Investing in commodities is not as popular as investing in stocks. However, having some of your capital in commodities can be very powerful. We analyze the main reasons for investing in commodities, and how to do it easily.
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Types of Commodities
Commodities are usually classified into the following 4 categories:
- Energy: the most important energy sources are oil, natural gas, coal, and uranium.
- Industrial Metals: they are mainly used in industry and construction. Some examples are copper, zinc, aluminum, nickel and steel.
- Precious Metals: despite their high price, they can be used in some industrial processes. For most investors, they are safe haven assets to protect the value of their wealth. Some examples are gold, silver, platinum and palladium.
- Agricultural: these commodities can be grown and are generally used as food. Some examples would be wheat, sugar, cocoa and coffee.
As you can see, due to the heterogeneity of commodities, their prices can move in different directions at the same time. If there is a real estate and infrastructure boom in India in the future, the price of copper may explode higher while the price of sugar drops.
Similarly, if the electric car industry is able to deliver on the high expectations many officials have, the price of copper and silver can move higher while oil prices go down.
Reasons for Investing in Commodities
There are several reasons why investing in commodities makes sense for most types of investors. Let us discuss them in detail:
1) Inflation Protection
Commodities are real, physical goods. For this reason, its price is mostly determined by the real economy. More specifically, commodity prices are closely related to the general price level and the level of economic activity.
The ideal scenario for commodities is one of high growth rates and strong inflation. Even if the economy is weak, inflation is likely to push commodity prices higher.
There is a logical reason for the correlation between the price of resources and inflation. Resources directly affect inflation because they are an input in the wealth creation process. Having some of our wealth in real goods can shield our portfolio from the negative effects of inflation.
There are many reasons in favor of rising commodity prices over the next few decades. While the production of commodities is either stable or slow to adjust to higher demand, the world’s population will increase significantly throughout the 21st century, especially in Africa and India. This will push demand higher relative to supply, thereby putting upward pressure on prices.
On the other hand, the expansionary monetary policies that Western governments have become used to can exert strong inflationary pressures in the long term.
2) Diversification
Commodities tend to have low correlations with stocks and bonds. That means they can significantly reduce the risk of our investment portfolio.
This is especially important in times of economic crises. If there are geopolitical problems that can affect the economy, stocks are likely to perform poorly. However, because supply chain issues may arise, the price of commodities can go up heavily. The gains from our commodities investments would cushion the losses in our stocks.
Another scenario where commodities are in high demand is stagflation. Stagflation occurs when there is low economic growth, or even an economic recession, and strong inflation at the same time. The 1970s became known as a period of stagflation. Stagflation tends to be negative for stocks, very negative for bonds, but very positive for commodities.
3) Potential Returns
Finally, it should be noted that commodities can go through periods of very strong performance in the future, regardless of what happens to stocks and bonds. We have already discussed that inflationary pressures around the world, global population growth, as well as the industrialization of Africa and India can be very positive factors.
But there is another reason to be optimistic when it comes to commodities. If we analyze the historical prices of many commodities, we will see that many of them are trading at similar nominal prices than in the early 1980s.
Thus, while the last 4 decades have been spectacular for stocks, bonds and real estate, they have been bad for commodities, which did experience a great decade in the 1970s. Because the economy is cyclical in many ways, commodities could experience a major bull market in the upcoming years.
How to Invest in Commodities
If you are now convinced of the benefits of investing a portion of your portfolio in commodities, you may be asking yourself how to do it. This is what we will discuss next.
Commodities are generally traded as derivative financial contracts called futures. Futures are contracts for buying or selling assets in the future. So, instead of buying barrels of oil and storing them, we can simply buy an oil futures contract.
Because investing in futures is complicated and requires a significant amount of capital, the simplest way of investing in commodities is through ETFs. Investing in an ETF is as straightforward as buying stocks. The managers of our commodities ETFs will take care of buying and selling futures contracts on our behalf. Or, in the case of some precious metals, of keeping them in storage.
There are several types of commodities ETFs, depending on whether we want to invest in a single commodity or a basket of them. The latter would be a more diversified option.
For example, one option is an ETF managed by Invesco, which replicates a diversified commodity index. If you want to look at it, here is the link to the website of Morningstar, which will give you additional information about the ETF.
Another option to invest in commodities is to do it indirectly by buying the shares of commodity producing companies. For example, we could buy the XLE ETF if we want to invest in oil producing companies, or the GDX ETF if we want to invest in gold mining companies.
Conclusion
Investing in commodities is a very interesting proposition. As with everything, it is important to always diversify the way we allocate our assets.
There are many fundamental reasons for investing in commodities and being bullish about their future price action. This means both the resources themselves as well as companies that are in the business of producing and selling them can turn out to be good investments.
Remember, however, that many corporations operate in risky jurisdictions, exposed to substantial political risk. Consequently, do your due diligence before buying anything, especially if you are interested in individual stocks.
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