What Are Commodities? What You Need to Know Before Buying Commodities.

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• Commodities are publicly traded tangible assets, agricultural products, and natural resources used in commerce and trade.
• Though highly volatile and high-risk, commodities can serve as a counterweight to stocks and bonds and a hedge against inflation.
• Investors can own commodities outright, but most buy commodity-related stocks or funds, or options on commodities futures contracts.

When you think about investing, stocks and bonds are probably the first things that come to mind. But you can also invest in tangible goods and substances. Known in the financial world as commodities, they’re often made up of the things you use or consume every day — from foodstuffs to gasoline to metals.

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What are commodities?

Commodities are among the oldest forms of wealth and investing, far predating stocks and bonds. In fact, the strength of many civilizations and countries has been linked to the buying and selling of commodities. The spice trade shaped the modern world in a lot of ways. The animals, textiles, and jewels moving along the Silk Road to market forged ties between Europe and Asia. The Vikings set sail to lands in search of grains and livestock. 

Commodities have financed societies and helped them grow. The ancient Greeks and Romans used gold as a currency. Hundreds of years later in the 19th century, the US Gold Rush more than tripled the population of California.

Today, commodities are considered alternative investments, while paper assets are considered the traditional ones. Still, they can play a key part in your portfolio.

“Commodities tend to have a low to negative correlation to stocks and bonds” — that is, their prices generally move in the opposite direction from these securities, explains to Trina Patel, a financial advisor at Albert, a savings and investing app.

For this reason, many investors turn toward commodities when the stock market has a poor outlook, or just to diversify their holdings.

Here’s what you need to know about commodities, how they work, and how to invest in them.

Types of commodities

Commodities are tangible goods that can be traded for other tangible goods or cash. They’re commercially sold products that you can buy, such as the coffee you brew in the morning or the gasoline you put into your car. The financial world splits commodities into two major categories: hard and soft. Hard commodities include resources that need to be extracted or mined, like gold or oil. Soft commodities are agricultural products and meat and livestock. 

There are four different groups of commodities within the hard and soft categories:

• Energy: This includes crude oil, heating oil, gasoline, and natural gas. As there is a limited global supply, energy prices have historically increased with demand. Energy commodities are volatile, affected by everything from economic ups and downs, regulations from the Organization of the Petroleum Exporting Countries (OPEC), and the shift toward renewable energy sources.
• Metals: This includes both industrial metals and precious metals. Gold is one of the most popular metal commodities because it’s one of the most stable in value. Many investors choose to invest in precious metals when stock prices are falling. Other metal commodities include silver, platinum, aluminum, tin, and copper.
• Agriculture: This sector includes crops, with some of the most popular being corn, soybean, wheat, sugar, and coffee. Overall, these commodities are subject to weather, natural disasters, and disease, but can be profitable in the face of population growth and limited food supply.
• Livestock and meat: This includes animals and animal products like live cattle, feeder cattle, live hogs, pork bellies, and milk. This sector faces many of the same constraints and benefits as agriculture.

How are commodities are traded?

Like stocks, commodities trade on public exchanges, their fluctuating prices posted openly. Exchanges either specialize in a particular group of commodities or offer several different types. commodities. For example, the London Metal Exchange (LME) specializes in metals, while the Chicago Mercantile Exchange (CME) trades agriculture, energy, and metals. 

Also like stocks, commodities’ performance is often tracked in indexes. The three of the most widely used commodities indexes in the United States are: 

• S&P GSCI index
• Bloomberg Commodity index
• DBIQ Optimum Yield Diversified Commodity index

What influences commodity prices?

Overall, commodities are typically considered high-risk investments. Their prices are driven by supply and demand, which of course also affects stocks. But, unlike stocks, commodities are affected — literally — by external, unpredictable elements like weather and natural disasters.

For example, in 1996, Hurricane Bertha swept through North Carolina, damaging 60% of the state’s corn crops. As much as 20% of the crop saw its yield cut in half. As a result, corn prices skyrocketed from $2.56 per bushel in May 1995 to a high of $4.77 per bushel in May 1996.

Commodities are also tied to politics and the macroeconomy. An extreme example is when between 1973 and 1974, oil prices spiked from a low of $3 per barrel to a high of $12 when Arab oil producers imposed an embargo to punish the West for supporting Israel in the October 1973 Yom Kippur War against Egypt and other Arab nations. 

In April 2020, the opposite happened. For the first time in history, the value of crude oil plummeted into negative numbers after the COVID-19 pandemic decimated demand and suppliers struggled to store their oversupply.

Why invest in commodities?

Just because commodities are vulnerable to a variety of risks doesn’t mean they’re a bad investment. In fact, commodity investing can be quite profitable as long as you have the right strategy and can watch the markets. 

Pros and cons of investing in commodities

4 ways to invest in commodities

There are a few different ways you can invest in commodities.

1. Direct ownership

One of the simplest ways to invest in commodities is to buy them directly. You don’t need to use a third party, and you can easily find a dealer, purchase what you want, and re-sell it when you don’t. However, this approach doesn’t work with every type of commodity.

Dealing with a precious metal like gold can be relatively simple since it’s among the more liquid commodities, available in coins. Direct ownership is a lot more complicated with large quantities of heavy — or living — things like cattle, crops, and drums of oil. When you get into the logistics of storage and shipping, it will be unmanageable for most people.

2. Futures contracts and options

Since it’s expensive to transport heavier materials like oil, metals, and agricultural products, commodities are often bought and sold as futures contracts. Futures contracts are legal obligations, in which someone agrees to buy or sell a commodity on a specific date at a specific price. 

Generally, you’ll see hedge funds or professional traders try to buy a commodity in the futures market hoping that the spot (or current) price of the commodity will rise, and the seller will be locked into honoring their obligation at the old, lower price. In turn, the hedge fund can flip the future for a profit.

Futures contracts can cost tens of thousands of dollars, though. And they’re highly speculative. You can guess wrong on the price move, and still be on the hook to buy the commodity. For individual investors, a safer move is often to buy options based on a futures contract. Similar to stock options, with these you have the right — but not the obligation — to follow through on the transaction by the specified date. This provides a way to profit but isn’t anywhere near as costly. 

3. Commodity stocks

Instead of investing directly in a commodity, many people prefer to invest in companies that produce or process those commodities. It should be noted that a company’s stock won’t necessarily rise and fall exactly with the price of the commodity, though it tends to be heavily influenced by it.

You can get a feel for a company’s financial outlook by examining its operations and contracts. For example, an upstream oil or gas company that plans to expand into renewable energy may have more longevity than one that isn’t. A company with high-yield, repeat contracts in place can be a safer bet than a company that’s still establishing its client base.

4. Commodity ETFs and mutual funds

Commodity-oriented exchange-traded funds and mutual funds can provide diversity and a lower-risk, lower-cost way to get exposure. 

These funds usually specialize in a particular type of commodity. Within that group, they may invest in one or a variety of commodity-related products like the physical commodity itself, futures contracts, and commodity stocks. 

Commodities FAQs