., 2022).

Economic forces of supply and demand drive commodity markets. A short supply combined with strong demand for a commodity drives the price up. On the other hand prices fall when supply remains abundant and demand decreases. This interaction creates opportunities for investors to profit by predicting market trends (ComFin Software, 2022).

Commodities are raw material inputs, that are processed further for consumption. Commodities are broadly categorized into two groups: Hard and Soft. Hard commodities are extracted from below the earth's surface, while soft commodities are cultivated or reared?(IG International, n.d.). Commodities are further classified into four distinct groups?(Rodeck & Curry, 2022):

• Energy: It includes non-renewable resources such uranium, natural gas, petroleum, oil, coal, etc., and renewable forms such as wind and solar energy.
• Metals: These include precious resources such as gold, silver, platinum, and also industrial resources such as tin, copper, iron, amongst several others.
• Agricultural products: This covers agricultural produce such as wheat, rice, cocoa, coffee, sugarcane, palm oil, etc.
• Livestock: Animals reared for consumption such as cattle and hogs come under this group.

How old far back does it really go?

Figure 2 describes the evolution of commodity markets, and a history of trading in commodities.

Commodity Trading in the real world

Commodity trading has been an ancient profession, predating the practice of investing in stocks and bonds. Throughout history, several empires have thrived through sophisticated and efficient trade networks centred around commodities?(Lioudis, et al., 2023). More recently, commodities trading required a significant amount of financial resources, time, and expertise, and was primarily restricted to professional trading circles. Today, there are more options for participating in the commodity markets?(Lioudis, et al., 2023).

Commodities, today, are traded on exchanges typically via a futures contract. The futures contract is based on the price of the underlying commodity. They are not traded physically, and instead investors speculate, i.e., make bets on whether prices rise or fall. This is achieved by either buying futures (i.e., going long) or selling them (i.e., going short)?(Rodeck & Curry, 2022). Commodities offer investors a means to diversify portfolios beyond traditional securities. Often, investors rely on commodities during volatile periods as they have a tendency to move in the opposite direction of stocks (Lioudis, et al., 2023). Table 1 summarises the various forms of commodity trading.

Like any asset class, they’ve their own set of benefits and drawbacks. The table below offers a summary of both. Of the benefits, perhaps the most important factor that makes commodity trading desirable is that it’s a good bet against inflation. As commodities are, in essence, input goods, their prices would go up when inflation goes up, per basic economic logic?(Banton, et al., 2022).

However, commodity trading is inherently risky, as several factors govern the market. Forces, typically unpredictable, such as that of unusual weather patterns, epidemics, disasters, unprecedented global and local macro-economic fluctuations, adverse government policy, amongst others, can impact commodity markets. It is because of these factors, they don’t make for an attractive asset class to most investors. It is for these reasons ‘commodities are meant for trading, not investing’ and in many ways is considered a ‘bet for commodities is a bet against technology and innovation’?(Carlson, 2017).

Why are they still relevant, at least presently?

Commodities may not be an ideal investment for most, but there are scenarios where they prove beneficial. Amidst economic uncertainty, they often serve as a means of safeguarding against the uncertainty. Given present uncertainty amidst geopolitical tensions and gloomy macroeconomic outlook commodities might make it important. In fact, as per McKinsey, commodity trading has enjoyed a boom in the recent period, and the prospects too, seem positive?(Rechtsteiner, et al., 2023).

In certain situations, investors can capitalize on predictable movements in commodity prices. For instance, in the oil and gas market, when a series of events may result in price fluctuations, watchful investors could identify opportunities to realise profits. While prices might have already adjusted in anticipation, the ensuing volatility during such events can be advantageous for short-term traders or those engaged in speculative investing.?(Kuepper, et al., 2021)

Lastly, commodities can play a strategic role when building effective investment portfolios. Consider a portfolio heavily concentrated in energy. To guard against a potential decline in crude oil prices, an investor could employ futures contracts to mitigate commodity-related risks while still retaining exposure to company-specific risks and potential rewards. (Banton, et al., 2022; Kuepper, et al., 2021)

Works cited

Baffes, J., Nagle, P. & Koh, W. C., 2022. The Evolution of Commodity Markets Over the Past Century. In: Commodity Markets: Evolution, Challenges, and Policies . Washington DC: The World Bank, pp. 27-120.

Banton, C., Murry, C. & Perez, Y., 2022. Commodities: The Portfolio Hedge. [Online] Available at: https://www.investopedia.com/articles/trading/05/021605.asp [Accessed 06 January 2024].

Carlson, B., 2017. Commodities Are Meant For Trading, Not Investing. [Online] Available at: https://awealthofcommonsense.com/2017/09/commodities-are-meant-for-trading-not-investing/ [Accessed 06 January 2024].

ComFin Software, 2022. Commodity Trading: An Evolution. [Online] Available at: https://www.comfinsoftware.com/the-evolution-of-commodity-trading [Accessed 06 November 2023].

IG International, n.d. What are commodities and how do you trade them?. [Online] Available at: https://www.ig.com/en/commodities/what-are-commodities-how-do-you-trade-them [Accessed October 06 2023].

Jain, Y., 2023. COP28 and Price Surge Power These Uranium ETFs. [Online] Available at: https://finance.yahoo.com/news/cop28-price-surge-power-uranium-195500191.html [Accessed 05 January 2024].

Kuepper, J., Stapleton, C. & Jasperson, H., 2021. Why You Should Rethink Investing in Commodities. [Online] Available at: https://www.thebalancemoney.com/why-you-should-rethink-investing-in-commodities-4153957 [Accessed 06 January 2024].

Lioudis, N., Silberstein, S. & Kvilhaug, S., 2023. Commodities Trading: An Overview. [Online] Available at: https://www.investopedia.com/investing/commodities-trading-overview/ [Accessed 03 November 2023].

Meredith, S., 2023. El Ni?o’s ‘sweet tooth’ means indulgent treats could soon be even more expensive. [Online] Available at: https://www.cnbc.com/2023/12/25/el-nino-lovers-of-sweet-treats-could-be-hit-by-rising-sugar-prices.html [Accessed 04 January 2024].

Rechtsteiner, R., Schabram, J. & Thomas, A., 2023. The future of commodity trading. [Online] Available at: https://www.mckinsey.com/industries/electric-power-and-natural-gas/our-insights/the-future-of-commodity-trading [Accessed 05 January 2024].

Rodeck, D. & Curry, B., 2022. A Basic Guide To Commodities. [Online] Available at: https://www.forbes.com/advisor/investing/commodities-trading/ [Accessed 03 November 2023].

Roy, M. & Dareen, S., 2023. Uranium primed to extend rally on resurgent nuclear power, say analysts. [Online] Available at: https://www.reuters.com/business/energy/uranium-primed-extend-rally-resurgent-nuclear-power-say-analysts-2023-09-20/ [Accessed 17 October 2023].

Thaxton, R., 2023. History of commodity markets. [Online] Available at: https://www.cityindex.com/en-uk/news-and-analysis/history-of-commodities [Accessed 03 November 2023].

Trading Economics, 2024. Commodities: Orange Juice. [Online] Available at: https://tradingeconomics.com/commodity/orange-juice [Accessed 04 January 2024].

Disclaimer: The information provided in this article is intended for informational purposes only and should not be construed as professional or trading advice. It is not a recommendation to buy, sell, or hold any financial instruments or securities. The content is based on publicly available information and analysis. The article is not a substitute for personalised financial advice, and readers are encouraged to consult with a qualified financial advisor for guidance tailored to their specific circumstances.