You might not know it, but you're already a commodities expert. Whether you've talked about high gasoline prices, or the quality of your last espresso, in some form you've had discussions on the topic. Commodities are a part of daily lives, so perhaps it's time to take a closer use at these items that make the world go ‘round.
Walk through the aisles of any major store and you will see a wealth of "soft" commodities. Coffee, cereal, orange juice, meat, bread made with wheat, and chocolate with cocoa and sugar. We are also surrounded by "hard" commodities, which are in our homes, automobiles, and in every piece of electronic equipment we use. The "hard" stuff includes industrial or precious metals, livestock, and the drivers of the energy market, crude oil, heating oil, natural gas and gasoline.
How Are Commodities Traded?
Now you're probably wondering how these daily essentials are priced, where they come from, and how they make their way onto supermarket shelves, or into the clothing we wear, or the cars we drive. Commodities futures markets around the world make this possible. A future is a financial contract to buy or sell a specified amount of a product or financial instrument at an agreed price on or before a given date in the future. For example, farmers can sell grain months before harvest in order to lock a price for their crop. The farmer is then assured of a steady price – despite weather risks. Therefore, the buyer assumes the price risk. Compensation for assuming that risk is given by setting the price below that of the expected spot price. The closer the time of delivery, the more the price of the futures contracts converges to the spot price. Since the futures price is initially set below the expected spot price, it gradually increases as the delivery date approaches, producing a return for the buyer.
Trading in futures originated in Japan during the 18th century and was used for the trading of rice and silk. In 1948, the United States followed with its first futures market, the Chicago Board of Trade. It was founded by 82 merchants to help agricultural producers and consumers manage the price risks of harvesting, marketing and processing crops each year. Many of the largest futures exchanges around the world have their roots in agriculture, and have developed into global marketplaces not only for agricultural goods, but also for currencies and financial instruments, such as bonds. Essentially, futures markets are major financial hubs, which provide an outlet for competition among buyers and sellers while managing price risks. "Trading decisions in futures markets are made through fundamental or technical analysis," says Tobias Merath, Credit Suisse Commodities and Equities Trading analyst.
Fundamental analysis includes all factors that influence supply and demand. For the physical commodities markets in producing countries, they include economic growth and outside forces that influence prices. Technical analysis is strictly based on inside market forces. It involves tracking past price patterns. Analysts focus on a variety of time frames, and trading decisions are based on past tendencies with the idea that these price patterns tend to repeat themselves.
Why Invest in Commodities Now?
The biggest catalyst for the commodities market is global economic growth. Currently, China and India are the main drivers of the boom that some financial experts have forecasted. "The integration of developing countries into the global economy presents a range of opportunities," says Giles Keating, Credit Suisse Head of Global Research. "Of the 6.5 billion people in the world, three-quarters are still outside the mainstream economy, but many are moving into the cities. To provide for them, a substantial investment is required in the provision of infrastructure, water, housing, offices, factories, sewage systems and transport." This production spurt translates into higher demand for all commodities.
Keep in mind that commodities are distinct from financial assets and react differently to changing economic conditions. "In a diversified portfolio, assets do not move in sync with each other, which limits the volatility of the portfolio and improves the consistency of returns over time," says Tobias Merath.
Be prepared
Before jumping in, it's important to note that investing in commodities is not as easy as investing in equities or bonds. Indices offer the simplest way of investing in commodities. "In contrast to the stocks of commodity companies, indices offer direct exposure to commodity futures and are a good way of profiting from the returns and the diversification potential that commodities offer." Now that you're armed with some of the basics, you can decide whether to add commodities to your portfolio with the help of your financial advisor.
