How to Invest in Commodities

Commodities refer to the physical goods humans consume in one way or another, stretching from food, like wheat or seeds, to raw materials that are used in the production of goods and services, like oil or aluminium.

In terms of materials, they are considered under two categories:

• Hard commodities that are mined or extracted – energy products, such as crude oil, natural gas, and coal, and metals, including gold, silver, aluminium, and copper;

• Soft commodities that are grown – livestock and meat, and agricultural products such as coffee, wheat, soybeans, cotton, or corn.

In terms of use, they are considered under four major categories:

• Agricultural products – Agricultural commodities such as corn, soybeans, wheat and sugar are traded on exchanges. These products can be used to hedge against inflationary pressures and expose investors to various markets.

• Energy products – Energy commodities include crude oil, natural gas, gasoline, and heating oil. These are often used for fuel or production purposes, so their prices tend to react quickly to changes in the global economy.

• Metals – Precious metals, such as gold, have long been seen as a safe-haven asset that helps protect against stock market volatility. Other types of industrial metals include copper, aluminium, and zinc.

• Livestock – Livestock is another type of commodity that can be traded on exchanges. Livestock products such as pork bellies and live cattle allow investors to invest in an asset class that has a weaker correlation with stocks and bonds.

Commodities are bought and sold on exchanges, much like stocks and shares. The major exchanges include the London Metal Exchange (LME), the Chicago Mercantile Exchange (CME), and the New York Mercantile Exchange (NYMEX).

While it’s possible to invest in commodities directly, as we will discuss in detail, it’s much more common to trade in futures contracts. Alternatively, investors can buy into ETFs that track specific commodity indexes, and buy stocks of commodity trading companies such as gas producers.

As with shares, commodity prices are largely driven by the forces of supply and demand, but they seldom act in tandem with stock prices. There are various other factors that influence commodities along with supply and demand, which ultimately leaves them volatile and oftentimes hard to predict.

Let’s sum up the risks and benefits associated with commodity investing:

Supply and demand are the fundamental forces that affect commodity prices. A decrease in supply or increase in demand for a specific commodity will boost its price, and vice versa.

The characteristics of supply and demand change frequently. While we always consume commodities one way or another, patterns of consumption change quite often. During the COVID lockdowns, for example, the demand for automotive construction and production plummeted, which resulted in the prices of most industrial metals declining. The rising cost of living, which turned into a global experience following the pandemic, led the demand for chocolate to decrease, which ultimately led to cocoa prices going down.

As we can see, supply and demand forces related to commodities change fairly frequently and are often unforeseeable, which means that the volatility in commodities tends to be higher than the one in stocks, bonds, or other securities.

Besides the specific supply and demand patterns, larger economic conditions are also crucial in driving commodity prices, with inflation being the most prominent.

Inflation can both be driven by and directly affect commodity prices simultaneously. One reason for that is that the commodity market often reacts to economic shocks, such as a surge in the cost of living, quite fast. When the prices of goods increase, so do commodity prices.

That’s the reason why commodities are often viewed as a solid indicator of inflation and are used by investors as a way to hedge against inflation. During times of economic downturn, almost every asset drops in value, except for commodities. Naturally, they attract more and more investors who wish to preserve the value of their portfolios.

Weather and natural disasters have a crucial effect on the value of commodities, which are increasingly disrupting global supply chains as climate change takes its toll. In 2021, for example, a frost fell on the coffee-producing regions in Brazil. This led to the harvest of the year yielding five million bags of coffee short. Events like this affect the production of commodities and therefore shrink the supply.

Commodities are extracted from specific areas around the world, and countries typically specialise in a few commodities and become a part of the global trade network. When political issues arise in those regions, this may disrupt the supply and ultimately affect the price of a commodity. Issues as such can take many forms, including sanctions, tariffs, or armed conflicts.

A prime example is the war in Ukraine and its repercussions on the global energy supply chain. In a bid to respond to Russia’s invasion of Ukraine, the Western countries, in particular, placed restrictions on trading Russian-sourced commodities, most notably natural gas. This led to a significant chunk of supply being cut out of the network, but as the demand remained the same, it resulted in a surge in energy prices that had a global impact.

Investing in commodities can be done by physically buying the commodity. This method is advantageous as it involves no third party and can be done easily online. For example, purchasing gold from a coin dealer is simple and can be safely stored and later sold.

However, investing in most physical commodities such as cattle, crude oil, or bushels of corn requires extra effort due to delivery and storage logistics being more complicated. As a result, individual investors often find this investment option too time-consuming to be feasible.

To invest in these goods, it’s best to work with an experienced broker knowledgeable about the product, its storage requirements, cost of delivery, stock market trends, and other nuances of the trade. This will allow for proper risk assessment and help in optimising returns.

Investing in commodities can involve trading in derivatives such as futures contracts. For example, if you think the price will go up, you can buy a futures contract to benefit from an increase in value. Alternatively, if the price decreases, you can short-sell or sell a futures contract to take advantage of a decline in value.

It's worth noting that it’s major companies that typically do this, rather than individuals. When trading these derivatives, a certain amount of capital, known as a margin, must be kept in the brokerage account.

Futures contracts are legally binding agreements between two parties to buy or sell a commodity at a predetermined price on a specified date in the future. They enable participants to gain exposure to changes in the underlying asset's price without actually buying or selling it.

For commodities, futures contracts can be used for hedging and speculation. If you'd like to try your chances with commodity futures contracts, make sure to check our list of the best futures brokers available for UK investors.

Another way to invest in commodities is by buying shares of commodity-producing companies. This offers indirect exposure to the commodity market and can be done with much smaller capital than directly investing and can be done through traditional investing platforms in the UK.

For example, an investor could purchase shares in a company that mines gold or drills for oil instead of buying the physical commodity itself. However, this option comes with its own set of risks as the share price of these companies may be affected by factors unrelated to the commodities market, such as changes in management or overall profitability.

Finally, investors can consider investing in the best exchange-traded funds (ETFs) and mutual funds focusing on commodities. These investment vehicles offer a diversified way to access the commodities market by allowing private investors to invest in various products simultaneously.

On the other hand, exchange-traded commodities, or ETCs, are a popular way to invest in commodities in the UK as they provide easy access to a range of physical commodities such as gold, silver, oil, and agriculture, through a stock exchange, without the need for investors to take physical possession of the commodity.