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Your Guide to Investing in Commodities – Motley Fool

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Beginning investors tend to start out focusing on stocks, exchange-traded funds (ETFs), and mutual funds. That’s generally a good idea, because more sophisticated asset classes can be difficult to understand fully when you’re just starting out. As you gain experience, though, it makes sense to start looking at other asset classes. Investing in commodities takes some extra learning, but it can have some real benefits for your overall returns in your portfolio.

However, identifying the best way to invest in commodities isn’t always as straightforward as it is for stock investors to buy shares of their favorite companies. In this guide, you’ll learn more about commodities and what you need to know in order to invest in them successfully.

What are commodities?

Commodities are goods that are more or less uniform in quality and utility regardless of their source. For instance, when shoppers buy an ear of corn or a bag of wheat flour at a supermarket, most don’t pay much attention to where they were grown or milled. Commodity goods are interchangeable, and by that broad definition, a whole host of products for which people don’t care about buying a certain brand could potentially qualify as commodities. Investors tend to take a more specific view, most often referring to a select group of basic goods that are in demand across the globe. Many commodities that investors focus on are raw materials for the manufactured products that consumers or industrial customers end up buying.

Pile of grain next to several bags of grain.

Image source: Getty Images.

Investors break down commodities into two categories: hard and soft. Hard commodities require mining or drilling to find, including metals like gold, copper, and aluminum, and energy products like crude oil, natural gas, and unleaded gasoline. Soft commodities refer to things that are grown or ranched, including corn, wheat, soybeans, and cattle.

How volatile are different commodities?

Supply and demand dynamics are the main reason commodity prices change. When there’s a big harvest of a certain crop, its price usually goes down, while drought conditions can make prices rise on fears that future supplies will be smaller than expected. Similarly, when the weather is cold, demand for natural gas for heating purposes often makes prices rise, while a warm spell during the winter months can depress prices.

Because those supply and demand characteristics change frequently, volatility in commodities tends to be higher than for stocks, bonds, and other types of assets. Some commodities show more stability than others, such as gold, which also serves a function as a reserve asset for central banks that provides a buffer against volatility. Yet even gold becomes volatile sometimes, and other commodities tend to switch between stable and volatile conditions as market dynamics warrant.

What’s the history of trading commodities?

People have traded various commodity goods for millennia. A number of early entities vie for the status of earliest formal commodities exchange, including Amsterdam in the 16th century and Osaka, Japan, in the 17th century. Only in the mid-19th century did commodity futures trading begin in entities like the Chicago Board of Trade and the predecessor to what eventually became known as the New York Mercantile Exchange.

Many early commodities trading markets came about as a result of producers coming together in their common interest. By pooling resources, producers could ensure orderly markets and avoid cutthroat competition. Early on, many commodities trading venues focused on single goods, but over time, these markets aggregated to become broader-based commodities trading markets with wide varieties of different goods featured in the same place.

How do you invest in commodities?

Commodities investing is a lot different from trading other types of investments. The biggest challenge with commodities is that they’re physical goods. There are four ways to invest in commodities:

  1. Investing directly in the commodity.
  2. Using commodity futures contracts to invest.
  3. Buying shares of exchange-traded funds that specialize in commodities.
  4. Buying shares of stock in companies that produce commodities.

If you want to invest directly in the actual commodity, you have to figure out where to get it and how to store it. When you want to sell the commodity, you have to find a buyer and handle the logistics of delivery. With some commodities, such as precious metals, it can be relatively easy to find a local or internet-based coin dealer where you can buy a bar or coin that you can keep safe and freely sell. But with bushels of corn or barrels of crude oil, it gets a lot harder to invest directly in goods, and it typically takes more effort than most individual investors are willing to put in.

Fortunately, there are other ways you can invest in commodities. Commodity futures contracts offer direct exposure to changes in commodity prices. Certain exchange-traded funds are custom-tailored to offer commodity exposure. And if you want to stick to the stock market, you can always focus on the companies that produce a given commodity.

When does directly investing in a commodity make sense?

The benefit of owning a physical commodity is that there’s no intermediary involved in your ownership. Typically, you can do a simple internet search to find a dealer to sell you a particular good, and when you no longer want it, that dealer will often buy it back.

The best commodities to invest in directly are those where the logistics are easiest to handle. Gold is one of the best examples, because you can make a meaningful investment in gold without it being too bulky to transport or store efficiently. Dealers will sell gold coins or bars to investors, and they’ll also buy back those goods when the investor wants to sell. You can find local dealers by word of mouth or through internet searches, and some are rated by the Better Business Bureau or other rating services for reliability and trustworthiness. Online-only dealers can be found through internet searches as well, and they’ll often have testimonials or reviews that can help you gauge whether they’re trustworthy.

The downside of direct ownership is that transaction costs tend to be high. For instance, a gold coin dealer might charge a markup of 2% or more in selling a coin but then offer a price that’s at or below market value to buy it back. That makes direct ownership best for commodities that you expect to hold for periods of years rather than months or days, because you’ll minimize your total transaction costs by making relatively few trades.

How do commodity futures contracts work?

Futures contracts offer an alternative to direct ownership of commodities. These contracts trade on special futures exchanges, and they’re obligations to buy or sell a certain amount of a given commodity at a specific time in the future at a given price. To trade commodity futures contracts, you’ll either need to find out if your stockbroker offers futures trading or need to open a special futures brokerage account.

A large number of oil barrels placed in organized rows and columns in a white room.

Image source: Getty Images.

The way futures contracts work is that when prices of the commodity go up, the buyer of the futures contract gets a corresponding increase in the value of the contract, while the seller suffers a corresponding loss. Conversely, when the price goes down, the seller of the futures contract profits at the expense of the buyer.

Futures contracts aren’t suitable for many investors, however, because they’re largely designed for the major companies in each commodity industry. For example, if you want a single gold futures contract, you’ll need to commit to buying 100 ounces of gold. That’s a $130,000 commitment at current prices, and contracts in other commodities often involve taking on more exposure to a given commodity than typical investors want to take on in their portfolios.

Why commodity futures are good for hedging

One reason that futures are especially popular among producers and major consumers of commodity goods is that futures can help them hedge their exposure effectively and efficiently. For instance, say you’re a farmer and expect to produce 5,000 bushels of corn this season. You had to buy a new tractor this year, and you want to be sure that you’ll be able to get at least the prevailing market price for your crop regardless of what happens between now and harvest time. By selling a futures contract, you can effectively lock in the price you’ll get for your corn, hedging against that uncertainty.

On the other side of the equation, say you’re a food processing company that takes corn and produces corn meal for distribution to food retailers. You know that you’ll need 5,000 bushels of corn, but you don’t want to have to deal with potentially higher prices if poor growing conditions result in a smaller total crop. If you buy a futures contract, you can hedge against that risk and ensure that you’ll pay the prevailing price right now. In fact, the way many commodities markets work is that producers and major consumers both get together with equal but opposite desires to hedge their exposure.

How commodity ETFs work

In part to bridge the gap between large commodity producers and individual investors, investment managers came out with exchange-traded funds that offer commodity exposure. Many ETFs own shares of companies that have something to do with commodities, but there are various types of commodity ETFs that handle investment a bit differently.

Some commodity ETFs buy physical commodities and then offer shares to investors that represent a certain amount of a particular good. For example, when they were first created, shares of the SPDR Gold (NYSEMKT:GLD) ETF each represented the value of one-tenth of an ounce of gold. Similarly, the iShares Silver (NYSEMKT:SLV) ETF had a price that was close to the value of one ounce of silver. Over time, fund expenses typically reduce the corresponding amount of the commodity represented by each ETF share. Right now, each SPDR Gold share corresponds to about 0.0948 ounces of gold, while each iShares Silver share has about 0.94 silver ounces backing it.

Other commodity ETFs use strategies using futures contracts to offer exposure. However, long-term use of futures contract-based strategies can often lead to performance that’s far different from how the underlying commodity performs. For instance, futures prices take into account the storage costs of a given commodity, and so goods that are expensive to store often have extensive premiums built into prices for such contracts that mature far in the future. That means that even if the spot price of the commodity rises, that rise might already have been incorporated in the price of the future, causing ETF owners not to see any gain.

Buying shares of commodity producers

Finally, one popular way to invest in commodities is to buy shares of the companies that produce them. In the energy sector, you can focus on exploration and production companies that actually find and extract crude oil and natural gas. Mining stocks mine for precious and base metals, while agricultural companies grow crops or purchase them from farmers and then resell them to processed food companies and other buyers.

The thing to remember about investing in commodities through stocks is that a given company won’t always see its value rise or fall in line with the commodity it produces. For example, an oil exploration and production company will benefit when crude oil prices rise and suffer when prices fall. But far more important is how much oil the particular oil-field assets that a company owns will produce over the long run. A company can see its stock fall dramatically if its commodity-producing assets don’t deliver the goods that investors expect — even if the commodity price itself is soaring.

What’s the best way to invest in commodities?

Each of the four ways of investing in commodities has its pros and cons. Direct investment gives you the privileges and responsibilities of ownership, and whether the benefits outweigh the costs depends on the commodity involved, your desired use for the commodity, and how long you intend to hold on to it. Commodity futures let you avoid the burden of physical ownership if you so choose, and while some people find the vast quantities of a commodity that most futures contracts cover to be more exposure than they need, major institutions like the fact that they can obtain massive amounts of a desired commodity with relatively little effort.

Exchange-traded funds that deal with commodities share some of the pros of direct investment while avoiding some of the cons, especially because most commodity ETFs let you buy and sell shares that correspond to more manageable amounts of the good in question. They come with extra fees, though, and the particular structure of any given ETF can carry traps for the unwary. Not every commodity ETF moves in sync with the price of the underlying good, and that can come as a surprise to unsuspecting first-time investors in the funds.

Stocks of commodity producers have the benefit of being an investment in a functioning business rather than just a physical good, and great businesses can bring strong returns to investors even when a commodity’s price is stable or falls. However, that dynamic works both ways, and sometimes, a stock won’t rise even when the commodity that it produces goes way up in value.

That’s a rather long-winded way of saying that there’s no one way to invest in commodities that’s best for everyone. All four methods have their pros and cons, and you need to consider your own particular intentions for your investment when you choose.

Which commodity stocks and ETFs are the best?

There are hundreds of stocks and dozens of ETFs that deal with commodities, and choosing the best ones requires knowing exactly what you’re looking to get from your investment. Especially in the stock realm, any individual company’s success often comes from finding a more lucrative place to operate, such as a mine or oilfield with vast resources, than its competitors. Alternatively, companies with lucrative supply contracts with high-demand purchasers sometimes fare better than peers who lack those contracts.

In general, though, if you want the most direct connection to the commodity itself, the best stocks are those that command their industries. Below, you’ll find a table of some stocks that are among the leaders in their respective fields.

Stock

Commodity

Annual Revenue

Anglo-American Platinum (NASDAQOTH:ANGPY)

Platinum-group metals

$5.4 billion

Archer-Daniels-Midland (NYSE:ADM)

Corn, wheat, other crops

$61 billion

Barrick Gold (NYSE:ABX)

Gold

$8.4 billion

Cameco (NYSE:CCJ)

Uranium

$1.7 billion

ExxonMobil (NYSE:XOM)

Crude oil and natural gas

$248 billion

Freeport-McMoRan (NYSE:FCX)

Copper, gold, energy products

$16 billion

Tyson Foods (NYSE:TSN)

Cattle, pork

$39 billion

Valero Energy (NYSE:VLO)

Gasoline, heating oil

$93 billion

Data source: Yahoo! Finance.

This is far from an exhaustive list, and plenty of other companies are also good investments. Again, though, if you just want big-name exposure to a particular commodity, these stocks can get you started.

For ETFs, the best fund is the one that matches up best with your particular needs. The following ETFs are among the most popular:

Commodity ETF

Assets Under Management

SPDR Gold Trust (NYSEMKT:GLD)

$36 billion

VanEck Vectors Gold Miners (NYSEMKT:GDX)

$7.8 billion

iShares Silver Trust (NYSEMKT:SLV)

$5.3 billion

PowerShares DB Commodity Index Tracking (NYSEMKT:DBC)

$3.1 billion

United States Oil Fund (NYSEMKT:USO)

$2 billion

Data source: Yahoo! Finance.

SPDR Gold, iShares Silver, and the U.S. Oil Fund all try to give returns that are directly linked to the returns of the underlying commodity. By contrast, the VanEck ETF holds shares of various gold-mining stocks, with only the indirect exposure to physical gold prices that mining stocks offer. The PowerShares ETF tracks an index of multiple commodities, with the goal of avoiding singling out any one specific commodity but rather offering a way to play the industry as a whole.

You can find ETFs that are more tailored to the specific commodity you want. However, the smaller the ETF, the more challenging it is to buy and sell shares without running into high transaction costs, and that’s a complication that many investors prefer to avoid.

Be smart with commodities

If you want to invest in commodities, these four methods can be useful in helping you define the exact exposure you want. Whether you pick commodities themselves or the companies that produce and sell them, you can profit if demand for the commodity you pick rises faster than supply can handle.

Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.