Everything You Need to Know About Commodities

Although a lot of people have heard of commodities — thanks Trading Places — they wouldn’t know a hog future if it nosed a truffle out from under their foot. Like stocks and bonds, commodities are a major asset class that many find worthy of investment. They can also be a good way to diversify your portfolio. Just be warned: commodities tend to be more volatile than stocks, and there’s a steep learning curve. That’s why a lot of people don’t recommend them for people who don’t have a lot of investment experience.

What are commodities?

Commodities are basic goods like oil, gas, wheat, soybeans, corn, gold, copper, and livestock. They’re classified by grades of quality, and any individual crops or hauls that get the same grade have the same value. For example, a corn crop rated U.S. No. 1 from a farmer in Kentucky is functionally equivalent to a crop rated U.S. No. 1 from Iowa, even though they come from different places and may even taste different. This way a bushel of soybeans is the same no matter which farmer brought it to the market.

If you want to learn even more, this U.S. government document from 1936 explains what commodities are and how they are regulated. We can’t promise it will be more fun than, say, going to the dentist on a Sunday, but it’s very informative.

What types of commodities are there?

All commodities are separated into two broad categories: soft and hard. Soft commodities are things like corn, soybeans, coffee, sugar, wheat, and livestock. They’re usually grown or raised, and come to maturity when they are harvested. Hard commodities are often natural resources — things that are mined or extracted from the earth, such as gold, copper, and oil. One easy test is spoilage. If it’s something that’ll go bad if you left it outside for too long, it’s probably a soft commodity.

Are commodities volatile?

Commodities can be quite volatile. For that you can blame supply and demand economics. If the weather is cold, the price of natural gas tends to go up to account for the increased demand as people heat their homes. When the weather starts warming up, demand for heating decreases, so natural gas prices go down. You see the same thing in agricultural markets: big harvests cause a glut in the market, which makes prices fall. Droughts lead to smaller harvests and shrink supply, and that drives prices higher.

How do I invest in commodities?

There are a few options:

1. Buy shares of commodity exchange-traded funds (ETFs)

2. Purchase stocks of companies that produce commodities

3. Acquire the commodity directly

4. Invest using commodity futures contracts

We’ll start with the options that are easiest for most people. Buying individual stocks of companies that produce commodities and/or buying shares of ETFs is something a lot of us are already familiar with. If you wanted to invest in crude oil without actually buying crude oil, for instance, you could buy stocks in a company that drills for oil. You can also buy shares in an ETF, which would offer a basket of companies involved in commodities and/or physical commodities.

Then, there are the harder options. The hardest is buying commodities directly. This requires pretty serious logistics. You have to find a way to transport whatever you bought (such as, say, hundreds of pounds of real live cows) and store it. If you end up selling the commodity later, not only do you have to find a buyer who can also handle storing everything, you’ll have to figure out how to get it to them. Most investors are not equipped to buy and sell bushels of soybeans or barrels of crude oil, which is why this strategy is primarily used by food corporations, the farming industry, and others who are actually using the commodities — and not just investing in them.

Futures contracts are better for institutional investors. With standardized terms such as the price of the commodity and the time frame to buy it or sell it, futures contracts have the option to be what’s called cash-settled. This means buyers and sellers do not have to physically move or store commodities, but instead exchange money when their contract is over. It’s a much simpler process, although the terms and timelines involved can still be very complicated. If you want to get involved in futures contracts, you’ll need to use a brokerage account or go through a stock broker.

What are these commodities futures you mentioned?

Commodities are bought, sold, and exchanged on the commodity market. The price for each commodity can change daily, the same way it does for stocks and bonds. This is one of the reasons that gas prices fluctuate: as oil prices go up or down, what you’re charged at the pump changes in response.

Prices that change from day to day can be hard on people like farmers, though. If they plant a crop of soybeans assuming they’ll get a certain price, then that price falls drastically when it’s time to harvest, they could be out quite a bit of money. The U.S. government smooths out some of this uncertainty by offering farm subsidies, but a farmer can also hedge their bets on the eventual price of a crop by pre-selling it on the futures market. This will lock in the current price, so when it’s time to sell, the farmer knows exactly what they’ll get. This can help the farmer budget for things like workers, equipment, and fertilizer.

Consumers of commodities need protection from price fluctuation as well. Airlines may want to buy large quantities of fuel. Locking in the price in advance can help with planning for future expenses.

The agreements that the farmer and the airline make to sell or buy a commodity on a specific date at a particular price are called futures contracts. These are bought and sold over exchanges that enforce standards about the minimum quality and quantity of the traded commodity. Because futures contracts are standardized, companies, farmers, investors, speculators, and consumers can all buy and sell futures contracts.

How does commodity trading work?

Most commodities are traded through exchanges such as the New York Mercantile Exchange (NYMEX), the Chicago Board of Trade (CBOT), and the Minneapolis Grain Exchange (MGE). Each exchange specializes in particular types of commodities.

Let’s say you own a bakery and need to buy wheat to make scones and cinnamon buns. Rather than going door-to-door to talk to farmers about all the wheat and cinnamon you’ll need, you can talk to a commodities broker who operates over one or more of these exchanges and they’ll help you buy contracts for what you need.

Remember: futures contracts are standardized, so each wheat contract must be for 5,000 bushels of a particular grade of wheat. Prices are listed in cents per bushel and include the date of physical delivery.

In this example, the bakery is a buyer on the commodities market. Other buyers might include a coffee roaster buying coffee beans in bulk or a gas station buying fuel. Buyers of commodities take delivery of the commodity in the futures contract.

The farmer who grows the wheat in this example is a producer. They make the physical commodity named in the futures contract, and they are the one who delivers it on the end date of the contract.

There are also speculators, who neither make nor use the commodity. Speculators’ goals are to buy and sell contracts just to profit from the volatile price movement. Intraday traders tend to like speculating in futures contracts. These buyers hope never to take delivery of the real product, because they don’t need it. And they certainly don’t want it: storing 5,000 bushels of wheat in the garage doesn’t leave a lot of room for the car.

What are commodity indexes?

One easy entry point into commodities is through commodity indexes. These funds track a group of commodities on price and investment return performance, kind of like a stock index, and are traded on exchanges in much the same way.

Some indexes include only one type of commodity. You see this a lot with natural resources like gold or oil. Others are baskets of different types of commodities ranging from copper to soybeans. Some indexes are weighted so that each commodity makes up the same percentage of the index. Others put heavier weight on specific commodities.

Unlike securities, commodities do not pay interest, dividends, and capital gains. The price performance of the commodities in the index is the sole determining factor on the return on investment. If there is no upward movement in the price of the commodity, investors end up with zero return on their investments. With some stocks and bonds, even if the price of the stock remains flat, interest and dividends will ensure the investment increases in value.

What are commodity equities?

Another way to get commodity exposure is as part of a package with equities. There are ETFs that track commodity-producing companies. These stocks behave like a mixture of regular equities and commodities, since the revenues of most commodity producers are tied to the price of commodities.

There are also ETFs tracking broad commodity producers, as well as subsets and individual commodities like energy or gold.

What’s the deal with commodities and inflation?

Stocks and bonds tend to lose value during inflation, but commodity prices tend to rise. You can see this in the supermarket: when inflation goes up, so does the price of bread, because the price of wheat went up. This effect can make commodity investing a good hedge against declining currency value. As the demand for goods and services goes up, so does the value of a commodity investment.

This is one of the reasons why portfolio and fund managers use commodities to balance out stocks and bonds — they offset each other. However, this hedge effect does not eliminate the high volatility in the commodities market. Commodities investments carry a higher risk than investments such as stocks and bonds.

If you’ve invested in gold, you’ve already used commodities to hedge against inflation, possibly without even realizing it.