Commodities are generally sensitive to economic cycles, tend to perform well during the mid-to-late stages of the business cycle, and offer exposure to growth associated with the global need for infrastructure replacement.
Commodities are said to be “inflation-adjusted” – because commodity prices form part of the definition and computation of inflation, they are positively correlated with inflation. Unlike financial securities, commodities have prices that are not directly determined by the discounted value of future cash flows. Instead, prices are based on supply vs. demand.
- Define the largest commodities players
- Define commodities sectors
- Explore portfolio construction with commodities
The Largest Commodities Players
The largest commodities companies on the planet are private companies, not public. This means we are unable to invest easily in those companies. However, there are several well-known and large commodities trading companies with public stock. The largest commodities players are not only producers, but also specialists in trading, marketing and transporting physical commodities.
These large commodities companies are literally the infrastructure that creates prices in futures markets:
- Glencore ($GLNCY) – one of the agricultural “ABCDs”
- Cargill – one of the agricultural “ABCDs”
- Salam Investment
- Archer Daniels Midland ($ADM) – one of the agricultural “ABCDs”
- Mercuria Energy Group
- Noble Group
- Louis Dreyfus – one of the agricultural “ABCDs”
- Bunge Limited ($BG) – one of the agricultural “ABCDs”
- Wilmar International
- Olam International
- Cannon Trading Company
As an asset class, commodities are segmented into three primary sectors: metals, energies, and agriculture. Industrial and precious metals move very differently from one another and have different catalysts, so they are separated into two distinct sectors. Energies includes alternative energies, although these have not seen huge traction with investors. Therefore, commodities sectors include:
- Industrial metals
- Precious metals
Energy commodity markets are complex, dynamic, global, and geopolitical. Not only that, but energy is also a major component in inflation indices around the world, which makes investments in energy an effective hedge against rising prices. And, as we are all aware, energy resources are essential to daily life. In short, energies exposure is an essential element for portfolio diversification in commodities.
The energy sector consists of companies involved in the exploration, production, or management of energy resources such as crude oil, natural gas, and coal, as well as derived products and companies that service these industries. The energy sector also includes less frequently considered sub-sectors such as electricity, solar power, wind power, and ethanol.
An agricultural commodity is defined in Commission regulation 1.3(zz) as, a commodity in one of four categories:
- The enumerated commodities listed in section 1a of the Commodity Exchange Act, including such things as wheat, cotton, corn, the soybean complex, livestock, etc.
- A general operational definition that covers: “All other commodities that are, or once were, or are derived from, living organisms, including plant, animal and aquatic life, which are generally fungible, within their respective classes, and are used primarily for human food, shelter, animal feed, or natural fiber”
- A catch-all category for commodities that would generally be recognized as agricultural in nature, but which don’t fit within the general operational definition: “Tobacco, products of horticulture, and such other commodities used or consumed by animals or humans as the Commission may by rule, regulation, or order designate after notice and opportunity for hearing”
- “Commodity-based indexes based wholly or principally on underlying agricultural commodities.”
That’s the long definition. The short definition: agricultural commodities are staple crops and animals produced or raised on farms or plantations.
Industrial metals are commodities used in a wide variety of industrial applications, including numerous construction and manufacturing businesses. Industrial metals are the metals that build things. Need a bridge? Gotta have steel. Need a telecommunications tower? Gotta have copper. As a play on global infrastructure and the growth of emerging markets, industrial metals commodities tend to correlate to strong global equity markets. Industrial metals include aluminum, copper, lead, nickel, steel, iron ore, tin, zinc, and energy metals such as lithium, cobalt, and uranium, although some analysts place uranium with energies. Of those industrial metals, aluminum, copper, lead, nickel, iron ore, tin, and zinc are base metals.
Valued for their use as investments, art, jewelry, and commodities, the rarity of precious metals has given them a high economic value throughout history. The most popular precious metals include gold, silver, palladium, and platinum. Those precious metals, except for gold, find more use in industrial applications than as stores of value, the primary utility of gold. As such, some refer to gold as the only true precious metal, with palladium and platinum, for example, seeing correlation to industrial growth as is the case with the primary industrial metals.
Note that the PGMs, or Platinum Group Metals, are a set of six transition metals that share similar properties. These are perhaps better considered as a sub-sector of precious metals, with much more use found in the industrial sector than in jewelry or stored bullion. The PGM metals are all extremely dense, highly resistant to wear and corrosion, have stable electrical properties, and are important catalysts in the petrochemical industry. The six metals in this group include iridium, osmium, palladium, platinum, rhodium, and ruthenium.
There are a number of ways to gain exposure to specific commodity sectors, some of which are not appropriate for a long-term diversified portfolio:
- Physical Commodities
- Commodity-Related Equities
Of course, an investor can purchase and physically hold a commodity. Physically storing a commodity can be problematic, though, and definitely increases transportation costs. Except in the case of gold, most investors are not prepared to deal with the marketing of physical commodities or in working with brokers. The storing of physical commodities is better left to professional commodities traders such as Glencore, who have the infrastructure to profit from the movement of physical commodities.
Perhaps the easiest way for investors to gain exposure to commodities is through commodity-related equities investments. After all, these companies derive a substantial part of their revenues from the sale of physical commodities. However, while it may be true that these companies see exposure to a related commodity, they may be poor substitutes with stock prices poorly correlated to the commodity prices to which we seek exposure. We can see this lack of correlation in the prices of gold miners of the last couple years against the price of physical gold.
The world of ETFs has opened up many commodity-related investments. Far from the days when the Hayes developed his Permanent Portfolio, investors now have investment opportunities in everything from, including and beyond: broadly diversified commodity baskets, sector-specific portfolios, individual commodities (without physically holding), leveraged plays, and even short, or negatively correlated, positions. And those are just the plays on commodities’ price movements – there are ETFs that offer exposure to commodity-related equities such as metals producers, as well.
Commodity futures contracts and forward contracts are a common way to achieve commodity price exposure. With these financial instruments, the return is generated from positive changes in the futures price of the commodity, assuming we’re referring to a long position, of course. It is entirely possible to take short positions with futures as well.
So, What’s the Point?
It is more important to diversify across assets classes than within an asset class, when the goal is risk management, minimized drawdown, capital preservation, and stable returns.
Get the book What is Investment Diversification? to explore commodities in more detail and with the final selections by the author.
Now, let’s take a look at cash & equivalents in the next study guide.
Staple crops and animals produced or raised on farms or plantations. Agricultural commodities include fruits, vegetables, grains such as wheat and soybeans, legumes, animal feed and forage crops, rangeland and pasture, seed crops, fiber crops such as hemp, oil crops such as corn, trees grown for lumber and wood products, nursery stock grown commercially, livestock, poultry, and any other agricultural products having a domestic or foreign market.
The process where near month futures are more expensive than those expiring further into the future, creating a downward sloping curve for future prices over time. (opposite of “contango”)
Bloomberg Commodity Index (BCOM)
Index constructed of futures contracts on 22 physical commodities across a diversified range of groups.
Raw materials or primary agricultural products that can be bought and sold, such as copper or coffee.
Commodity Research Bureau (CRB) Index
The Reuters/Jefferies Commodity Research Bureau (CRB) Index is made up of 19 commodities traded on various exchanges and uses a four-tiered grouping system to weigh the commodities in the index, with the system designed to reflect the importance of each commodity to global economic development.
The process where near month futures are cheaper than those expiring further into the future, creating an upward sloping curve for future prices over time. (opposite of “backwardation”)
Companies involved in the exploration, production, or management of energy resources such as crude oil, natural gas, and coal, as well as derived products and companies that service these industries. The energy sector also includes less frequently considered sub-sectors such as electricity, solar power, wind power, and ethanol.
Exchange Traded Funds (ETFs)
An investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds and generally operates with an arbitrage mechanism designed to keep it trading close to its net asset value, although deviations can occasionally occur.
Exchange Traded Notes (ETNs)
Senior, unsecured, unsubordinated debt securities issued by a bank or financial institution that have a maturity date and seek to mimic the return of specific equity, commodity, and currency indexes.
Agreements traded on an organized exchange to buy or sell assets, especially commodities or shares, at a fixed price but to be delivered and paid for later.
Industrial metals include aluminum, copper, lead, nickel, steel, iron ore, tin, zinc, and energy metals such as lithium, cobalt, and uranium, although some analysts place uranium with energies. Of those industrial metals, aluminum, copper, lead, nickel, iron ore, tin, and zinc are base metals.
The actual commodity that is delivered to a futures contract buyer when the expiration of the commodity contract occurs. Metals such as copper, gold, and silver and agricultural products such as cattle, wheat, and soybeans are examples of physical commodities.
Platinum Group Metals
Six transition metals that share similar properties. Perhaps better considered as a sub-sector of precious metals, with much more use found in the industrial sector than in jewelry or stored bullion. The six metals in this group include iridium, osmium, palladium, platinum, rhodium, and ruthenium.
The most popular precious metals include gold, silver, palladium, and platinum. Most precious metals, except for gold, find more use in industrial applications than as stores of value, the primary utility of gold. As such, some refer to gold as the only true precious metal,
The Standard & Poor’s Goldman Sachs Commodity Index, or the S&P GSCI, is constructed of futures contracts on 24 physical commodities across five groups: precious metals, industrial metals, livestock, agriculture, and energy.