The Difficulty With Investing in Commodities

The Difficulty With Investing in Commodities

In addition to investing in stocks and bonds, there are also ways you can invest in commodities. These are raw materials that are either consumed directly or more commonly used by manufacturers to create other products. Examples include metals such as gold, silver, aluminum, and copper; energy raw materials such as oil and natural gas; basic food supplies such as wheat and corn; and other types of raw materials such as cotton and wood (timber), to name a few. Because commodity prices tend to be uncorrelated with stock and bond prices, adding commodity investments to a portfolio can provide valuable diversification.

To be clear, I’m not talking about investing in the stocks of commodity producers such as mining or farming companies but rather directly in the commodities themselves. The former is much more correlated with stock investing than it is with commodity price movements. Fortunately investing in commodities is as easy as investing in stocks these days. There are numerous mutual funds and ETFs through which you can do it. However, the risks with commodity trading are quite different than with stocks or bonds. Here’s why.

It helps to understand how commodity trading first began. It originated with farmers. It takes a whole season to grow foodstuffs, and farmers had no way of knowing that far into the future what the demand (and consequently price) for their produce would turn out to be. That need spawned the creation of futures contracts, agreements between the farmers and the wholesalers that fixed the future price in advance so that the farmers could avoid the risk of losing money. The farmer agreed to provide a certain amount of corn, for example, in exchange for a certain price on a set date. It didn’t take long for the financial industry to figure out that these contracts had value and could be bought and sold before they expired. As with bonds or options, the value of a commodity futures contract fluctuates from day-to-day based on the current price of the commodity (called its spot price) together with the latest expectations of its price when the contract expires. Today a large volume of futures contracts for a wide array of commodities are traded on a daily basis at exchanges such as the Chicago Mercantile Exchange Group. It is primarily these futures contracts in which commodity funds invest.

Why don’t the funds invest directly in the commodities themselves? Because that would require purchasing them. Fund companies are not equipped to be able to take possession of thousands of barrels of oil or bushels of corn, for example. That’s why almost all commodity investments involve futures contracts. And the situation that makes it difficult to get positive returns with such contracts is called contango.

Contango is when the price you have to pay today for the futures contract is higher than the spot or current price of the commodity. There are numerous causes for this, such as basic supply and demand as well as the cost of storing the commodity. Let’s use an example to explore some of the issues with this situation.

Suppose the spot price of corn today is $3 per bushel and the price of a one year corn futures contract is $4. That means there’s an expectation that the price of this commodity will be rising in the future. If it were a stock it would sound like a good investment. But the value of the contract will converge toward the spot price at expiration. If at that time the price of corn has not increased to at least $4 you’ll lose money on this investment.

What if the situation were reversed? That’s called backwardation, another obscure term but at least a bit more descriptive than contango. Let’s assume the spot price of corn is $4 per bushel and the futures contract price is only $3. That sounds like a better deal! But it really means that the market is expecting the price of corn to drop over the next year. The only way you’ll get a positive return is if the market is wrong and the current price holds up or at least doesn’t drop as much as anticipated. It’s not as risky as contango but would you want to invest in something whose price is expected to go down?

There are a few commodities (gold, for example) for which you can buy shares of ETFs or mutual funds based on its spot price rather than via a futures contract. The fund is able to achieve this by actually buying the commodity and storing it. Commodity funds based on spot pricing do not face contango and backwardation.

The description of contango and backwardation above is highly simplified. Commodity spot and futures pricing movements are in reality much more complex. Funds that hold hundreds of futures contracts can use arbitrage and other techniques to try to manage contango and backwardation. Nonetheless it’s important to understand these unique challenges to commodity investing before deciding to take the plunge.

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