In addition to investing in stocks and bonds, there are ways you can invest in commodities, raw materials that are either consumed directly or more commonly used to create other products. Examples include metals such as gold or aluminum, energy raw materials such as oil and natural gas, and basic food supplies such as wheat and corn, 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 too correlated with stock investing. Fortunately, investing in commodities is as easy as investing in stocks these days. There are numerous mutual funds and exchange-traded funds (ETFs) through which you can do it. However, the risks with commodity trading are quite different from those of stocks or bonds.
In the beginning
It helps to understand how commodity trading first began. It originated with farmers. It takes an entire 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. 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. The value of a commodity futures contract fluctuates from day to day based on the current price of the commodity – 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 storing them. Fund companies are not equipped to be able to take possession of thousands of barrels of oil or bushels of corn. That’s why nearly all commodity investments involve futures contracts.
Contango and backwardation
The situation that makes it difficult to get positive returns with such investments is called “contango,” which is when the price you have to pay today for the futures contract is higher than the spot or current price of the commodity, typically caused by basic supply and demand as well as the cost of storing the commodity.
Here’s an example: Suppose the spot price of corn today is $3 per bushel and the price you have to pay for a one-year corn futures contract is $4 per bushel. That means there’s an expectation that the price of this commodity will be rising over the next year. 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 your investment.
What if the situation were reversed? That’s called “backwardation,” another obscure term but 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 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 spot prices rather than via a futures contract. The fund achieves this by actually buying and storing the commodity. Commodity funds based on spot pricing do not face contango or backwardation.
Keep in mind that this explanation is highly simplified. The drivers of commodity spot and futures pricing are actually much more complex. Furthermore, 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.