There’s a lot of talk now about where the stock market is going from here and what investments might do well if the stock market does badly. One classic alternative to buying stocks is investing in commodities, which move independently from the stock market and so act as a hedge against stock market losses. But investing in commodities is a completely different ball game than investing in stocks. I understood very little about commodities, so I have been trying to dive in and figure them out.
What is a commodity?
Commodities are physical, tangible, assets, like gold or oil or copper or wheat. They are called commodities because they are undifferented, one ounce of gold is just like any other ounce of gold, one pound of copper is just like any other pound of copper. The market for commodities is international. Their price is determined not by the company that mines or drills or produces them, but by what global buyers are willing to pay. And that price is usually determined by how badly the commodity is needed and how much of it is available, and both of those factors go up and down over time.
Commodities are divided into several groups:
- Energy (oil, gas)
- Industrial metals (copper, aluminum)
- Platinum (apparently a category of its own)
- Precious metals (gold, silver)
- Other metals (lithium, rare earth metals)
- Agriculture - grains (wheat, corn)
- Agriculture - softs (sugar, coffee)
- Livestock (cattle, hogs)
There are also value-added commodities, like chemicals, and miscellaneous commodities like uranium.
There are lots of steps in making a commodity available to the market. In the case of oil and metals, land has to be purchased or leased, deposits have to be discovered, the commodity has to be extracted, processed, stored until needed, and transported between all of the places where these activities take place until it ends up in the hands of the final consumer. Some of the supply of any commodity exists in all these stages of production, and that distributed supply, collectively, makes up the supply of the commodity.
Some commodities, like oil and wheat, are used up when consumed, and have to be replaced by starting the whole process over again. Other commodities, like silver and gold, can be stored and retain their value indefinitely.
Commodity Prices
The supply of any given commodity is limited. Nobody can create it out of thin air. Theoretically, the fixed supply of a commodity should put a floor under the price, but that doesn’t happen. The price of a commodity represents a balance between the current supply and the current demand. If supply is greater than demand, the prices goes down. If demand is greater than supply, the price goes up.
The price of commodities is influenced by many things:
- In times of inflation, commodity prices generally go up, commodities are considered a good hedge against inflation.
- During recessions, commodity prices generally go down because commodities are critical to the production of various products, and production may dry up in a recession.
- In booming economies prices go up because everyone wants and can afford the things that commodities go into.
- The supply of agricultural commodities are vulnerable to weather and drought and war, which can drive their prices up when the supply goes down.
- A previously “hot” commodity may lose its value when someone discovers some new technical innovation that reduces or avoids the use of that commodity.
- Commodities are vulnerable to behavioral changes. People may decide to quit using a commodity that gets too expensive and start using a different one instead, or just do without.
- Prices of precious metals are affected by the perception or hope that they are a hedge in bad times or inflation.
- Commodities can be left in the ground or in storage if prices are unattractive, which limits supply, which might end up causing prices to rebound.
- Prices are affected by local government policies and controls, like import/export limitations and restrictions on new development. Restrictions can drive up prices, and loosening of restrictions can push them down.
- Many commodity markets are vulnerable to speculation, which also impacts prices.
Commodity prices are relatively low right now, in mid 2023. The question is what direction they might go in the future. Many experts believe that commodity prices are destined to go up in the long term:
- There hasn’t been a huge investment in metal and oil extraction and processing in the last few years, so the supply of metals and oil is lower than it would otherwise be.
- Russia and China contain huge supplies of many commodities. As relations between the US and those countries sour, commodities sourced in those countries may become inaccessible to us and we may need to find new, friendlier, sources.
- Mining and drilling and processing are dirty processes and nobody wants them nearby, so mines and processing plants need to be in friendly locations that are not near people, and permits and construction can take years. All of that increases the cost, reduces the supply, and ultimately increases the price.
- The green energy revolution will require lots of metals for cars and batteries and fortification of the electric infrastructure, and there is already an undersupply of the metals needed. That far ranging and long term demand should drive metal prices up.
- Higher interest rates make huge, risky, investments like mines much more expensive, which will restrict supply and increase prices.
Investing in Commodities
If it makes sense to invest in commodities, the question is how exactly to do it. It’s inconvenient, if not impossible, for an individual investor to take actual delivery of investment levels of commodities. Investing in commodities usually means one of two things:
- Investing in companies that own or extract or store or transport a commodity.
- Investing in the commodities futures market.
The futures market exists because of the length of time it takes to find, extract, process, and deliver commodities, and the big up front investment that is required. The companies that perform the early steps want some certainty about what they will get paid for their work, and they need to evaluate future demand to see if they should increase or decrease production. The futures market allows them to enter into contracts with purchasers at a specific price at a specific time in the future. Both parties in the futures contracts are taking a risk that actual prices will move against them before the contract settles, but at least they know what their commitment is.
The futures markets create multiple prices for a commodity, the “spot” price, or the current price for immediate delivery, and future prices at various specific dates in the future. If the future price is less than the spot price, that is called backwardation. If the future price is more than the spot price, that is called contango. Both of those conditions are analyzed by traders to judge where prices are going.
The futures market is not a place for individual investors. Most futures contracts are huge. They are also very heavily leveraged, meaning investors only put up a small percentage of the cost ahead of time. Leverage increases the gain for contracts that do well, but also introduces the possibility of devastating losses if the price goes the wrong way. Someone can be completely right about the future direction of the price and still lose big if that doesn’t take place by the time their contract expires.
Since investing in futures via ETFs is one of the only ways to invest in commodities, there is a lot of activity other than the commodity producers and consumers, and commodity markets, and ETFs can become very skewed. For instance, at the beginning of the Ukraine war many investors, anticipating a wheat shortage, piled into wheat futures via an ETF, which totally distorted the ETF’s returns.
Nothing about investing in commodities is “safe” or “guaranteed”. Prices can fluctuate wildly on a dime. Commodities aren’t like stocks or bonds, it’s important to understand how they work and when to get in and get out.
Resources
(1) Saxo Market Call Special Edition: How to invest in commodities through futures and stocks - A great source of information about commodities investment from expert Ole Hansen.
(2) A Wheat ETF Teaches the Meme Crowd a Lesson the Hard Way - “the Teucrium Wheat ETF and the only U.S. ETF tracking wheat—was unable to handle the volume of cash that was flowing into the fund from investors looking to profit from a record rally in the price of the grain ... the ETF ended up trading at an unusually large 9% premium above the fund’s net asset value. So, anyone who bought the shares significantly overpaid for the underlying assets.”
(3) Excessive Speculation in the Wheat Market - “Traders’ steady purchases of futures to buy wheat have had a one-way impact on futures prices--pushing the prices up. In addition, their purchases have created a steady demand for wheat futures, without creating a corresponding demand in the cash market.”
(4) MacroVoices #358 Robert Friedland: Geopolitical outlook & Geothermal Energy Revisited - Every solution to the energy transition is metal-intensive, the war is using up most of the existing inventory of metals like copper, and there isn’t enough copper left to mine in places where it is actually feasible.