All about assets: commodities

Will Hodges continues his series by looking at how investors make money out of products we consume every day

What are commodities?

A commodity is a type of resource or good which is standardised and not differentiated by seller. For example, a kilo of refined sugar of a certain kind produced by one company is regarded as no different from a kilo produced on the other side of the world, whereas some consumer goods are distinguished by brand and by the components used.

  • Commodities can be split into the following sub-classes:
  • Precious metals, such as gold, silver and platinum
  • Industrial or base metals, such as copper, zinc, lead and aluminium
  • Energy, such as oil, natural gas, ethanol and heating oil
  • Agricultural goods (also known as soft commodities or "softs"), such as wheat, soybeans, cotton, sugar and coffee
  • Livestock, such as cattle, live hogs and, until recently, pork bellies.

What's all the fuss about?

Renowned US investment guru Jim Rogers was one of the first in the financial sector to recognise the potential of commodities as an asset class. Back in 1999, Rogers identified what he saw as the beginnings of a bull market (a prolonged rise in demand and, consequentially, prices) in commodities, which he predicted would run for a further 15-20 years. Twelve years on, he appears to have been proved right as the world has witnessed huge increases in the value of resources. The price of crude oil, for example, has risen from around $35 dollars a barrel in 2000 to around $100 a barrel. The cost of oil and other commodities has been driven up by increasing demand from emerging markets such as China and India, where private consumption levels and industrial output have soared. Against this backdrop, Rogers' contemporaries have increasingly turned to commodities rather than other assets such as shares and bonds.

Who invests in commodities?

Once a niche asset class, commodities are now a popular investment option for many kinds of investor, including pensions funds, general investment managers and hedge funds. Many larger investment firms run dedicated funds offering exposure to a variety of different commodities, thereby hedging against a drop in the value of any particular resource.

Traders and other short-term investors are able to purchase commodities through an exchange, such as the London Metals Exchange. Doing so means that ownership rights can be transferred without the physical exchange of goods. Goods are sold either under a spot contract, that is, at today's price, or under a futures contract, which allows the buyer to take delivery of the good at a point in the future at a pre-agreed price. More recently, private investors have also started to play the commodity markets. One of the easiest ways to do so is to buy shares in a commodities index run by a bank or investment firm. Usually this means purchasing a share in a "basket" of commodities of different types.

What are the advantages of investing in commodities?

In the light of sluggish western stock markets and continued concerns surrounding European and US debt markets, commodities are currently one of the more exciting asset classes. Unlike many other investments, commodities offer excellent exposure to emerging markets and, in particular, the consumption boom taking place in China and India. With neither economy showing signs of slowing down any time soon, commodities should present an attractive long-term investment.

What are the disadvantages of investing in commodities?

Commodity investing is not for the faint-hearted and has the potential to make fools of even the most battle-hardened of financial savants. Despite their growth in value over the past decade, commodities still represent one of the riskier asset classes to invest in on a short-term basis. Commodity assets, be they oil products, grains or livestock, are vulnerable to large fluctuations over a short time meaning that the potential for losses in the short term is significant. Bet the wrong way and the potential costs are huge. Take oil prices, which fell over a six-month period from mid-2008 to early 2009 from more than $120 a barrel to just $35 a barrel. Political and environmental factors can have a dramatic effect on returns. An unforeseen drought, for example, might send crop prices soaring, while over-production may lead to a price slump.

Where could I fit in?

With the impact of commodity markets on the global economy ever more apparent, there are more and more job opportunities for graduates. Here are some potential positions:

  • Commodity analyst at a bank or investment firm
  • Commodity trader with a brokerage or hedge fund
  • Consultant working for an agriculture, metals or mining consultancy
  • Graduate recruit at an energy company or a mining firm.