As non-financial investments, individual commodities are tangible assets that are relatively homogenous. This attribute allows these assets to be standardized as contracts for purchase and sale in futures markets.
In recent years, many investors have become involved in the ownership of or participation in commodities and natural resources. Commodities can be bought and sold quickly in large quantities and held by investors directly in the form of physical assets or indirectly through the functioning of the derivatives markets.
There are two ways that an investor can access the markets: directly and indirectly.
Direct Access to Market
Investors can gain direct exposure to commodities by purchasing them in cash markets (e.g., buying gold coins) or in the futures markets where asset delivery is deferred. Direct commodity investment involves the cash purchase of the asset and taking delivery of it. Space is required to store and insure the asset purchased.
Exposure to futures and forwards in the same asset class does not involve taking delivery until the derivatives contracts expire. For example, an investor in oil can buy several thousand barrels of crude oil in the forward or futures market for delivery on a future agreed date. The future price of the oil is set, and the investor may close this contract and take a profit between now and an agreed future date when the contract will expire. An increase in oil price will give the investor a return on the deal. Trading in this way is convenient because there is no need for an individual to take delivery of the product.
Indirect Access to Market
Alternatively, the investor may prefer indirect commodity investment via, for example, commodity-based collective funds or shares in commodity-related companies.
Types of Commodities
Some commodities are used mainly for consumption, while others are used primarily for investment purposes. Things could be accessed using the derivatives markets or holding the physical material. Commodities could be broadly classified into two categories, namely, 1) Hard Commodities and 2) Soft Commodities.
Hard Commodities
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Precious and Base Metals
These include metals (including gold, copper, platinum, lead, tin, nickel, and uranium) and diamonds. Hard commodities generally relate to metals, which require substantial capital expenditure to extract from the ground. These commodities are finite resources. The demand for some metals is dependent on specific industrial conditions.
Gold has traditionally been used as a hedge against inflation and a store of value when other investment markets have become weak or unstable.
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Energy Commodities
Crude Oil and Natural Gas Oil and other energy costs can rise due to various factors, such as economic growth and war or political unrest in key oil-producing areas such as the Middle East. Such supplies are obviously of great concern to a world still dependent on fossil fuels.
Soft Commodities
These agricultural products include cotton, edible crude oil, oil seed, and foodstuffs such as meats, cocoa, coffee, soya, and sugar. ‘Softs’ have the characteristic of being renewable, usually on an annual cycle. Therefore, crops can be grown season after season.
Additionally, many soft commodities are perishable. This can make their price highly volatile: if there is a surplus of coffee relative to typical levels of demand, the price may fall significantly as producers seek to sell as much as possible.
The prices of soft commodities are, as for all assets, driven, among other factors, by the supply and demand.
Supply can be significantly affected by factors such as:
- Excellent/poor harvests,
- Diseases affecting livestock, such as pigs and cattle,
- Exceptionally good/bad weather,
- Political unrest in the producing country.
Investors need to bear in mind the short cyclical factors of an agricultural commodity. For example, a shortage one year leads to increased prices, which can, in turn, lead to much-increased production the following year and a subsequent collapse in prices.
Conclusion: Commodity as an Alternate Non-financial Asset Class for Investors
Commodities are essential general goods, and one commodity of a kind is not substantially different from another of the same type, i.e., they are homogeneous. Commodities are also similar in pricing. The items are generic, and the products are not purchased based on their differentiating factors. These commodities include grain, livestock, metals, soft products, and energy.
During unexpected economic and financial uncertainty periods, commodity prices have responded positively to news and events. Further, commodity attractiveness is enhanced by the finite supply and shortages during some periods. For example, oil has a limited supply, and the world will likely run out of it in half a century. Still, there are risks in commodity investment that investors need to be aware of; commodities are susceptible to business cycles, and demand falls during recessionary periods. In addition, energy commodities such as oil also come under pressure with technological advancements in alternative energy sources.
