What is a commodity and what is the commodity market?

Historically, a commodity is something that many people need which can be traded for other commodities or money. Think about the basics of life here: food, shelter, warmth – we’re already covering a decent whack of modern-day commodities like agricultural crops, building materials, and energy products. Clearly, commodities and commodities trading has been around for as long as people have needed the basics of life (i.e., as long as people have been around!), and long before the advent of money.

What are commodities?

Just as old, is the relationship between the supply and demand for a particular commodity and how these factors impact its value as a unit of exchange. Unlike stocks, bonds, or non-fungible tokens (NFTs), commodities are generally quite difficult to procure. You’ve got to plant a crop, dig a great big hole, or pump something out from deep beneath the ground. It follows, the supply of certain commodities may sometimes become acutely constrained – often by unpredictable natural events such as droughts and floods, or by man-made events such as war and the pandemic.

As the demand for commodities, particularly those essential to life and industry, is generally very stable, history is littered with instances where the prices of certain commodities have spiked to levels well beyond what might have been considered normal up to that point. At other times, an abundance of a certain commodity (for example after a bumper global coffee crop) may cause the market to be flooded with excess supply. Put simply, there’s more of the commodity around than people can consume or store long enough to keep it fresh. In this scenario, the old rule of supply and demand works against the price of the commodity, and prices may be subdued for an extended period of time.

This is ebb and flow of commodity prices is often referred to as the “commodity price cycle”. If you’re going to invest in commodities, the commodity price cycle ensures you’ve got to stay on your toes! This is because commodity markets are notorious for prolonged periods of suppressed prices and then sudden and massive spikes. Ironically, the two are often related, and it is common for the commodity price cycle to play out like this:

1.  A shortage of a commodity (in an environment of steady or building demand) sends its price higher. Speculators and trend followers jump in on the demand side, pushing the commodity’s price even higher.
2. Producers or potential producers of the commodity, emboldened by higher prices, invest more into increasing their capacity to further produce it. As the process of securing funds, building the requisite infrastructure, and the eventual increase in production takes time, there is generally a lag between the triggering price increase and any eventual supply increase. Prices may rise exponentially in the meantime.
3. As supply increases, over time, demand is increasingly met, and prices stabilise.
4. Sometimes, overinvestment in supply causes too much production of the commodity to hit the market. The extra supply overwhelms demand, or potentially, demand patterns change and less of the commodity is required. In either scenario, prices decline, sometimes for a very long time.
5. In some cases throughout history, so much supply of the commodity has flooded a market, that prices fall so far it causes a significant amount of current production to become uneconomic. As a result, producers scale back production of the commodity, and some producers go bankrupt, never to return. A prolonged period of lower price for the commodity generally reduces investment in the capacity for its future production. This increases the risk that production is structurally unable to respond to an improvement in demand for the commodity down the track.
6. There is a pervasive shortage of the commodity due to a prolonged period of underinvestment in the capacity to produce it. Something occurs to re-spark demand for the commodity. Go back to Stage 1 and start the commodity price cycle again!

The major commodities & commodities markets

The COVID-19 pandemic has restricted the production and supply of a number of commodities that are vital to the global economy. In the face of steady demand, the prices of these commodities have in many cases skyrocketed. More recently, the war in Ukraine has further exacerbated the problem. The price of nickel, for example, exploded nearly 400% in just a few days on the London Metals Exchange, causing the exchange to shut down trading. As a result of these types of news events, investors are waking up to the opportunities that commodities trading offers.

Here is a summary of the major commodity markets:

Soft Commodities (Agriculturals)

Soft commodities are those which are grown. They are broadly divided into two categories:

• Grains – This group includes wheat, corn, coffee, cocoa, sugar, soybeans, fruits (like frozen orange juice concentrate) etc.
• Livestock – This group includes beef, pork, poultry, etc., but also products produced by or from animals such as milk, leather, and wool.

Hard Commodities

Hard commodities are those which must be mined or extracted from the earth in some way. There are four major categories of hard commodities:

• Industrial Metals and Minerals – This group includes metals used by the construction and manufacturing industries such as iron ore, nickel, copper, aluminium, and zinc, but also minerals such as spodumene, which can be refined to produce the lithium compounds used in rechargeable batteries.
• Precious Metals – This group includes gold, platinum, palladium, and silver.
• Building Materials – This group includes lumber and stainless steel.
• Energy – This group includes hydrocarbon-based commodities such as crude oil, natural gas, heating oil, and coal, but technically, uranium is also considered to be an energy commodity.

How you can invest in commodities

What’s the main difference between stocks and commodities? Well, it’s easy to buy one share, store it while you need it, and then sell it when you don’t. As a bonus, that share won’t take up any space and it won’t spoil while you’re holding it. You might even earn a regular return such as a dividend in the process, therefore reducing the opportunity cost of owning the share.

Commodities…hmmm, well, not so much! If you wanted to get exposure to the rising price of oil, it wouldn’t be very practical to drive down to your local oil well, buy a few barrels, load them in the back of your SUV, and then drive them home and stack them behind the shed! Another drawback of owning the barrels is that they won’t earn you any income while you own them. Worse still, in some cases, it might actually cost you money to store your commodity safely.

Fortunately, there are some very easy ways for us everyday investors to trade in commodities without having to make space in the backyard! Commodity stocks, exchange-traded funds (ETFs), futures, and CFDs are the most practical ways we can invest in commodities without ever having to own them. Let’s investigate each option in detail.

Commodity stocks

One obvious way to get exposure to rising commodity prices is to invest in stocks that produce and sell the commodity you’re interested in. For example, if you thought the war in Ukraine was going to cause the price of crude oil to rise, you could buy shares in an oil producer like Woodside Petroleum (WPL). Indeed, in the three weeks following the Russian invasion of Ukraine, the price of Woodside shares rose 20% as the price of crude oil increased 23%.

But there are a few potential disadvantages to investing in commodity stocks. The value of any stock is based upon what investors are prepared to pay for its future profits. Investor sentiment can be volatile — so it is possible that the price of a commodity your company produces increases, but other investors don’t bid up its stock price accordingly.

This may occur for a variety of reasons. For example, a company’s management must balance costs against revenues to earn profits. Costs are often volatile, especially when commodity prices are rising, and are largely beyond management’s control. Rising costs of production will likely impede the company’s future profitability and therefore make its stock less attractive to investors.

It’s also possible that the company has large debts to service (interest rates and commodity prices tend to be positively correlated, and therefore they tend to rise at the same time). A higher interest expense for the company may crimp its profits and this will also drag on its stock price. Alternatively, management may have put in place hedging contracts that limit the company’s upside exposure to an increase in the price of the commodity it produces. Now, tip in geopolitical risks, supply chain constraints, labour shortages, and the list goes on and on! The upshot? Well, it’s possible you were correct in your call that the price of oil was going to go up, however, the price of the oil stock you chose did not.

Exchange Traded Funds

There are several ETFs available on the ASX that aggregate exposure to a number of stocks that produce a particular commodity. This gives you significantly greater diversification than investing in a single stock exposed to your target commodity, but it doesn’t eliminate entirely the risk that you get the commodity price right and your investment wrong. The ETFs currently available on the ASX which fit into this category include:

• ETFS Battery Tech & Lithium ETF (ACDC) – ACDC provides exposure to a broad range of battery technology stocks, but with respect to commodities, investors may like the fund’s approximately 10% exposure to lithium stocks including Pilbara Minerals (PLS).
• Betashares Global Agriculture ETF (FOOD) – FOOD tracks a large number of global agricultural companies, but also those involved in supplying inputs to the agricultural industry.
• Betashares Global Energy Companies ETF (FUEL) – FUEL tracks a large number of global energy companies including Chevron, Exxon Mobil, Shell, and Conoco Phillips.
• Betashares Global Gold Miners ETF (MNRS) – MNRS tracks a large number of global gold mining companies including Newmont Mining and Barrick Gold.
• Betashares Australian Resources Sector ETF (QRE) – QRE tracks a large number of ASX listed resources companies including BHP, Rio Tinto (RIO), Woodside Petroleum (WPL) and Fortescue Metals Group (FMG).

Other ETFs are backed by physical holdings of the commodity, or by futures contracts which give them the right to purchase the commodity. The prices of these ETFs are far more likely to have a close correlation with the price of the underlying commodity they’re exposed to. The ETFs currently available on the ASX which fit into this category include:

• ETFS Physical Gold (GOLD) – GOLD provides exposure to the gold price and is backed by physical gold bullion. This means investors can choose to redeem their ETF holdings for actual gold (conditions and fees may apply).
• ETFS Physical Silver (EPTMAG) – Same idea as GOLD, but for silver.
• ETFS Physical Platinum (ETPMPT) – Ditto again, but for platinum.
• ETFS Physical PM Basket (ETPMPM) – Ditto, but this time you’ll get exposure to gold, silver, platinum, and palladium.
• Betashares Gold Bullion ETF (QAU) – Betashares’ version of a physical gold-backed ETF.
• Betashares Crude Oil Index ETF (OOO) – OOO provides exposure to the oil price byways of holdings in various futures contracts on crude oil.

There’s a great deal to learn when it comes to getting started in commodities trading. We’ve gone over the basics here including the types of commodities which exist and some of the instruments you can use to invest in them. However, we haven’t discussed the need to monitor the fundamental drivers associated with a particular commodity which could impact its supply and demand. Clearly, these are likely to be both diverse and dynamic. For this reason, aspiring commodity investors will need access to up-to-date information for their chosen commodity, and/or to have a firm grasp of technical analysis concepts.

But, whilst at times certain price drivers might be complex, it’s also fair to say that when it comes to some commodities, for example, crude oil, we’ve probably had a lifetime of watching and understanding certain occasional market-moving forces such as war. This guide is a first step in inspiring you to do something with that knowledge, and therefore to investigate commodities investing further.

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