What You Should Know About Investing In Commodities
Recent strong performance has attracted a lot of neophytes. They may have much to learn.
5 min
After years in the investing wilderness, commodities are hot again. And it looks as if the rally may continue for at least the foreseeable future, some analysts say.
The speed of the rally has been striking. The Refinitiv/CoreCommodity CRB Index, which tracks a basket of commodities selected to represent prices of futures contracts across the whole sector, doubled from April 2020 through mid-February.
That performance follows a yearslong period when the index trended lower. And the surge is now attracting investors of all types—from veterans to neophytes.
The latter would do well to understand some of the basics in how commodity investing works. Commodities typically get grouped into three broad buckets: energy, foodstuffs and materials. Each has endemic risks, including weather, local and geopolitics.
Each also offers the possibility of direct investment, in the commodities themselves, or indirect investment, through vehicles such as mutual funds and exchange-traded funds. For the relatively inexperienced, direct investing in commodities can be particularly challenging, in part because of additional costs and risks generally not found in other types of investing. We’ll get to those details in a moment.
What follows is a look at some of the basics of commodity investing.
Complicated economics
The price of each commodity gets determined by the supply and demand dynamics for that item. For instance, last year bad weather in Brazil hurt the coffee crop and pushed up the cost of beans. Likewise, an attack on an oil-refining plant in the Middle East will tend to disrupt supplies and spark an energy-market rally.
Commodity markets are global. What happens in one country can have an impact on commodity prices world-wide. Therefore, all commodity investors should keep an eye on what’s happening not just in the U.S. but around the world.
While even just the risk of war can send prices higher for commodities, particularly those that originate in the countries directly involved, actual invasion tends to send those prices even higher. That is exactly what happened with the conflict between Ukraine and Russia as both countries are leading exporters of foodstuffs. Although the invasion began on Feb. 24, prices were rising long before. A bushel of wheat is fetching $13.48, up 77% from $7.61 at the beginning of February on fears that global supplies would be disrupted. Likewise, corn prices have rallied 21% over the same period. Such surges added to those already happening in the commodity markets. Even before the war, unfavourable weather- and pandemic-related disruptions across the world were reducing supplies and sending prices higher when production couldn’t keep up with demand.
Sometimes a price change in one commodity causes the cost of another one to move as well. One typical example is in livestock farming. Farmers sometimes switch from feeding hogs or cattle with costly grain to less-pricey alternatives. They might decide to buy corn from arable farmers instead of wheat or vice versa depending on the relative prices. In turn, those prices change to reflect the new demand for each product. This phenomenon shouldn’t be too surprising. Imagine if the cost of aged blue Stilton increases at the supermarket; at least some people will likely switch to a less-expensive cheese.
Price swings
Unlike commodity traders and other professionals whose direct positions in oil or grain might change from second to second, average investors in commodities will have longer time frames in mind for their commodity-related holdings. But a simple buy-and-hold strategy here won’t help you accumulate wealth as it would in the stock market.
Commodity prices can frequently trend lower for decades. New technologies, such as better farming techniques or methods of mineral extraction, have allowed supplies to increase over time, depressing prices.
For instance, oil hit a record high of around $147 a barrel in 2008 versus the current price of $115.68. Likewise, Arabica coffee prices peaked at $3.35 a pound in 1977 versus $2.24 now. When these prices get adjusted for inflation, the declines look starker.
Thus, even for individual investors in commodity-related investments, timing in these markets can be critical. Whether you think of your investment as short term or long term, investors need to pay attention to buy at the right moment and sell at an auspicious one. Lean-hog prices tripled from 37 cents a pound in April 2020 to $1.20 in June 2021 before collapsing to 72 cents in October. Anyone not ready for such swings will be in for a shock and an emotional roller coaster.
Adding commodities to a larger balanced portfolio can also help reduce risks as commodity prices tend to have low correlation to other assets such as stocks and bonds. That means when the S&P 500 falls, commodity prices may go up, or down, or not move at all.
One more advantage to investing directly in commodities rather than commodity companies is that a layer of risk is removed. When investing in stock there is always the possibility that management may make mistakes even when the underlying sector economics are favorable.
The futures market
Commodity investors typically don’t operate in the cash market, meaning they don’t purchase physical materials such as metals, oil, or foodstuffs. Instead, traders mostly buy or sell futures contracts in the hope of benefiting from the increase or decrease in prices. These contracts are legally binding agreements to buy or sell a specific volume of a commodity on a specific date in the future.
Ultimately, the prices in the futures market and those in the cash market will tend to converge. That’s why commodity producers and consumers use futures to hedge the risks of market price movements.
No dividends
Most stocks pay dividends to investors, meaning you can make money even if the share prices don’t move. Pretty much the opposite is true for commodity investors. It costs money to own commodities. For example, a buyer of 100 ounces of gold bullion will need to cover the costs of storage and insurance for the metal. While such expenses can be low for precious metals, they can stack up faster for crude oil and grains such as wheat and corn as more extensive facilities are needed to hold the stuff.
Mutual funds & ETFs
For fund investors, there are many choices. More than 150 mutual funds and ETFs cover the sector. Unfortunately, that means much due diligence is required. In short, it’s essential to understand what the fund owns and what its strategy is.
Just as with stocks, there are both passive funds (those that track a benchmark index) and active ones (those that follow a discretionary investing strategy).
In the passive category, some track the price of single commodities, such as SPDR Gold Shares ETF (GLD) and Invesco DB Gold Fund (DGL), which track slightly different benchmarks. Likewise, there is an ETF for wheat, Teucrium Wheat (WEAT). There are also passive funds that are designed to track groups of commodities, such as Invesco DB Base Metals (DBB), or the whole sector, such as iShares S&P GSCI Commodity-Indexed Trust (GSG).
Actively managed funds, such as the active ETF First Trust Global Tactical Commodity Strategy Fund (FTGC), make decisions on what commodities to buy or sell.
A warning on leveraged funds
There are a couple of wrinkles to watch out for with all types of funds. First, average investors should avoid any fund that uses leverage to enhance performance. Such funds often promise to deliver two or three times the performance of a given commodity. While that means such funds can deliver multiplied profits, they also magnify losses.
Other funds claim that they’ll mimic an inverse performance so that if a commodity’s price falls, the fund will increase in value by a similar amount. This isn’t the same as a hedge against losses unless the trade is made specifically to diversify risk within a larger portfolio. Another problem with these funds is that there can be significant tracking errors. These funds are best left to sophisticated investors.
It’s also worth being cautious about exchange-traded notes, or ETNs. This type of investment can expose investors to the risk that the fund company goes bust. ETFs and mutual funds protect investors against such events.
As with all investing, investors should find funds with low expense ratios. Annual fund expenses mainly range from 0.5% to 1%. Leveraged funds tend to have expenses of 1% and more. These compare with costs of 0.09% for SPDR S&P 500 ETF, which tracks the S&P 500.
Riches and rags
Investing guru Jim Rogers famously made a boatload of money during the 1970s investing in the commodity markets while material prices and food costs jumped. And there will likely be other people who do similarly again.
However, even the most sophisticated investors sometimes come unstuck, such as the Hunt brothers. In 1980 they accumulated major positions in the silver futures market using borrowed money. But a change in exchange rules led to a price drop, and quickly the brothers couldn’t cover their obligations. In other words, be careful in the commodity markets.
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Food prices continue to rise at a rapid pace, surprising central banks and pressuring debt-laden governments
4 min
LONDON—Fresh out of an energy crisis, Europeans are facing a food-price explosion that is changing diets and forcing consumers across the region to tighten their belts—literally.
This is happening even though inflation as a whole is falling thanks to lower energy prices, presenting a new policy challenge for governments that deployed billions in aid last year to keep businesses and households afloat through the worst energy crisis in decades.
New data on Wednesday showed inflation in the U.K. fell sharply in April as energy prices cooled, following a similar pattern around Europe and in the U.S. But food prices were 19.3% higher than a year earlier.
The continued surge in food prices has caught central bankers off guard and pressured governments that are still reeling from the cost of last year’s emergency support to come to the rescue. And it is pressuring household budgets that are also under strain from rising borrowing costs.
In France, households have cut their food purchases by more than 10% since the invasion of Ukraine, while their purchases of energy have fallen by 4.8%.
In Germany, sales of food fell 1.1% in March from the previous month, and were down 10.3% from a year earlier, the largest drop since records began in 1994. According to the Federal Information Centre for Agriculture, meat consumption was lower in 2022 than at any time since records began in 1989, although it said that might partly reflect a continuing shift toward more plant-based diets.
Food retailers’ profit margins have contracted because they can’t pass on the entire price increases from their suppliers to their customers. Markus Mosa, chief executive of the Edeka supermarket chain, told German media that the company had stopped ordering products from several large suppliers because of rocketing prices.
A survey by the U.K.’s statistics agency earlier this month found that almost three-fifths of the poorest 20% of households were cutting back on food purchases.
“This is an access problem,” said Ludovic Subran, chief economist at insurer Allianz, who previously worked at the United Nations World Food Program. “Total food production has not plummeted. This is an entitlement crisis.”
Food accounts for a much larger share of consumer spending than energy, so a smaller rise in prices has a greater impact on budgets. The U.K.’s Resolution Foundation estimates that by the summer, the cumulative rise in food bills since 2020 will have amounted to 28 billion pounds, equivalent to $34.76 billion, outstripping the rise in energy bills, estimated at £25 billion.
“The cost of living crisis isn’t ending, it is just entering a new phase,” Torsten Bell, the research group’s chief executive, wrote in a recent report.
Food isn’t the only driver of inflation. In the U.K., the core rate of inflation—which excludes food and energy—rose to 6.8% in April from 6.2% in March, its highest level since 1992. Core inflation was close to its record high in the eurozone during the same month.
Still, Bank of England Gov. Andrew Bailey told lawmakers Tuesday that food prices now constitute a “fourth shock” to inflation after the bottlenecks that jammed supply chains during the Covid-19 pandemic, the rise in energy prices that accompanied Russia’s invasion of Ukraine, and surprisingly tight labor markets.
Europe’s governments spent heavily on supporting households as energy prices soared. Now they have less room to borrow given the surge in debt since the pandemic struck in 2020.
Some governments—including those of Italy, Spain and Portugal—have cut sales taxes on food products to ease the burden on consumers. Others are leaning on food retailers to keep their prices in check. In March, the French government negotiated an agreement with leading retailers to refrain from price rises if it is possible to do so.
Retailers have also come under scrutiny in Ireland and a number of other European countries. In the U.K., lawmakers have launched an investigation into the entire food supply chain “from farm to fork.”
“Yesterday I had the food producers into Downing Street, and we’ve also been talking to the supermarkets, to the farmers, looking at every element of the supply chain and what we can do to pass on some of the reduction in costs that are coming through to consumers as fast as possible,” U.K. Treasury Chief Jeremy Hunt said during The Wall Street Journal’s CEO Council Summit in London.
The government’s Competition and Markets Authority last week said it would take a closer look at retailers.
“Given ongoing concerns about high prices, we are stepping up our work in the grocery sector to help ensure competition is working well,” said Sarah Cardell, who heads the CMA.
Some economists expect that added scrutiny to yield concrete results, assuming retailers won’t want to tarnish their image and will lean on their suppliers to keep prices down.
“With supermarkets now more heavily under the political spotlight, we think it more likely that price momentum in the food basket slows,” said Sanjay Raja, an economist at Deutsche Bank.
It isn’t entirely clear why food prices have risen so fast for so long. In world commodity markets, which set the prices received by farmers, food prices have been falling since April 2022. But raw commodity costs are just one part of the final price. Consumers are also paying for processing, packaging, transport and distribution, and the size of the gap between the farm and the dining table is unusually wide.
The BOE’s Bailey thinks one reason for the bank having misjudged food prices is that food producers entered into longer-term but relatively expensive contracts with fertilizer, energy and other suppliers around the time of Russia’s invasion of Ukraine in their eagerness to guarantee availability at a time of uncertainty.
But as the pressures being placed on retailers suggest, some policy makers suspect that an increase in profit margins may also have played a role. Speaking to lawmakers, Bailey was wary of placing any blame on food suppliers.
“It’s a story about rebuilding margins that were squeezed in the early part of last year,” he said.
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