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Investing In Commodities

How One Invests In Commoditiies

As the prices of commodities have such broad-reaching effects on the economy, an investor can take advantage of changes in commodity prices in several ways.

Generally speaking, coverage or discussion of commodity prices is in terms of futures prices, wherein the buyer is paying for a specified quantity of the commodity for delivery at a later, predetermined date. It should be noted, however, that seldom does a futures investor actually receive the commodity in question, but instead sells it to some other buyer upon the contract’s expiration (if not before). Futures trading reduces the risk for producers of commodities – a good example is a farmer, who must risk the cost of producing agricultural goods without knowing the price they will earn on the market several months later. In this case, futures contracts assure the farmer that he will be paid for the commodity when it is ready for delivery. Spot prices are another means of valuing commodities, wherein the buyer pays the commodity’s producer for the immediate delivery of the product. Spot prices can be thought of as the amount of money a buyer would pay a producer for the latter to throw the commodity into the back of the former’s truck right now. A more indirect way to invest in commodities would be to buy or sell the stocks of companies that are most affected by the commodities in question. For example, one could bet on an increase in oil prices by buying stock in Exxon Mobil (XOM) or BP (BP). By contrast, if a company has a harder time passing the cost of the commodity onto the consumer would likely see a decline in net income with higher commodity prices. As such, one could take advantage of climbing oats prices by short selling stock in General Mills (GIS).

Commodity Prices Are Heavily Inter-Connected

Commodities prices, more so than stocks or currencies are vastly inter-dependent; that is to say the price of one commodity depends heavily on the prices of other commodities as their production and transportation often require the use of, or are in some way intrinsically linked to, other commodities. For example, the ability to raise and deliver beef requires a significant input of feed grains. As such, if demand for beef increases, so too demand for grains. If demand for beef increases dramatically, grains producers may convert their land for the raising of cattle instead of grains to realize more profit from the highly demanded beef. Conversely, if the supply of feed grains is somehow diminished (bad weather, for example) the price of beef will likely increase to reflect this grain scarcity, as will the price of grain itself. Further, both grains and beef must be transported from their production center to the delivery location, which requires the use of oil. An increase in the price of oil then necessarily creates higher prices for beef and grains.

Commodity Prices Have Immense And Far-Reaching Impact On The Economy As A Whole

As commodities are the raw materials and goods used in the production of finished goods or the facilitation of services, even small fluctuations in commodity prices have far reaching effects on industries or the economy in general. For example, in the above described grain/beef relationship, an increase in the price of grain necessitates an increase in the price of beef, which in turn would have direct effects on either the stock prices or profit margins (or both) of the fast food industry, the grocery industry, and the restaurant industry.

Commodity Prices Are Dependent Upon Global Currency Values

For commodities traded internationally, the strengths of producers and consumer’s currencies can affect the prices of the commodities. For example, even if Brazil (the world’s leading sugar producer) produces an abundance of sugar in any given year, if the Brazilian Real is particularly strong relative to other currencies, sugar prices will remain inflated.

Commodities Booms And Busts

The global boom in commodity prices in 2008 – for everything from coal to corn – was fueled by heated demand from the likes of China and India, plus unbridled speculation in forward markets. That bubble popped in the closing months of 2008 across the board. As a result, farmers could face at times more volatile crop prices, after years of record revenue. Other commodities, such as steel, are also expected to tumble due to lower demand and failing economies. This might be a rare positive for manufacturing industries, which will experience a drop in some input costs, partly offsetting the decline in downstream demand. In 2012, many commodities have come down a long way off their highs, but weather risk may cause some commodity prices to begin going up again. See the section on “Weather Bias Commodity Risk” please.

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