Commodity Investing

What Is a Commodity?

A commodity is a basic good or raw material that is interchangeable with other goods or materials of the same type. Commodities are typically used as inputs in the production of goods or services. They can be traded on specialized commodity markets, where they are bought and sold in standardized contracts.

Commodities are often divided into two main categories: hard commodities and soft commodities. Hard commodities are natural resources that must be extracted or mined, such as metals (e.g., gold, silver, copper) or energy resources (e.g., crude oil, natural gas). Soft commodities are agricultural products or livestock, such as wheat, corn, soybeans, coffee, sugar, or cattle.

The prices of commodities can be influenced by various factors, including supply and demand, geopolitical events, weather conditions, and economic data. Due to their often global nature, the commodity markets can be subject to significant price fluctuations.

A commodity is a basic good or raw material that is interchangeable with other goods or materials of the same type.

Types of Commodities

1. Agricultural Products

Agricultural commodities are agricultural products that are grown to be sold. They include food, fiber, and livestock.

Examples: coffee, corn, wheat, soybeans, cotton, and lumber

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2. Livestock and Meat

Livestock commodities are any animal used for food, including beef, pork, poultry, dairy products, and fish.

Examples: cattle, beef, pork bellies, and milk

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3. Energy products

Energy commodities are the raw materials that are used to produce energy, such as crude oil, natural gas, and coal.

Examples: crude oil, natural gas unleaded gasoline, propane, ethanol, and coal

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4. Metals

Metals are typically used in industrial processes and include metals such as aluminum, copper, nickel, and gold.

Examples: gold, silver, copper, aluminum, and palladium

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Investors Known for Their Commodity Positions

There are several notable investors known for their expertise and strategic positions in the commodity markets. These investors have gained recognition for their successful bets on commodities, often employing unique and innovative investment strategies. Here are five such investors:

1. Jim Rogers

In his book "Hot Commodities," published in 2004, Rogers argues that the world is on the verge of a long-term commodities boom, driven by factors such as population growth, increasing demand from emerging markets, and dwindling supplies of many essential resources. He believes that investing in commodities can provide an effective hedge against inflation, currency fluctuations, and stock market volatility.

Jim Rogers on Commodities

2. Paul Tudor Jones

A successful hedge fund manager and founder of Tudor Investment Corporation, Paul Tudor Jones has a reputation for making significant bets in the commodity markets. Known for his macroeconomic approach and technical analysis, Jones has made successful trades in various commodities, including crude oil, gold, and agricultural products.

Paul Tudor Jones on Commodities

3. Michael Burry

Famed for his bet against the U.S. housing market in the 2000s, Michael Burry has also been known to invest in commodities, particularly gold and farmland. Believing that these investments offer protection against inflation and economic instability, Burry has often advocated for the importance of real assets in a diversified portfolio.

Michael Burry on Commodities

4. Ray Dalio

As the founder of Bridgewater Associates, one of the world's largest hedge funds, Ray Dalio has been known to include commodities in his "All Weather" investment strategy. This approach seeks to balance risk across different asset classes, including commodities, to protect against various economic environments. Dalio has expressed interest in gold as a hedge against currency debasement and inflation.

Ray Dalio on Commodities

What Are the Reasons to Invest in Commodities?

Investing in commodities can offer several potential benefits for investors. Some of the primary reasons to consider investing in commodities include:

Diversification

Commodities often have low or negative correlations with traditional asset classes such as stocks and bonds. This means that adding commodities to a portfolio can help diversify investments, potentially reducing overall risk and improving long-term returns.

Inflation protection

Commodities can act as a hedge against inflation. During periods of rising inflation, the prices of commodities often increase as well, helping to preserve the purchasing power of an investment portfolio. This is particularly true for commodities such as gold, which has historically been considered a store of value during inflationary periods.

Supply and demand dynamics

The prices of commodities are influenced by global supply and demand dynamics, which can create investment opportunities for those who can accurately predict these trends. For example, factors such as population growth, economic development, and resource scarcity can drive demand for certain commodities, leading to potential price increases and investment gains.

Geopolitical events

Commodity markets can be significantly impacted by geopolitical events, such as wars, political unrest, or trade disputes. Investors who can anticipate and navigate these events may find opportunities for profit in the commodity markets.

Currency hedge

Since commodities are often priced in global currencies, such as the U.S. dollar, they can provide a hedge against currency fluctuations. This can be particularly valuable for investors with exposure to multiple currencies or those concerned about the potential for currency devaluation.

Speculation

Some investors engage in commodity trading to speculate on short-term price movements, aiming to profit from market volatility. This can be a high-risk strategy but can offer the potential for significant returns if successful.

Portfolio performance enhancement

Including commodities in a well-diversified portfolio can help enhance overall performance by providing exposure to different asset classes with varying risk-return profiles. This can lead to more consistent returns and a smoother investment journey.

What Are the Main Drivers of Commodity Prices?

Supply and Demand

When supply and demand for a commodity changes, so does the price of that commodity. The basic rule is that when demand increases, prices rise. The opposite is true when supply increases.

Currency Movements

Commodities are generally priced in US dollars. As the value of the dollar rises or falls, so can the price of commodities. For example, if the dollar experiences a sharp rise against a basket of major currencies, as expressed in commodities, this could see a fall in the prices of commodities such as crude oil, as well as other energy, precious metals and agricultural products. Of course, markets don't always operate so uniformly - but this is something you should consider when trading.

Geopolitical Situations

Commodities are often impacted by political uncertainty. For example, crude oil is largely produced in countries around the Middle East. This means that the price of Brent and WTI can be heavily influenced by tensions that historically occur in that region. For example, when the USA imposes economic sanctions on Iran, the crude oil market generally trades higher due to the anticipated cut-off of supply of Iranian oil to the market.

Economic Growth

When a country's economy is stable and prosperous, the price of a commodity will be high because people have more money to spend. For example, Venezuela is a major oil producer and exporter. However, the government has damaged its oil industry due to lack of investment and corruption. This has crippled the economy, which in turn has caused hyperinflation. Moreover, economic sanctions imposed on Venezuela have further constrained oil production, exports and revenues in the country.

How Inflation Affects the Price of Commodities

Inflation refers to the rate at which the general level of prices for goods and services is rising, leading to a decrease in the purchasing power of money. Inflation can have a significant impact on the prices of commodities, and understanding this relationship is crucial for investors and traders alike. Here are some ways in which inflation can affect the price of commodities:

Increased production costs

As inflation rises, the cost of production for various goods and services also increases. This includes the cost of labor, raw materials, and energy, all of which are essential for producing commodities. As a result, producers may pass on these increased costs to consumers in the form of higher commodity prices.

Demand for real assets

During periods of high inflation, investors often seek to protect their wealth by investing in real assets, such as commodities. This is because commodities typically retain their intrinsic value over time, making them an attractive hedge against inflation. As the demand for commodities increases, their prices tend to rise as well.

Currency depreciation

Inflation can lead to the depreciation of a country's currency, as the purchasing power of money decreases. When a currency's value declines, it takes more units of that currency to buy the same amount of a commodity, which is often priced in global currencies, such as the U.S. dollar. This can result in higher commodity prices for consumers in the country experiencing currency depreciation.

Interest rates and monetary policy

Central banks often use interest rates and monetary policy tools to control inflation. When inflation is high, central banks may increase interest rates to slow down economic activity and reduce inflationary pressures. Higher interest rates can lead to increased borrowing costs for producers, which can, in turn, drive up the cost of producing commodities and result in higher commodity prices.

Speculation

The expectation of rising inflation can lead to increased speculative activity in the commodity markets. Investors and traders may buy commodities in anticipation of higher future prices, further driving up the prices of commodities.

How Interest Rates Affect the Price of Commodities

An increase in the interest rate reduces firms’ demand for holding inventories and therefore lowers the commodity price.

By encouraging extraction to take place today rather than tomorrow (think of the rates at which oil is pumped, gold mined, forests logged, or livestock herds culled).
By reducing the desire to carry inventories (think of oil inventories held in tanks)
By persuading speculators to shift their money away from commodity contracts and into treasury bills
When a country's currency appreciates, it reduces the price of globally traded commodities, even if the price hasn't fallen in terms of foreign currency.

Source: Harvard University