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Commodities (pt 1)

This is an article about commodities and how they relate to investing in general, not Orbis Access in particular.

Investing in commodities

Not everything gets to be a commodity

What is a commodity?

In the world of investing, commodities are usually physical goods often used to produce other goods and services. Their distinguishing feature is that they are interchangeable.

For example, if you buy a TV you might care whether it was made by Samsung or Sony. Televisions come in a variety of sizes and have different features. They aren’t all the same.

Compare that to a barrel of oil. One is very much like another and you probably don’t care where it came from so long as it meets a minimum standard. TVs aren’t a commodity. Oil is.

One commodity with a high profile in recent years has been gold. This is partly because it is viewed as a possible alternative to paper currencies, which looked less stable in the wake of the Financial Crisis of 2008.

But there are plenty of other commodities. Some are well known, others less so. They include:

  • metals - such as copper and silver
  • energy - oil, coal, gas
  • foodstuffs - wheat, corn, sugar
  • other natural resources, like cotton

In recent years the list of tradable commodities has grown and includes services (internet bandwidth, say). Foreign currency – when bought and sold in pursuit of profit – is sometimes referred to as a commodity too.

Advantages of commodities

Commodity prices may not move in sync with the stock market, which can be useful. If your shares take a battering, it may be that commodities are doing just fine – or vice versa. Investing across assets that don’t share price movements helps manage risk.

Commodities are also thought to provide a degree of protection against inflation. After all, if goods and services are getting more expensive it could be because commodity prices themselves have risen.

Disadvantages of commodities

Firstly, the price of a commodity doesn’t necessarily go up in real terms over the long term – and they don’t generate income (as company share dividends might).

Take a look at oil. There has been a rising world population and it was the defining energy product of the 20th century. And yet in real terms, the price of oil only returned to the peaks seen during the 1860s a century later. That’s a long wait. What’s more, the price soon crashed back down again close to its long-term historical average, before climbing again more recently.

Oil price, adjusted for inflation

Commodities 1B

Source:   BP (crude oil prices)

The second disadvantage relates to the practical issue of buying and selling commodities. Commodity trading involves derivative contracts (more on this later). This opens the possibility that the contract isn’t honoured.

Derivatives

Company shares are just pieces of paper – or electronic blips nowadays – and easy to trade. Physical commodities take up more space in the filing cabinet. Squeezing £1m worth of oil in there could be a problem.

The upshot is that commodities are commonly traded as ‘futures’. These are a type of contract, which require delivery of a set amount of the commodity for a particular price on a given date in future.

This is an example of a derivative contract – because rather than giving you outright ownership of an asset, it gives you rights to something derived from an underlying asset.

Imagine you held such a contract for wheat. If the wheat harvest is much better than expected, the price of wheat will drop as supply increases. Then your contract will probably lose value – because the price stipulated in the contract will likely be higher than the going market rate at the time.

If the harvest turned out to be terrible, there would be less wheat available and prices could rise. This means that the price you are contracted to pay could well be lower than the market rate. In this case, your contract has become more valuable.

In practice, futures contracts are often traded on a ‘margin’, which means that you don’t have to pay the full value of the contract up front. This has the effect of amplifying your gains, but also your losses and means you could lose more than 100% of your initial stake.

Are commodities for me?

Businesses may buy and sell such contracts to make life more predictable. For example, some airlines buy jet fuel futures to know what they’ll be paying in advance. This helps them plan ahead financially.

However, there are also speculators and investors who seek to make money solely from movements in price of the contracts. They never intend to get to the point where the commodity in the contract is actually delivered to their doorstep.

The additional complexity inherent in derivatives introduces a particular set of risks. The upshot is that while experienced investors and traders are no strangers to commodities, they are less common among everyday investors.

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