Commodity Investing

Published: 12/23/2022

What Is a Commodity?

A commodity is a basic good used in commerce that is interchangeable with other goods of the same type. Commodities are often used as inputs in producing other goods or services. A commodity, thus, usually refers to a raw material used to manufacture finished goods. On the other hand, a product is the finished good sold to consumers.

A commodity is something that is used to make something else. A product is what you get when you make it.

5 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

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

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

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

Investors Known for Their Commodity Positions

1. Jim Rogers

Jim Rogers is betting that the prices of crops will go up because people are not studying to be farmers anymore. He thinks that this will lead to falling supplies and higher prices.

2. George Soros

In 2012, George Soros made lots of money from selling gold, and then he invested some money in gold again. He also likes to invest in agriculture.

3. Eike Batista

At the age of 23, Batista started a trading company to buy and sell gold. The operation earned him a $10 million profit.

4. Larry Hite

Hite became rich by using computerized statistical models to trade commodities. His company, Mint Investment Management, was the largest commodities trader in the world when he ran it.

Why Invest in Commodities

There are several reasons why investors might choose to invest in commodities:

Diversification

Commodities can provide diversification benefits to a portfolio by having low correlation with other asset classes such as stocks and bonds, which can help to reduce overall portfolio risk.

Inflation Hedge

Commodities, particularly precious metals such as gold and silver, have historically been seen as a hedge against inflation. As the prices of goods and services rise, the value of these metals tends to rise as well, which can help to protect investors' purchasing power.

Supply and Demand

Commodities are often driven by supply and demand factors, such as changes in weather, natural disasters, and geopolitical events. These factors can create opportunities for investors to make profits from price movements.

Short-Term Trading

Commodities are also often used by short-term traders and investors who are looking to make quick profits from price fluctuations. Commodities markets are highly liquid, meaning there are many buyers and sellers, which makes it relatively easy to buy and sell positions.

Long-Term Investment

Some investors also invest in commodities for the long-term, viewing them as a store of value. For example, some investors consider gold as a safe haven asset that holds its value over time, regardless of fluctuations in other markets.

It is important to keep in mind that investing in commodities can be riskier and more complex than other types of investments, and it is important to have a good understanding of the markets and the factors that drive price movements before investing.

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

Commodities are a hedge against inflation, so buying before periods of high inflation is a good investment strategy; however, predicting when inflation will occur can be tough.

Inflation can have a significant impact on the price of commodities. When the overall level of prices in an economy is rising, the prices of commodities tend to rise as well. This is because the cost of producing and transporting commodities increases as the prices of goods and services such as labor, energy, and raw materials increase.

Additionally, when inflation is high, the value of money decreases, which can lead to investors seeking out alternative investments that hold their value. Commodities such as precious metals, which have a historical track record of holding their value in inflationary environments, can become more attractive to investors as a hedge against inflation.

Commodities prices can also be affected by changes in the exchange rate. If a country's currency depreciates, its commodities become more expensive to foreign buyers and this can push up the price of the commodities.

On the other hand, if a country's currency appreciates, it makes the country's commodities cheaper to foreign buyers, which can push down the price of the commodities.

It is also important to note that the impact of inflation on commodity prices can vary depending on the specific commodity and the factors that influence its supply and demand. Some commodities, such as agricultural products, can be more sensitive to inflation than others, such as metals.

In general, it is important to keep an eye on overall inflationary trends and their potential impact on commodity prices when making investment decisions. It is also important to do thorough research on the specific commodity and the factors that influence its supply and demand.

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.

  1. 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).

  2. By reducing the desire to carry inventories (think of oil inventories held in tanks)

  3. By persuading speculators to shift their money away from commodity contracts and into treasury bills

  4. 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