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Oct 08

How to invest in commodities…and why you should right now

Reading Time: 9 mins

Even if you are only a casual investor you will likely have heard of people who invest in commodities. The word ‘commodities’ immediately brings to mind Wall Street bankers urgently making trades in steel, corn and pork bellies in front of huge computer screens.

However, the truth is far simpler. A commodity is a raw material that can be bought and sold, and this provides ample opportunities for investors to profit.

A commodity can range from something like oil, to something more niche like copper or sugar. Even a precious metal like gold, silver or platinum qualify as commodities.

There are many ways to gain access to commodities even for relatively inexperienced investors, and these will be detailed later. We don’t advise buying them directly as that’s really for the most knowledgeable investors, but you can get your hands on commodities now, before their prices rise any more, through funds, ETFs and stocks and shares. Here’s how and why you could invest in commodities.

 

 

What are commodities?

Commodities are the raw materials that underlie a huge range of manufacturing and business processes.

They are often described as the building blocks of the world economy and are used to make the myriad of products we are used to seeing on our shelves every day.

The difference between a commodity and another product or material is usually defined as them being entirely interchangeable from each other.

This means that two units of a commodity are the same no matter where they come from. A litre of oil extracted in Saudi Arabia is identical to a litre of oil extracted in Russia or Canada, for example.

This makes them attractive for investors looking to make solid returns.

 

Types of commodity

Commodities are roughly split between

  1. so-called “hard” commodities, comprising of natural resources, including energy products, like oil or natural gas, and metals like gold, silver, copper or aluminium.
  2. “soft” commodities, those which are farmed or grown, such as agricultural commodities which could include crops like sugar, cotton or cocoa, as well as livestock and meat

Some of the most popular commodities chosen by retail investors are

  • oil,
  • gold
  • base metals.

However, buying oil is not as straightforward as buying other types of commodity as you cannot simply buy a barrel. Instead you would have to consider alternative ways to invest as detailed below.

 

What drives commodity prices?

Commodity prices are driven by several global factors.

demand for commodities

The most important is demand – the amount of interest there is around the world for the particular material.

This can be driven by many things, including, but not limited to, changing consumer trends, the general health of the economy and the growth of middle classes in the developing world – who may develop an increased taste for a certain product.

supply of commodities

The other side of the coin is supply. When there is a limited supply of a certain material, for whatever reason, the price is bound to increase – as long as demand remains high.

currency movements

Commodity prices are also affected by currency movements. Most are priced in US dollars, meaning changes in the strength of that currency will affect the price of commodities around the world.

governments

The other major factor pushing prices up and down is action by governments or certain geopolitical events. For example, earlier in 2021 an attack on oil facilities in Saudi Arabia pushed the price of oil above $70 a barrel for the first time in more than a year.

Oil prices were also massively affected after the Covid-19 lockdown put an end to the vast majority of air travel, meaning demand for oil nosedived hurting the unit price.

 

How to invest in commodities

Buy direct

The most straightforward way to invest in a commodity is simply to buy it and hold it until the price is sufficient for you to sell.

However, there are significant complications to this approach, depending on the resource itself.

The only type of commodity most investors would consider buying directly would be precious metals like gold and silver. These can be purchased in the form of coins or bars either direct from the Royal Mint itself or from dealers like Bullion Vault.

This is an attractive option for those looking to simplify the process as there is no third party involved. However, there are downsides and risks to consider.

Firstly commodities purchased directly will need to be stored. While this may not be too much of an issue for something like gold bars, although this will come with costs like insurance, if the chosen commodity is livestock or agricultural this becomes far more of an issue for any ordinary investor.

Some commodities, like oil, cannot be purchased directly.

There are other downsides. For example, commodities are not always a particularly liquid investment. This means they can be difficult to sell quickly.

ETFs

Far more accessible for the majority of investors would be to invest in ETFs, or exchange-traded funds, which have exposure to commodity markets, or the stocks of companies which own or work with raw materials.

The former would suit investors looking to have a broad and varied exposure to different types of commodities. ETFs are usually passive funds, meaning they are not directly managed by a fund manager and instead aim to replicate the performance of a certain market or sector.

ETFs are available that track a range of commodities, including gold, silver and corn.

For investors who are not bothered about actually owning the commodity in question ETFs can offer good exposure with greater flexibility.

The main cost involved will be in fees to the investment company that provides the fund itself and also to your individual investment platform.

stocks and shares

Buying stocks in companies that directly work with commodities is another option. These can offer potentially higher returns than ETFs, however they are higher risk as your returns would depend entirely on the performance of an individual company rather than the entire sector.

Company stocks will also not necessarily follow the unit price of the specified commodity itself. There could be other factors that affect only the specific company, and damage its share price, rather than the wider market.

For example, a mining company that mines gold could see its share price fall even if the price of gold increased due to a mining accident or similar.

 

How to invest in ETFs or stocks

Those looking to take this option will need to open an account with an online stockbroker. You can find information and links to some of the main platforms (like AJ Bell, Interactive Investor and Charles Stanley) here.

After registering your personal details you can buy stocks or funds on the platform. The platform itself will charge a fee, usually somewhere between 0.25% and 0.45%, while there will also be an additional fee depending on the fund, while dealing in stocks often incurs an additional charge. It is worth comparing the cost of trading on a number of platforms to ensure you are getting the best deal.

CFDs

An easy but undoubtedly risky way to trade in commodities is to use so-called “contracts for difference” (CFDs).

CFDs allow investors to profit from price movements of a commodity without actually owning the resource itself. Essentially the buyer places a bet on whether the price will go up or down and the contract stipulates that the seller must pay the buyer the difference.

The buyer never owns the underlying asset itself, and the return is based on the difference in price between when the trade is opened and when it is closed.

The benefits of CFDs are that there is no need to purchase the commodity itself, with the additional costs that come with it, and there are usually no transaction fees involved. Investors will instead pay the “spread” between the price when they buy and sell.

However, there are massive risks involved. In many ways, trading in CFDs is more akin to speculating than investing, and they are usually recommended for very experienced investors only.

Those wanting to take this approach can use a service like eToro. More information on the risks and how to make a trade is available here.

 

Pros and cons of investing in commodities

There are many upsides to investing in commodities as a retail investor, but you need to make sure you fully understand the risks.

benefits

  • Firstly commodity markets are nearly always open meaning you can essentially buy and sell on your own schedule. This is unlike some types of investment funds which are traded once a day, limiting your options.
  • The volatile prices of commodities mean there is potential for massive profits on your investment, although this also comes with the possibility of large losses.
  • Commodities can be a good way to add diversity to a wider investment portfolio. The value of commodities does not tend to follow traditional asset classes like stocks and bonds, meaning that their price is unlikely to rise when the price of stocks do. This is because the factors that lead to rising commodity prices are often the same factors that lead to stock prices falling. Increases in the price of oil for example are often accompanied by a weakened stock market. For an investor this means holding some commodities can protect your portfolio in the event that the stock market is wobbling.
  • Similarly, it can act as a hedge against inflation. Unlike stocks, commodity prices tend to move in line with inflation, meaning that investors could protect their portfolios from high inflation by holding a portion of it in various commodities.

risks

  • While the volatility of commodity prices can lead to large profits for investors, naturally, the opposite is also true. Investors who stake too high a percentage of their portfolio in commodities could be burned by large losses.
  • They are also, by their nature, a highly speculative investment. Unlike buying company stocks or funds which track the market there is no underlying strategy or past performance to judge them on. Commodity prices can be affected by unforeseen events which could threaten your investment.
  • Even professional investors find it near impossible to predict these movements in price. Those looking to the long-term would be better served by investing in ETFs with exposure to the commodity markets.
  • Those who invest in commodities via CFDs (as discussed earlier) must also beware the risk of being highly leveraged.
  • Leverage allows you to access potentially higher returns through borrowed money. It can massively amplify any profits, but on the flipside it can also multiply potential losses.
  • Generally, the higher the leverage the higher the risk. Investors can somewhat mitigate against these risks by putting in place stop losses, automatic instructions to sell if an asset price hits a certain level, which can limit the damage if a commodity unexpectedly collapses.

 

What is the future for commodities?

Predicting the commodities of the future or the direction of prices is incredibly difficult as they are so vulnerable to freak and unforeseen events. That being said there are some factors you can look out for that may signal what could be the commodity of the next 10 or 15 years.

Consumer or industrial trends play a major role in what raw materials will soar in demand.

For example, one of the products likely to grow massively in popularity over the next decade is likely to be electric vehicles. In the UK the sale of new petrol and diesel cars will be banned from 2030, while other countries are also promoting the push to lower polluting vehicles.

According to Deloitte, most analysts are predicting global demand for lithium to double or triple by 2030 as a result, while electric vehicles contain as much as four times the amount of copper as their petrol counterparts.

This could mean those raw materials could become a good investment, however it is near impossible to come to a conclusion with any certainty.

 

Are commodities for you?

Commodities are definitely a high risk, high reward investment. Anyone seeking to enter the space should ensure they fully understand the risks and proceed with caution.

That being said, there are opportunities for very healthy returns.

Tim Price of wealth managers Price Value Partners says, “Commodities haven’t been this cheap relative to US equities (for example) for 60 years. Given how much money central banks have pumped into the system since the beginning of the COVID crisis, the inflationary risks are quite clear: the only question is how much of them to own. Within our discretionary asset management business we have a roughly 40% allocation to commodities and real assets. Part of that is in the form of the monetary metals, gold and silver, and part in the form of the broader commodities complex, in the form of listed commodities businesses with little or no debt – but generating huge cash flows. I suspect we are at the beginning of a multi-year commodities bull market and we hate the idea of being in any way underweight the most compelling asset class in our investment universe.”

not for the faint-hearted

Nevertheless, commodity investing is unlikely to suit novice investors who would probably be better served looking at other asset classes, like investment funds or bonds.

However, for those who feel confident and have taken the time to properly analyse and understand the risks, commodities could be a good way to diversify an investment portfolio.

Investors should have a good understanding of supply-and-demand economics as well as historic and current price trends. CFDs should also be approached with extreme caution.

Disclaimer: MoneyMagpie is not a licensed financial advisor and therefore information found here including opinions, commentary, suggestions or strategies are for informational, entertainment or educational purposes only. This should not be considered as financial advice. Anyone thinking of investing should conduct their own due diligence.

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