Do you know your corn from your crude oil?05 may 2016, 16:15
Commodities are the raw materials that everything around us is built on and they play a big part in everyday life. Practically everyone is impacted by the commodities market – through the price you pay to fill up your car with petrol, to the cost of a cup of coffee at your local coffee shop, and the size of your electricity bill each month. Commodities matter.
There are three groups of commodities: metals, agricultural and energy.
Metals, also known as “hard” commodities, can be broken up into two sub-sectors made up of industrial metals, such as copper, nickel, lead and aluminium; and precious metals, which includes gold, silver, platinum and palladium.
Agricultural commodities can be broken into three sub-sectors made up of soft commodities, such as cocoa, coffee and sugar; grain and oilseeds, such as corn, wheat and soybeans and livestock. And finally, there are the energy commodities, which are predominantly oil and gas.
While it is possible to gain access to the commodities market in more or less the same way that you would for shares and bonds, commodities have several key features that sets them apart from other investments and are important for an investor to consider. The commodity market can be highly volatile, with prices moving quickly at key times, and it is advisable for anyone new to trading commodities to take the time to understand the features and risks of trading commodities before investing.
There are four key features to trading commodities that do not apply to other investments such as trading the stock market:
1. Politics: As raw materials, commodities are exposed to the risks of the political regime in their source location. Consider that 66% of OPEC’s oil supplies comes from the Middle East and around 30% of the cocoa bean is sourced from the Ivory Coast. Geopolitical issues within those countries and regions can have a profound effect on supply and thus the overall cost of key commodities.
2. No income: In direct contrast to the likes of shares and bonds, there is no dividend or interest achieved from owning commodities, such as gold. While the price may rise over the period of your investment, most commodities are not a source of income.
3. The pricing of and the attractiveness of commodities depends very much of the availability of the individual raw materials. In an oversupplied market the cheapest price is found in the spot market while getting progressively more expensive further out. This scenario is called contango and it tends to erode the investment return as the monthly roll creates a negative return when selling the expiring future lower than where the next is bought.
4. Transportation and storage are two other key components when pricing physical commodities.
Even though some of these features can make commodities a more risky investment, the volatility in the market makes them exciting to trade and profitable with the right understanding of risk management.
How you access the commodities market depends what kind of investor you are. Institutional or wholesale trading of commodities is largely carried out via specialist futures exchanges, such as the New York Mercantile Exchange (NYMEX), London Metals Exchange (LME), Chicago Board of Trade (CBOT) or the Chicago Mercantile (CME).
For retail investors, it is possible to buy physical commodities, but unless you’re buying a few gold coins it is not terribly practical. Not many people have anywhere appropriate to store one tonne of lead or 1000 barrels of oil! Instead, most retail commodity investors utilise derivatives, such as Exchange Traded Funds (ETFs), Futures and Contracts for Difference (CFDs) to access the commodity market.
ETFs are funds which are traded in much the same way as shares are. They are listed on an exchange and each ETF usually tracks a specific commodity or a group of commodities. They also offer the retail investor the advantage that you are trading on the performance of the commodity market without having to physically own the underlying commodity.
Some of the most popular traded commodity ETFs are those related to oil and precious metals trading. The world’s three largest ETF are the SPDR Gold Shares (GLD), iShares Gold Trust (IAU) and iShares Silver Trust (SLV). The most popular energy ETF is the US Oil Fund (USO) which tracks the performance of WTI crude oil.
Futures, one of the oldest forms of derivative, are another popular way to access the commodities market. Futures contracts were traditionally utilised by farmers to allow them to hedge the price of their crops from the time of planting the seeds to harvesting and then bringing the crops to market. They were initially utilised mainly for crops, but were subsequently expanded to include the likes of precious metals, oil and treasury bonds. Now they are used speculatively by hedge funds and money managers and commercially by producers and hedgers.
Another derivative product which is popular with commodity traders is CFDs. These instruments allow investors to take a much smaller position in the market than what they would otherwise have to in the futures market. So while the price of CFD’s tracks the underlying future it is often the instrument of choice for retail investors seeking a smaller exposure. Investors realise a gain from CFDs trading by predicting whether the underlying asset will rise or fall in price, and CFDs on oil markets are a particularly popular commodity trade.
Futures and CFD’s both have regular expiry dates which requires active position management from the investor. Popular commodity futures trades in the market at the moment include Brent Crude Oil and WTI Crude Oil. Both of these two global oil benchmarks can be traded as futures as well as CFD’s
One of the reasons that derivatives such as Futures, ETFs and CFDs are growing in popularity is the flexibility they offer, specifically the fact that investors can take advantage of both upward moving prices by “going long” and also downward moving prices by “going short”. This means that even when the price of an asset, is declining, such as was the trend in oil markets earlier this year, it is still possible to take advantage of the market for profit.
It is important to remember that while trading derivatives with the added benefit of leverage does offer the potential for higher returns, it can also mean that losses can be magnified and investors must trade with caution. From a trading perspective always worry first and foremost about how much you can and will afford to lose on a specific trade. Always use stops as a way of limiting your losses and once the trade goes the way you were hoping a decision about when to take profit can be taken.
Commodities to watch
Gold and Silver have attracted phenomenal interest since January. Investors have primarily been using ETF’s to gain exposure. As long central banks continue to suppress interest rates the demand for precious metals will remain.
Crude oil will move higher over the coming year and that has led to an explosive buying interest from major hedge funds. So much that the long positions held in WTI and especially Brent has exceeded 650 million barrels. While we believe this trade will be profitable in the longer run we caution getting to long at this stage and would rather be patient and wait for a set-back over the coming months.
Drought in Vietnam and Brazil has raised the prospect of a smaller production of coffee than previously expected. If conditions do not improve we may see coffee rally further during the coming months.