An Introduction to Investing in Commodities

A Guide to Commodity Investing

You may have heard the phrase “a rise in commodities” frequently in the last year or so as commodity prices have skyrocketed. Usually, the first thing that comes to mind when you think of a commodity is a common physical good that is bought and sold. Something generic and pure in form. You’d be exactly right, but not just any physical good is traded on market exchanges. This post will discuss what commodities are, some common commodity terminology, commodity performance, how to invest in them, and whether you should or should not be investing in commodities.

First, let’s take a look at what is considered to be a commodity. There are over 100 commodities traded on the market today. Here are some of the most common commodities:

Commodities on Trading Exchanges:

• Agricultural Commodities: corn, wheat, oats, rice, soybeans, soybean meal, soybean oil, coffee, cocoa, sugar, cotton
• Livestock/Meat: bacon, lean hog, live cattle, feeder cattle
• Energy: propane, ethanol, natural gas, uranium, heating oil, light sweet crude oil, brent crude oil, gulf coast gasoline, RBOB gasoline
• Precious Metals: gold, silver, platinum, palladium
• Industrial Metals: aluminum, zinc, tin, lead, copper, aluminum alloy, nickel, recycled steel
• Other: rubber, palm oil, wool, polypropylene, polyethylene

Commodity Terminology:

• Commodity trading: When people refer to trading commodities it is in reference to the buying and selling of the aforementioned physical goods on exchange markets.
• Commodity stocks: This is the stock of companies that actually produce and sell these resources in a pure or altered form. Some people may also broadly lump in the companies that supply these producers because they were trade in line with them. This is because when an industry is booming, the companies that supply the companies within the industry are booming as well.
• Commodity mutual fund: A mutual fund that invests in commodity stocks and related company stock.
• Futures contract: An agreement to purchase or sell a commodity for delivery in the future at a price that is determined via contract. This contract ties each party to fulfill the contract at a specified price, which is used to assume a shift in the price risk and may be fulfilled by delivery or offset.
• Commodity Hedging: Common practice primarily where farming co-operatives insure against a poor harvest by purchasing futures contracts of the same commodity.
• Natural Resources: Often used interchangeably with commodity terminology.

Commodity Investment Performance:

Commodities have performed very well over the past six years any many believe that the bubble is going to burst soon. Commodity indexes have gone up about 38% this year and 75% in the last year. Speculators have run up prices, and it’s hard to predict how much longer they will run.

In a recent Kiplinger article, Theresa Gusman, manager of DWS Global Commodity Stock fund states, “Going back to 1870, major commodity bull markets have lasted an average of 18 years. The current cycle is only six years old and there’s never been a situation in which the likes of China, India, Russia, Brazil and the Middle East all passed through a commodity intensive phase of economic development simultaneously”.

Those in Favor of Investing in Commodities:

• Commodities are a way to balance your portfolio as commodity performance can often run inversely to other stocks.
• The long-term fundamentals of commodities are very strong. With emerging markets growing at a rapid pace there will be a strong demand well into the future for commodities.
• Commodities have had a huge run, but relatively short in length of time compared to historical commodity bull markets.
• In terms of oil, many believe that the world has reached it’s peak supply production. Demand is increasing at growing rates. The economics of this are going to push oil prices even higher.

Those Against Investing in Commodities:

• Commodity prices have run up so tremendously high in a few short years based mostly in pure speculation. The bubble is going to burst. Indeed, we’ve seen a huge silver (SLV) selloff.
• Companies that are extracting natural resources are becoming more efficient to meet the demand of the world.
• Commodities are very volatile and poor investment vehicles for those not holding for the long-run.

How to Invest in Commodities

If you are going to invest in commodities, you’d be wise to go the route of index funds or well performing actively managed mutual funds. Look for the following categories, all of which usually contain funds that own one form or another of commodity stocks: precious metal, natural resources, commodity, and energy. You can use either of the following mutual fund screeners to find strong performers at a good price:

• Morningstar mutual fund screener
• Yahoo mutual fund screener

Personally speaking, I invest in commodities via ETF’s because of their low management fees.

The Bottom Line in Commodity Investing:

The long-term fundamentals for commodities are so strong it is hard for me personally to hold back from investing a large portion of my portfolio in them. We are living in a world of growing demand and dwindling resources. Economics 101 tells me that the rising values in commodity stocks is only going to continue, with some strong corrections along the way.

On the flip side is a voice that is telling me that recent astronomical rise in commodity pricing is based mostly on speculation and will soon collapse. Very few ‘advisers’ would recommend that you have a large portion of your assets in commodities, and most recommend no more than 5% of your assets.

This is a highly volatile asset class and if you’re going to invest, do so only after much consideration of risk. Also, look at commodities as a long-term fundamental play versus trading for a short-term gain, or you are probably going to get burned.

Commodity Discussion:

• What percent of your portfolio is invested in commodities?
• How do think commodities will perform over the next year? 5 years? 20 years?
• What commodities do you see demand increasing for the most?

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