#24 Investing in commodities: an introduction

Raw materials are natural resources that are needed for the production of goods and services that we consume on a daily basis.

They can be divided into three main categories:

• Energy,
• metals
• and agricultural commodities.

The energy category includes oil, natural gas, coal and other fuels used to produce energy. Metals include precious metals such as gold and silver as well as industrial metals such as iron, copper, aluminum and zinc, which are used in industry for various purposes. Agricultural commodities, on the other hand, include agricultural products such as wheat, corn, soybeans, sugar, cotton, and other agricultural products.

Although commodities are investable goods, unlike many other investment instruments, they do not generate regular dividends, interest payments or other cash flows. Anyone investing in commodities is therefore merely speculating on their value being maintained or increased in the future.

The market on which commodities are traded for immediate delivery is known as the spot market. However, there is also a futures market, on which commodities are also traded forward via so-called «futures». With futures, producers, and buyers of commodities can hedge against the risk of price changes.

Characteristics of commodities as an asset class

The two most important characteristics of commodities are, firstly, the inflation protection they offer and, secondly, their suitability for diversifying portfolios. Certain commodities, particularly precious metals such as gold and silver, are often seen as a hedge against inflation. Experience shows that their value remains stable or increases even in inflationary times, while the purchasing power of currencies falls or national banks start the printing presses. Furthermore, due to their low correlation with traditional asset classes such as equities and bonds, commodities can help to diversify portfolios and thus reduce overall risk.

Risks of investing in commodities

Commodities can be an attractive asset class, especially in times of economic uncertainty and high inflation. However, they also carry risks:

• Price volatility: commodity prices can fluctuate widely, which can lead to significant losses. The price of commodities is determined by supply and demand (unless it is set by the government), which can be influenced by various factors. For example, through geopolitical events or regulatory intervention.
• Currency risk: As many commodities are traded in US dollars, investors are exposed to the risk of currency fluctuations. However, the utility value of commodities is basically independent of the trading currency.

Causes of commodity price volatility

A weak economy often reduces the demand for commodities. Conversely, a booming economy can increase demand, which frequently leads to rising prices. On the other hand, geopolitical events such as wars or trade blockades can also lead to abrupt price changes if they affect the export, import, or transportation of raw materials. The influence of technological changes should also not be neglected. These can increase or decrease the demand for certain raw materials in the long term. For example, the increasing share of renewable energies in the electricity sector can lead to a reduction in the price of fossil fuels. Finally, the seasonality of commodities also plays a role. Agricultural commodities are subject to seasonal cycles that impact their production and harvest. The prices of agricultural commodities are of course also dependent on the weather.

Is trading in commodities unethical?

Anyone investing in commodities may also be trading in staple foods such as wheat, corn, and sugar. There is therefore a widespread perception that as an investor you are playing the role of a price driver and are therefore partly responsible if commodity speculation makes food unaffordable for people in less economically strong countries.

In principle, however, commodity futures markets, where producers, buyers and derivatives traders come together with speculative intent, have a useful economic function in that they protect both producers and buyers from price uncertainty. They also send out important price signals: For example, if it is foreseeable in winter that an agricultural commodity such as wheat will be in short supply in the fall, its forward price on fall contracts rises in winter. This in turn creates an incentive for producers to grow more wheat, which ultimately leads to a higher physical supply and thus to lower spot prices after the harvest in the fall.

Scientific studies have also come to the conclusion that abrupt price increases in the area of basic foodstuffs in the recent past were mainly caused by real economic factors. It is difficult to say whether speculation has at least partially contributed to the price increase; the effect of speculation is disputed in the scientific community. For example, the meta-study
«The impact of speculation on commodity futures markets - A review of the findings of 100 empirical studies.» from 2015 compared 100 studies with one another. The result: around half of the studies recognized an effect, the other half did not. A recent study entitled «Financial Speculation Impact on Agricultural and Other Commodity Return Volatility: Implications for Sustainable Development and Food Security.» from 2022 observed no correlation between speculation and higher price fluctuations in recent years, even during the Covid pandemic.

The use of commodities or their futures markets in investment portfolios nevertheless remains a question of value, which is why commodities are not included as standard in our sustainable investment universe (but can be added individually).

Investment opportunities

There are various ways to invest in commodities:

• Direct investments: Some investors choose to buy physical commodities such as gold coins, or silver bars and thus hold commodities directly.
• Futures and options: Experienced investors can trade commodity futures and options to profit from price movements without directly owning physical commodities. However, you need to know what you are doing. For example, futures should be closed out before the expiry date, otherwise you will have to arrange for their physical delivery.
• Exchange-traded funds (ETFs): ETFs, which track commodity indices, allow investors to invest in a broad range of commodities without having to buy individual commodities. With the exception of precious metals, which are easy to store, most commodity ETFs track the commodities market via futures.
• Shares in commodity companies: A fourth, indirect way to invest in commodities is through shares in commodity companies. Investing in shares of companies involved in the extraction, processing, or distribution of commodities also offers indirect exposure to commodity prices.

Conclusion

Anyone wishing to invest in commodities should be well-informed about the risks involved, depending on their preferred investment option, and handle them responsibly. For private investors, commodities as an investment instrument can be particularly suitable for diversification and as a hedge against inflation in economically turbulent times. At True Wealth, we use a small proportion of commodity ETFs, depending on our clients' risk appetite and investment preferences.

Do you have gold or other commodities in your investment mix? E-mail me your feedback.