Commodities such as gold, copper and crude oil are attractive investment alternatives to popular stocks or bonds. Although the prices of most of them are constantly going up, investing in commodities is not always profitable. As usual, the knowledge and skills of the trader are crucial. Check what you should know about investing in raw materials.
What is investing in commodities?
Commodities have always played a key role in the global economy. These are mineral, vegetable, animal or energetic substances that occur in nature and can be processed or used directly to produce a variety of products in many industries.
Raw materials are mined, harvested, farmed, or extracted differently, depending on their nature and use. The raw materials market can be divided into five basic groups:
- energy resources, e.g. oil, coal, natural gas;
- industrial raw materials, e.g. copper, aluminium, nickel;
- precious metals, e.g. gold, silver, palladium;
- agricultural products, e.g. wheat, sugar, cotton;
- livestock and meat, e.g. animal carcasses, cattle, swine.
Investing in commodities involves buying and holding a variety of natural resources or their financial instruments for a certain period of time in order to make a profit or hedge an investment portfolio. How to start investing in commodities, we will explain later in the article.
What affects the prices of raw materials?
Commodities are widely regarded as low-risk investment alternatives. However, this is not entirely true. The fact is that compared to financial instruments such as stocks or bonds, commodities are more resistant to economic market fluctuations. However, there are many other factors that affect changes in commodity prices.
The most important is the fundamental relationship between demand and supply. Among the factors shaping the supply of raw materials, we distinguish:
- Weather conditions. Droughts, floods or extreme temperatures can significantly affect agricultural production and the extraction of natural resources. For example, extreme weather events can disrupt the extraction of raw materials, which can lead to a reduction in supply and an increase in prices.
- Mining costs. An increase in mining costs, e.g. due to an increase in energy prices, can lead to an increase in the price of raw materials in the market. In turn, reducing the cost of mining may contribute to a decrease in the prices of these raw materials.
- Political decisions and government regulations. For example, changes in environmental law can affect the cost of extracting raw materials, which can lead to a change in their prices on the market.
- The value of the base currency. The value of the currency of the country producing the raw material has an impact on its price on the world market. A decline in the value of the national currency can make the commodity cheaper for foreign buyers, which can lead to increased exports and higher prices on the global market.
- Geopolitical events. Armed conflicts, political unrest or crises in the international arena can lead to instability in the commodity markets. Ideal examples are the events of recent years – the COVID-19 pandemic, the outbreak of war in Ukraine – caused the supply of raw materials on the global market to decrease, which periodically resulted in an increase in their prices.
How to invest in raw materials?
You can invest in commodities on the physical (spot) market and the financial (futures) market.
In the physical market, investors purchase physical commodities such as gold, silver, or crude oil. Investing in this market involves buying actual raw materials, which can be stored personally by investors or stored in special deposits.
- The advantage of investing in the physical market: investors have full control over their investments and can physically own the raw materials.
- The disadvantage of investing in the physical market: you need to have large capital expenditures to purchase, store and secure raw materials.
In the financial market, investors trade financial instruments whose underlying assets are raw. Investing in the financial market allows investors to participate in the price movements of commodities without having to physically own those commodities.
- The advantage of investing in the financial market: investors can easily trade various commodities, having access to a wide range of financial instruments.
- Disadvantage of investing in the financial market: in addition to knowledge about given raw materials, investors must know the specifics of selected financial instruments.
Basic financial instruments for investing in commodities
One of the popular ways to invest is shares of companies related to the commodity sector. Investing in shares of such companies allows investors to participate in potential increases in commodity prices and profits associated with the activities of these companies.
CFDs (Contracts for Difference) also allow you to trade commodities without having to physically own them, making them a popular instrument among traders.
Another option is ETFs, which are index funds that track selected commodity or commodity sector indices. Investing in commodity ETFs allows you to diversify your investment portfolio by investing in different commodities with a single stock trade.
Traders can also use options that allow you to buy or sell commodities at a specific time and price, giving you the opportunity to hedge against adverse movements in commodity prices or speculate on those prices. The cost of the option is the so-called premium – after paying it, the investor has the right (and not the obligation!) to perform the contract.