Understanding commodities

Did you have some orange juice at breakfast this morning? Or perhaps you had a slice of toast, some bacon and a coffee, before getting in the car and stopping off at the petrol station? You may not be aware of it, but all of these activities involve commodities.

Certain types of commodities are important in our everyday lives, but they are also important as a specific class of investment. Commodities that come under this category include:

  • Agricultural products, such as wheat, coffee, orange juice, sugar, soya beans and corn
  • Livestock, such as cattle and hogs
  • Precious metals, such as gold, silver and platinum
  • Industrial metals, such as lead, zinc and aluminium
  • Energy products, such as natural gas, oil and ethanol
  • Miscellaneous items, such as wool, rubber and palm oil

The trading of commodities plays a major role in investment markets around the world and the price fluctuations have a big impact on world economics. Commodities can also play an important role in personal investment portfolio, depending on an investor needs and risk profile.

How do commodities differ from other investments?
From an investor’s point of view, commodities have some characteristics that differentiate them from other forms of investment, such as shares, bonds and bank accounts. By their very nature, commodities are subject to risks and costs, such as storage costs, delivery costs, weather, physical deterioration and political instability. For example, with a large portion of the world’s oil being produced in Middle Eastern countries, any political upheaval in that area may affect the continuity of supply and this could impact price. Similarly, a warehouse full of corn or wheat may perish. These risks are not likely to affect other types of paper investments like bonds and shares.

These factors make commodity investment particularly volatile and risky, requiring specific skill, knowledge and a continual vigilance over a range of issues that may affect prices and markets.

Another differentiating factor is that commodity investments do not generate income and the gains to be made on commodities are instead based on the trading price on the market. A successful operator in commodities markets can make significant gains through shrewd trading and this is where the opportunity may exist for some personal investors.

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The Middle East is home to vast amounts of the commodity oil

How can you invest in them?
In the same way that shares can be bought and sold on a share market, commodities are traded on a commodity market. There are around 50 designated commodity markets around the world and billions of dollars in commodities are traded every day. These markets are not involved in the physical movement of the material itself, but rather the exchange of ownership rights.

Unlike a share market, however, commodity markets are not directly accessible to personal investors, as it is impractical for them to access the trading floor. The nature of most commodities also makes it highly unrealistic to physically purchase and hold commodities directly (with the possible exception of precious metals like gold).

The way investors can gain access to commodity markets is through a managed fund, where the manager has a particular skill or specialisation in commodities. Another alternative for investors is an exchange traded fund that focuses on commodities and seeks to track a commodities index.

Investors can also choose a more indirect way of investing in commodities by owning shares in companies that are directly involved in the production of commodities, for example a mining company.

How do commodities affect the global economy?
In general, developed and industrialised countries tend to be net importers of commodities, while resource-rich developing and emerging countries tend to be net exporters. This means the price rises favour those developing countries and price falls benefit developed countries.

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Did you know? Your morning coffee is part of one of the world's most sought after commodities

Australia is one of the exceptions to these rules. As a developed country that has rich resources, we are a net exporter and rely heavily on that export income for our balance of trade. The growth downturn in the industrial powerhouse of China has had a well-publicised impact on our resource miners and exporters, as our largest market has reduced demand and the prices have dropped as a result. Other large commodity producing nations, such as Brazil and Russia are in a similar boat to us and in fact their economies are currently going in reverse.

These dynamics, however, are not always as simple as this. The world is now a lot more interconnected and interdependent, due to globalisation. As consumption has increased in emerging countries thanks to their commodity riches, the industrialised developed countries have come to depend on them as a market for their production. If low commodity prices impact an emerging country’s economy it therefore means the developed nations will also suffer from a drop in demand for their output.

Like any other investment market, commodity markets can be vulnerable to market sentiment and negative issues, such as political instability, banking crises and governments losing debt credibility. This can cause volatile movements, which underscores the need to be cautious when investing in commodities markets.

How to capitalise on opportunities
The potential for attractive gains on commodity markets makes them an important element for personal investors to consider, but the considerable risks involved means that your investment objectives, timeframes and risk profile need to be carefully considered. Professional financial advice can help you assess these factors and help you determine the best method to incorporate commodities in your portfolio.

What do you feel are the risks and opportunities of commodity investment? Let us know below.

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