What are commodities and how do people invest in them?

Commodities are raw, physical assets like oil, livestock, wheat or sugar, that are used in the manufacturing of finished products. These commodities can be traded in many different ways, including through futures contracts and exchange-traded commodities (ETCs).

• A commodity is a physical asset. There are hard commodities (metals and energy) and soft commodities (agriculture).

• Commodities are most often traded through futures contracts in derivative commodity markets. 

• ETCs are an alternative way of trading commodities for those who don’t have access to commodity markets.

• Commodities are considered to be a good hedge against inflation and a way to diversify investment portfolios.

Let’s look a little closer at how to invest in commodities.

What are commodities?

Commodities are physical, tangible assets. Unlike finished products, commodities are raw materials like oil, livestock, corn, sugar or metals used to create other products. The market distinguishes between two categories of commodities: hard commodities, which includes energy and metals, and soft commodities, which are agricultural assets like corn and wheat. 

Commodities can be traded for commodities of the same type and, in order to uphold the global standard of traded commodities, they must be of the same quality. It doesn’t matter where a commodity is produced as long as it meets the universal grade. For example, corn from the United States and corn from France is considered to be the same commodity as long as they are of the same grade.

What determines the value of a commodity?

The supply and demand of the market are what determine the value and trading price of commodities. If the supply of a commodity like wheat or coffee increases, then the price of each unit of that commodity will decrease. And if the demand for a commodity like oil increases, as it tends to in hotter seasons, then the price for one barrel of oil will also increase.

The supply of certain commodities is also heavily dependent on external factors like weather or the political climate of their production region. In agriculture, one season of too much rain or too much sun can ruin entire crops, thereby severely limiting the supply and driving up the prices. Similarly, if oil-supplying countries like those in the Middle East find themselves in local or international political conflict, this might affect the price of oil.

What are futures contracts?

One of the most common ways of investing in commodities is through commodity markets, specifically derivative markets. Here is where experienced investors can buy or sell, hedge or speculate through futures contracts. Futures contracts allows commodity sellers and commodity buyers to agree upon a fixed quantity, price and future delivery date of the physical commodity. When the price of a commodity increases, so does the value of a buyer's contract while the seller suffers a loss, and vice versa. More often than not, contract holders close their contracts or let them roll over before the physical commodities can actually be delivered.

As the production of commodities, particularly agricultural crops, is not consistent year-over-year, there is an inherent risk involved in these types of investments. Futures contract holders are essentially speculating on the outcome and price of the underlying asset, which significantly increases their financial exposure.

What are Exchange-Traded Commodities (ETCs)?

ETCs allow investors who do not have direct access to commodity markets to buy and sell commodities, either individually or as baskets. ETCs are traded on an exchange just like stocks, tracking the price of their underlying commodity and fluctuating in sync with that price. 

When investing in ETCs, investors do not actually have ownership of that commodity. Instead, the ETC functions as a debt note or a token. It is representative of the commodity, but it is not actually backed by physical assets. This makes ETCs different from investing directly in metals, for example – but also less risky. Investors enjoy the benefits of investing in commodities without the risk of having to pay the difference in their futures contract or being stuck with the delivery of sixty hay bales to their doorstep. ETCs therefore present a viable alternative to complicated futures contracts and are especially useful for inexperienced commodity investors. 

Exchange-Traded Commodities (ETCs) vs. Exchange-Traded Funds (ETFs)

Although they sound similar, ETCs and ETFs are not the same thing. ETCs can track one single commodity like wheat, or track baskets, like multiple types of wheat or a group of agricultural commodities, including corn, soybeans or cotton. This makes ETCs much more specific than ETFs, which are broad and include securities from a wide variety of companies from different industries.

Investing in commodities

Since the commodity market is independent from the stock and currency market, it is not usually affected by their volatility. The value of commodities can fluctuate quite dramatically, however, depending on the current supply and demand situation of the market. The price of oil, for example, can be heavily influenced by conditions of war or political conflicts in certain regions. Similarly, if it was a particularly good year for wheat and there is an oversupply, the price typically goes down accordingly, and vice versa if there is an undersupply of wheat. 

Still, some experts argue that since commodities are goods that are needed by most modern countries, they therefore have an inherent value. As prices go up during inflation, so do the prices of commodities, making them a good hedge against inflation. 

Some experts also recommend commodities as a smart way to diversify your portfolio and spread your risk across several uncorrelated asset types. Since commodities are relatively uncorrelated with stocks, fiat currencies and cryptocurrencies, they are considered to be a good way to diversify.