What Are Commodities?

In simple terms, commodities are the raw materials used to help in our everyday lives. We use energy to sustain it, metals to build weapons and tools, and agricultural products for food. These — energy, metals, and agricultural products — are the three classes of commodities, and they are the essential building blocks of the global economy.

Commodities in general meet the following criteria:

Tradability: Meaning there needs to be a viable investment vehicle to help you trade it. For example, a commodity is included if it has a futures contract assigned to it on one of the major exchanges, or if a company processes it, or if there’s  a mutual fund that is traded like stocks on an exchange.

Uranium, which is an important energy commodity, isn’t tracked by a futures contract, but several companies specialize in mining and processing this mineral. By investing in these companies, you get exposure to uranium.

Deliverability: Crude oil is included because it can be delivered in barrels, and wheat is included because it can be delivered by the bushel.

Liquidity: Every commodity must have an active market with buyers and sellers constantly transacting with each other. Liquidity is critical because it gives you the option of getting in and out of an investment without having to face the difficulty of trying to find a buyer or seller for your securities.

Risks with Investing in Commodities

Investing is all about managing the risk involved with generating returns. Here are some common risks you face when investing in commodities and some small steps you can take to minimize these risks.

Geopolitical risk with commodities investments

One of the risks of commodities is that the world’s natural resources are located in various continents and the jurisdiction over these commodities lies with governments, international companies, and other entities. For example, to access the large deposits of oil located in the Persian Gulf region, oil companies have to deal with the sovereign countries of the Middle East that have jurisdiction over this oil.

International disagreements over the control of natural resources are quite commonplace. Sometimes a host country will simply kick out foreign companies involved in the                       

Production and distribution of natural resources.

So how to protect yourself from this uncertainty? One way is to invest in companies with experience and economies of scale. For example, if you’re interested in investing in an international oil company, go with one with an established track record.

Speculative risk with commodities

The commodities markets, just like the bond or stock markets, are populated by traders whose primary interest is in making short-term profits by speculating whether the price of a security will go up or go down.

If you trade commodities, constantly check the markets, finding out as much as you can about who the market participants are so that you can distinguish between the commercial users and the speculators.

One source you can check out is the Commitment of Traders report, which is put out by the Commodity Futures Trading Commission (CFTC).