Commodities

Commodities are another main asset class, although certainly less common among personal investors than stocks, bonds and real estate. Commodities are also known as “natural resources.” Overall, we can divide them into three categories:

1. Energy commodities. This includes oil/petroleum, and natural gas.

2. Metals. This includes things from nickel to copper, silver and gold.

3. Food. This includes all the agricultural inputs we eat, from soy to wheat, to pork and beef, to cocoa beans.

Commodities of course have an intrinsic real world value. They are the things that build the world around us, from skyscrapers to electric vehicles (copper, cobalt, nickel). They are the things that feed the world, from soy to cocoa. They are the things that power the world, from oil to natural gas. This means that commodities are always traded around the planet, for their own intrinsic value and real world applications. There is always demand, and therefore supply, and therefore a market for these. Commodities have been traded by humankind for as long as we’ve existed.

They have also been a hotbed of financial innovation historically. It is in commodity markets, in 19th century Chicago to be more precise, that “futures” were invented: futures are contracts to buy and sell an agreed amount of a commodity (i.e. oil, wheat), at a certain time in the future (i.e. next July), for an agreed price (i.e. 17USD per pound of “lean hog” for example, which trades on the Chicago Mercantile Exchange). These futures were developed as a form of insurance for farmers — it would allow a farmer to sell part, or all of their production for the next harvest, at a pre agreed price. This would provide them with price certainty for their crop, and an insurance against a dramatic fall in crop prices at the end of the harvest season for example.

A lot of investors and traders either stay away from these, or focus solely on these — they are a world of their own in trading and investing. To be frank, as a personal investor, if you do venture into commodities, you will really only focus your attention on oil, some well known industrial metals maybe (copper, lithium…) and two or three precious metals such as gold and silver. As mentioned, the price of commodities like oil or copper depends mostly on demand and supply across the world. Experts study each commodity and try to anticipate demand — economic growth driving demand for oil for example, and supply — how much Saudi Arabia, Russia, Iran and other large oil producers will produce this year for example.

The one exception is a staple in many portfolios around the world, gold. This specific commodity deserves its own treatment, which I address in the article on gold.

Why trade them?

The main reason commodities are traded, is because they are used around the world on a day to day basis. American Airlines needs oil for its planes, Walmart needs beef and chicken, and your favorite alternative dairy brand needs soy. It is important to not forget that global commodity trade really is driven by the massive daily amounts that we, as a society, use and consume. It is a professional, business to business market. Producers of everything from oil to wheat, sell to large groups that use, process or distribute these products to their end consumers.

But why would we trade commodities will you ask?

There are three reasons personal investors invest in commodities:

1. Portfolio diversification. This simply refers to the fact that many commodities behave differently from stocks. And this makes sense — commodities move with the law of supply and demand in their own markets much more than with the wider stock market. If all investors are pessimistic, and the American stock exchange is going down, but meteorological conditions in the United States destroy this year’s wheat harvest for example, the price of wheat will skyrocket. The same applies to oil, assuming a drastic reduction in production by Saudi Arabia for example: the price of oil could skyrocket irrespectively of whether the economy is doing well or not. To substantiate this argument, we need to look at the correlation of a few major commodities, with the US stock market:

What are we looking at here? The daily price of the S&P 500 against oil, lithium (an energy and a metal commodity I chose), and an ETF of a diversified group of commodities. What we can all agree is that the price of these commodities does not seem to be highly correlated with the S&P 500 over this period. We see for example that beginning in 2010, the price of the S&P 500 began significantly going up, while oil started a 10 year decline (this would mean negative correlation between them, when S&P 500 goes up and oil goes down). Lithium went down for 5 years until about 2015, before starting to dramatically increase for 3 years until 2018 (arguably Tesla/electric vehicle boom expectations), then decreasing again for 2 years until 2020, and then skyrocketing in 2020.

2. The second reason is protection against inflation. As we all know, inflation is simply the increase in the prices of goods, and services. And commodities are raw inputs to most of the world’s goods and services: the person who delivers your Amazon parcel to you uses oil to drive to your house, and the restaurant that cooks your burger needs beef and bread (wheat) to make your dish. What this means is that the price of commodities, which are required inputs to goods and services, can easily rise with the price of goods and services — producers of commodities will have the power to increase their prices as the world around them gets more expensive. Or in other terms, when inflation rises, commodity prices also rise. This means that as inflation rises, the commodities in your portfolio will typically also increase in price/value, and therefore protect you against the harmful effects of inflation.

3. A more challenging reason to trade commodities, which is usually the most widespread one of course, is speculation. People buy oil or lithium or copper because they think its price will go up and they want to benefit from it. At this level, think of each commodity as a company: if you know it very well, know its market very well, and are intent on following developments in this market, and think you have an ability to find opportunities or to predict supply and demand in the future (and therefore the price), nothing prevent you from investing in it. However as mentioned I stay away from commodities other than gold. I have no edge in these markets, don’t actively follow them, and have no clue whether oil or lithium will go up or down this year, next year, or in 5 years. I studied themes like lithium a week before writing this article for example, and you will see that even when the growth in demand for a commodity is obvious (the demand for batteries/electric vehicles keeps going up), there may be even more supply coming on the market (new and expanded mines in lithium’s case), which might actually push the price down rather than up in the coming years. If you want to invest in single commodities you really need to know that market and its future well.

Specificity of these markets

While commodities have an intrinsic value due to their real world applications, the prices of commodities jump up and down a lot, and are impacted by everything from an act of piracy in the Gulf of Guinea, to a drought in West Africa. They swing up and down with news about China’s GDP growth last quarter, OPEC’s upcoming meeting, the winter temperature in the US, or yet yields on government bonds. They are known to be a volatile and unpredictable asset class.

How to trade them?

The easiest way to trade commodities for investors like us is, of course, by buying commodity ETFs. You have diversified commodity ETFs such as the Invesco Bloomberg Commodity UCITS ETF Acc (at the time of writing 30% energy commodities, 23.5% grains, 18.4% precious metals, 14.8% industrial metals, 7.3% “softs,”, and 6% livestock), or ETFs specific to each commodity (for oil the United States Oil Fund USO for example).

Or you can buy commodity futures. These are standardized and heavily traded financial contracts in which you buy 100 barrels of oil at a price of 30USD per barrel, in 6 months’ time. Commodity futures are best reserved for more advanced/professional traders in my opinion.

You can also buy commodity companies, either individually, or as a group through an ETF. The share prices of companies that produce commodities (mining companies, oil companies, gas companies), often moves up and down with the price of that commodity. For example when the price of oil goes up a lot, the share price of oil producing companies tend to go up as well. Of course, this is not a perfect relationship, but it is close enough that people use it as a proxy. Beware: if you want exposure to oil, and you buy only one oil company, for example Shell, you are always taking company specific risk, which has nothing to do with the commodity (fraud, management issues, government sanctions, a disaster such as an ocean oil spill — these are all specific to a single company and not to the entire industry of oil…). ETFs that offer exposure to commodities by holding a diversified basket of shares in commodity producing companies include Energy Selector SPDR Fund — XLE for oil, or the VanEck Vectors Gold Miners Etf — GDX for gold.

Having a diversified commodity ETF in your portfolio is not a bad idea. Just make it a small part of your portfolio allocation, and expect it to be more volatile than your stocks ETF or your bonds ETF for example. And if you dabble in single commodities such as lithium or oil, make sure you know what you are doing and keep the position small.

What not to do in commodities:

1. Do not buy single companies unless you know them well. A single commodity company is subject to the wild swings in the price of the commodity it produces + company specific risks, from an oil spill to a government sanction in the countries where it producers or sells its commodity.

2. Stay clear of “physical” contracts, which many commodity futures are. Remember that such contracts are used by professional companies that actually buy and use these commodities. These contracts typically stipulate that you WILL (not can, but will) buy 100 barrels of oil in 6 months’ time at 30USD per barrel for example. If you read the contracts carefully, you will see that they even stipulate where and how the oil will be delivered to you — typically in a major oil hub such as a Texas terminal. [this is why I suggest investing in commodity ETFs and not commodity futures]

Hilarious anecdotes (unless this happened to you): in April 2020, as a result of several issues, the price of oil went negative. That is right, people were trying to pay others in order to sell them their oil! This episode lasted a day, right before a large amount of oil futures were due to expire. A lot of traders who were planning to easily sell their futures contracts to others before expiration, suddenly ended up stuck with those contracts, and the very real delivery of oil barrels to them that this implied. Desperate to sell their contracts before their expiration in order to avoid receiving physical delivery of the oil barrels, they ended up having to pay others in order to sell to them these contracts. Whatever you do, don’t get caught with 100.000 barrels of oil delivered in your name to a Texas oil terminal or 2 tons of soy delivered to you in some warehouse on the other side of the planet. You laugh but when you’ll start receiving invoices for storage, or have to arrange transport to whomever you finally manage to sell your oil or lithium or wheat to, you’ll laugh a lot less I promise. Life is beautiful. Don’t mess it up like this.

3. Because commodities are so volatile, and because many commodity companies are entirely exposed to the price of the commodity they sell, it is highly advisable to diversify in this asset class. I always buy a diversified commodity ETF rather than any specific commodity or single company. I have a close friend who had invested a significant amount of money into BP, seeing the company as a stable and safe investment, a few weeks before the Deepwater Horizon spill in the Gulf of Mexico, one of the largest oil spills and pollution episodes in history…