If you invested equal amounts in commodities, bonds and stock markets for 100 years, the stocks would beat the other two asset classes hands down. That is the example given by many analysts and advisors when they try to make a point in favor of stock markets. And why not? It’s the truth.
A crucial point often missed, though, is the fact that no one stays invested for 100 years. Both commodities and stocks go through sharp ups and downs. On smaller timescales, say 10 years, commodities could beat stocks (or vice versa). In fact, the number of corrections commodities go through every 10-20 years presents multiple golden opportunities for investors. Given that many commodities are 40-50% down from their peaks in 2014, this might be one of those moments.
Even if prices fall further, low prices will fuel demand sooner or later. That will mean higher growth, higher inflation and higher commodity prices. Below are two graphs charting the ups and downs of the last 100 years for silver and the Dow Jones. Notice how silver prices reverted to the same levels seen 100 years ago many times but the Dow Jones has continued to surge despite the corrections.
Here are some things you need to know about the most heavily traded commodities if you are just starting out or are adding more exposure.
If you hear about a barrel of crude oil you should picture more than just the running costs of your car. A barrel of oil comprises many things like gasoline, gases, jet fuels, asphalt, and lubricants. It affects more things than one might suppose. If the price of oil changes then the cost of doing business (raw materials and transportation), corporate earnings (which affects stock prices), jobs, and the budgets of countries/states are all affected as well as the value of currencies, GDP, and other commodities. Oil companies don’t make all that much money. Look at a comparison of Exxon with Apple and Google. Notice how much Exxon makes in its best year (less than 15%).
You can’t invest in oil without actively following the news. It is not just about economic news but also political news. Production of oil is affected by wars, borrowing rates, and the balance of budgets. Decisions made by monarchies (part of OPEC) are not the same as decisions made by democracies. Countries like Saudi Arabia, for example, have the power and risk-taking capacity to drive oil prices up or down by large percentage points.
The U.S. accounts for more than 40% of oil consumption, more than any other country (so it is not just about China). Also, the U.S. buys more oil from Canada and Mexico than the Middle East. The U.S., Saudi Arabia and Russia are the biggest oil producers in the world (ahead of producers like China and Canada by more than two times).
The price of oil is not the same everywhere and the change in oil prices doesn’t trickle down to consumer prices equally. Currently, countries like Hong Kong, the Netherlands, Norway, and the UK happen to have the highest gasoline prices in the world. Venezuela has shockingly low oil prices currently.
Oil futures can be traded at the following exchanges: the New York Mercantile Exchange (NYMEX), the Intercontinental Exchange (ICE), the Dubai Mercantile Exchange (DME), the Multi Commodity Exchange (MCX), India’s National Commodity and Derivatives Exchange (NCDEX) and the Tokyo Commodity Exchange (TOCOM).
Indexes to watch for that invest in oil or related commodities include: the NYSE ARCA OIL & GAS INDEX, the S&P GSCI Crude Oil TR, the S&P GSCI Brent Crude and the S&P GSCI Unleaded Gasoline.
ETFs to consider while investing in oil related commodities include: the United States Oil Fund, the S&P GSCI Crude Oil Tot Ret Idx ETN, the United States Brent Oil Fund and the DB Oil Fund.
After being range-bound for three years, prices have fallen through the floor in the last 18 months.
Coffee is the most traded commodity after oil. It comes ahead of commodities like natural gas, gold, sugar and corn. Further, 67% of all coffee is grown in the Americas. So in that sense, Americans and coffee have a relationship similar to the Middle East and oil. There are two main type of commercial coffees: Arabica and Robusta. As the name suggests, Robusta is the more resilient of the two and is also the cheaper of the two beans. Of course, weather is a big factor in coffee production and prices. You have to track weather-related news in the countries that produce coffee to be able to intelligently in the bean.
It is not the U.S. but rather Finland that drinks the most coffee per capita in the world. Kraft, Nestle, Procter & Gamble and Sara Lee account for more than 50% of all Robusta coffee bean purchases. Cafes are growing faster than fast food companies.
Coffee futures can be traded at the following exchanges: the Brazilian Mercantile and Futures Exchange (BM&F), the Intercontinental Exchange (ICE), the Kansai Commodities Exchange (KEX), the Multi Commodity Exchange (MCX), the National Commodity and Derivatives Exchange (NCDEX), the Singapore Commodity Exchange (SICOM), the Tokyo Grain Exchange (TGE) and the NYSE Euronext.
Indexes to consider include: the S&P GSCI Coffee.
ETFs to consider include: the Dow Jones-UBS Coffee ETN, the Pure Beta Coffee ETN, the DB Agriculture Fund and the JJS Dow Jones-UBS Softs Total Return Sub-Index ETN.
Coffee prices have been falling for the last five years. There was a brief recover in early 2014 but the market has corrected and taken back all the gains.
3. Natural Gas
Liquefied natural gas is odorless, colorless, nontoxic, noncorrosive and nonflammable (in its liquid state). It only burns if the concentration is within a certain range of air-gas mix, and the smell is artificially added so that it can be easily identified. It is one of the safest and cleanest conventional energy sources.
The U.S. and Russia are the largest producers and consumers of natural gas in the world. It is the second-most used energy source after oil, just ahead of electricity. It is used in products like plastic, fertilizer, anti-freeze and fabrics. More than 50% of homes in the U.S. use natural gas for heating. Further, 98% of the natural gas consumed is produced in the U.S. and Canada. You would think this makes natural gas prices in the U.S. less dependent on external situations, like war or geopolitics. While part of that is true, natural gas does have a limited correlation with crude oil.
Both natural gas and oil have had a supply expansion (for multiple reasons) and that has driven prices down. Farmers are one of the greatest beneficiaries of the fall in prices because fertilizers derive their components from natural gas.
Natural gas futures can be traded on the New York Mercantile Exchange (NYMEX), the U.S. Futures Exchange (USFE), the Intercontinental Exchange (ICE) and the Multi Commodity Exchange (MCX).
Indexes to follow for natural gas investing include: the S&P GSCI Natural Gas and the NYSE ARCA NATURAL GAS INDEX.
ETFs to consider include: the United States Natural Gas Fund LP, the VelocityShares 3x Long Natural Gas ETN (leveraged), the VelocityShares 3x Inverse Natural Gas ETN (leveraged) and the DJ-UBS Natural Gas Subindex Total Return ETN.
The below graph is unlike the others. There was a decline in the prices in 2011, then natural gas recovered in 2012 only to decline again after 2014.
Sugar is derived either from sugar cane, found in tropical climates, or from sugar beet, found in temperate/mild climates. Sugar is traded only for three hours a day (9am – 12pm). Brazil accounts for 25% of the sugar produced in the world. The Brazilian real’s decrease against the dollar has helped Brazilian exporters. As per Luiz Correa, director at Archer Consulting, the Brazilian real has accounted for 60% of the fall in sugar prices.
An important factor that will come into play in 2017 is that the EU is cancelling the quota system for all sugar beet production. This could prove disastrous for farmers and result in an even sharper decline. Investor need to track weather news in Brazil, the currency fluctuations of the real and the EU reform to end quotas to make an informed decision.
Sugar futures can be traded on the following exchanges: London’s NYSE Liffe (contract code:W), the Intercontinental Exchange (contract codes: SB and SF), the Zhengzhou Commodity Exchange (contract code: SR) and the Brazilian exchange BM&F Bovespa (BM&F).
Indexes to track include: the S&P GSCI Sugar.
ETFs to consider include: the Dow Jones-UBS Sugar Subindex Total Return ETN and the Sugar Fund, Pure Beta Sugar ETN.
The price of sugar has fallen consistently for the last five years, with minor recoveries.
The Bottom Line
Investing is not just about returns. One needs to think about risk too. Commodities have a low correlation to the stock market. That presents a solid argument for diversifying and reducing portfolio risk. To start investing in any sector, irrespective of the method, you need to understand the sector. For stocks, these are factors like earnings, dividends, and financial ratios. For commodities, these are macroeconomic indicators about supply and demand, the geopolitical situation of commodity-producing countries, interest rates and currency values.
If you are not used to reading these metrics, all this might seem a bit tedious. Many investors find it easier to understand and react to macroeconomic data. For example, we know that commodities have an inverse relationship to the dollar. We also know that the Fed is likely to increase interest rates and that will make the dollar stronger. That will put commodity prices under further pressure in the short term. Add that to OPEC’s resistance to cut supply and a weak demand forecast and it is obvious that oil is likely to fall further from its current levels. You don’t have to have an economics degree to understand these relationships.
If investing via derivatives is not for you, here is a list of top commodity ETFs that will make the investment process convenient and effective.