Exposure to commodities is a portfolio diversification strategy that investors may explore, particularly during inflationary periods. Encompassing raw resources such as metals, oil and gas, agricultural products, and livestock, commodities investing has historically been viewed as a hedge against inflationary pressure.
What are Commodities?
Commodities are naturally occurring materials or goods that are extracted, raised, or grown and harvested and then used to produce essentials such as food, energy, and clothing. They differ from stocks in that commodity pricing is often standardized. The following are examples of different commodities that may be traded on an exchange.:
Precious metals are one commodity that can be used in the production of other consumer goods. Gold can be used as a base for jewelry, a form of currency, and has industrial applications in dentistry and the production of electronics. The value of gold can be affected by the laws of supply and demand, and the desire to purchase gold can be affected by systemic financial concerns, inflation, and war or political crises. Silver has some use cases that overlap with gold, like jewelry, electronic production, and currency, but silver is also used in batteries, superconductors, and medical products. However, silver’s value can be dependent on the use case – whether as currency or an industrial metal. For that reason, silver may be considered a more volatile product than gold and the value is potentially affected by its application. Platinum is a precious metal used in automotive catalysts, jewelry, computers, and also falls under the industrial metal category. Palladium is lesser known than gold, silver, and platinum, but has many industrial use cases. Catalytic converters, manufacturing, dentistry, medicine, jewelry, and groundwater treatment all use palladium in their processes.
Broad in nature, agricultural commodities encompass livestock, animal byproducts, grains, oils, seeds, lumber, cotton, rubber, and many others. The United States Department of Agriculture (USDA) found in 2020, the 10 largest sources of cash from the sale of U.S.-produced farm commodities were cattle/calves, corn, soybeans, dairy products, miscellaneous crops, broilers, hogs, wheat, chicken eggs, and hay. Agricultural products provide a source of food for humans and livestock from grains, livestock, and dairy. Also, some common products are clothing from wool and cotton, industrial building materials from lumber and rubber, and corn is an important ingredient in fuel production.
Energy commodities are those that are used for the production of energy. Encompassing crude and heating oils, natural gas, gasoline, coal, solar power, wind power, and hydroelectricity, energy commodities can impact our day to day life. Energy prices can affect the costs of many items we consume and can play a role in determining the prices for the other commodities listed within this blog, as energy may be required to turn those commodities into products and is typically needed to transport the finished goods to market.
Advantages of Commodity Investing
Historically, and in general, commodities have exhibited low correlation with the more traditional equity and bond asset classes over the long term. Broad exposure to commodities can serve to enhance portfolio diversification and reduce overall portfolio volatility. Commodity investing can be used as an inflation hedge, as commodity prices tend to rise when inflation increases.
Risks of Commodity Investing
Proceed with caution. Commodity prices can be extremely volatile, and commodity investing is associated with increased risk versus that of traditional investment methods. Prices can be affected by the weather, world events, tariffs and customs, government regulations, and economic conditions, and rumors.
Investing in commodities directly is possible, but for many investors, storing and maintaining the commodity may be expensive (precious metals), impractical (crude oil), or impossible (lean hogs).
Investment products that invest in commodities (commodity pools) may employ options, swaps, and futures – time-limited contracts for the future right to buy or sell the underlying commodity. Given price volatility and the uncertainty inherent in derivative investing, the value of the commodity pool shares may deviate from the value of the underlying commodities.
Investing in commodities via derivatives involves more than a passive “buy and hold” approach. Commodity futures expire, and maintaining a long-term position involves selling a contract about to expire and purchasing the next contract. The risk is therefore twofold – the shorter-term risk of selling low and buying high as the futures contract is continuously rolled forward and the long-term risk associated with the pricing of the underlying commodity asset.
Commodity investing can be complicated and should not be seen as a guaranteed hedge against inflation and other variable economic pressures. Visit the U.S. Commodity Futures Trading Commission to learn more.
Commodities are tangible goods we use in our daily lives and are key components in the production of food, clothing, and energy. Understanding commodities and how changing market conditions affect commodity pricing can help investors make informed decisions about participating in the commodity markets.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.