Commodities are a hot topic at the moment, with prices soaring as other asset classes falter. NMTBP finds out more

What’s a commodity?

What do lean hogs, wheat, oil, and sugar have in common? They’re all physical products which are bought and sold on commodities exchanges in the form of three-month contracts, the prices of which directly affect the cost of your loaf of bread in the supermarket, a jar of coffee or the petrol you put in your car

Probably the most publicised is oil — you’ll often hear news reports on the price of a barrel of oil. One contract equals 1,000 barrels, and each ‘tick’ (price change) equals $10. The price of oil can affect lots of other things; for example the price of airline shares

There are two types of commodities: hard and soft. Hard commodities are natural resources that are mined or extracted (gold, rubber, oil), and soft commodities are agricultural products or livestock (wheat, coffee, sugar)

Despite the high profile of petrol and food prices, the commodity market is probably one of the least well-known

Buying and Selling

In days of yore, if you wanted to buy a cow, you could simply pop down to the nearest cattle market, purchase said animal, and then lead it back to your field. Nowadays, the buying and selling of commodities happens on exchanges where the contracts are traded. The actual trading can happen in a couple of different ways — usually spot or future:

Spot — a transaction where delivery of the commodity takes place pretty much immediately. So you buy your cow and take ownership of it there and then

Future — where the two parties agree to buy or sell a cow at a price that they set on that day (called the strike price), but delivery of the cow and payment occurs at a future date

The majority of commodity trading is electronic, but like many exchanges, it used to be open-outcry, in which the traders shout at each other and use hand signals to communicate. Want to see what an open-outcry trading floor is like?

This very short videois from the London International Financial Futures Exchange (LIFFE) floor around 1993. And that was probably on a quiet day!

The role of the exchange in all this is to act as an intermediary between buyer and seller. Each party puts an agreed amount of money into an account to reduce the risk of either side defaulting on the contract — this is called the margin

As in all financial markets, the price of the commodity will change on a daily basis, so each day the exchange will draw money out of one party’s margin account and put it into the other’s so that each party has a daily loss or profit that reflects the market price. If the margin account goes below a certain value, then a margin call is made and the account owner must put more money into the account

If you’ve seen Rogue Trader, the film about Barings Bank trader Nick Leeson, and how he came catastrophically unstuck, the term ‘margin call’ may be familiar. In Leeson’s case, he’d accumulated a loss of $1.4 billion from trading futures that he hid from his employers. The exchange then made a margin call on the hidden losses, which Barings was unable to meet. This resulted in the collapse of Britain’s oldest merchant bank and the Queen’s personal bank

“I’ve got a lorry full of pork bellies downstairs, can you sign for it?”

This is probably the worst possible thing a commodities trader could hear, apart from “You’re fired”. The City is full of anecdotes about someone who knows someone else who forgot to sell a commodity future contract and ended up with a lorry full of corn outside their office. In reality it doesn’t happen unless the party buying the contract is a manufacturer or someone who actually wants to take delivery (that usually happens in the spot market). All commodity futures have a delivery date, as they’re obviously physical products, but actual delivery only happens on about 2% of contracts. Many safeguards are in place to prevent inadvertent deliveries, not least because the office fridge couldn’t cope with that volume of meat!

How to invest

You can invest in commodities physically, by investing in a mining or exploration firm or indirectly through a fund or an investment trust. Investing physically means actually buying and holding the asset, although this comes with storage problems

In the case of buying a physical asset, gold is typically the most popular, with several bullion firms offering online gold dealing and safe storage of the asset. Buying physical gold coins also offers an easy way to access the metal. The World Gold Council gives details of reputable companies on its website, so always check there first

As for other natural resources such as oil and gas, one way to access them is to buy shares in companies, such as BP (BP), Royal Dutch Shell (RDSB) and Tullow Oil (TLW). The same applies to ‘soft’ commodity companies, although they are less numerous on the Footsie indices in the UK. However, your investment will be subject to movements in the stock market, as well as changes in the price of the commodity

To spread risk, an investment fund is an easy way to access the sector. They also provide a degree of diversification, as they will invest in a variety of commodities

Several natural resources funds have posted spectacular results in the wake of soaring gold prices

Specialist agriculture funds, such as the Baring Global Agriculture and First State Global Agribusiness funds have opened to new investors hoping to capitalise on rising food prices, and passive funds have also risen in popularity over the last few years, with ETFs becoming a viable way to access commodities

Equity-based commodity ETFs will invest in shares of commodity companies through an index such as the FTSE 100, whereas exchange traded commodities (ETCs) are instruments that track the future price of the commodity, or a basket of commodities. They can either be physically-backed by the commodity itself, or use swaps with other financial institutions to provide the exposure

However, as they

only track an index such as oil futures, there is little room for manoeuvre. Should the price of the commodity fall, so will the investment, as the ETF will simply track its performance. ETCs also allow investors to ‘short’ or ‘leverage’ their investment, allowing investors to either take bets on the price falling, or the price rising

Investors should be careful here, as although there are potential gains to be made, there could be huge potential losses too

Another avenue to explore is investing in a futures contract of a particular commodity. This investment will track the price of the metal, for example, at a particular point in the future, and are typically limited to large institutional investors who have the resources to take these positions

While this investment is linked more directly to the price of the metal than commodity equity funds, it might diverge from the current (spot) price of the metal because of the access costs to the future market

What investors should be aware of

There are four main reasons to invest in commodities are: portfolio diversification,  a hedge against inflation, being a safe haven and to take a bet on specific industries or regions

In addition, commodities already make up a significant proportion of the FTSE 100. Overall, the oil and gas industry makes up 17% of the index, while basic materials makes up 13% – which translates as a large part of any UK-focused portfolio

So look at your current portfolio carefully before ploughing money into commodities, as it’s likely a large part will already be invested in commodities, albeit through listed commodity companies

Also, with a smaller portfolio worth £50,000 or less, such a large percentage will already be invested in the sector so it makes little sense to invest further

Instead, if you really have a taste for commodities, it may be better to up your exposure to the emerging markets, as it’s here where some real growth can be gained from commodities. For example a large part of South America’s output is very commodity-driven. Investors can put a little bit extra into emerging market equities, which are heavily weighted towards commodities

Keep a good focus on costs. If you’re enticed to invest in a commodity fund, there can be up to a 5% initial charge. The more specialist the fund, the more you can expect to pay. If 5% is disappearing before you’re started, you’re on the back foot immediately

The meaning of LIFFE

In 1996, the London Commodity Exchange (LCE) merged with the London International Financial Futures Exchange (LIFFE) and started trading “soft” and agricultural commodities as well as financial derivatives. LIFFE was also open-outcry until 2000 and was eventually acquired by Euronext in 2002

Last year, the London Metal Exchange achieved a trading volume of $15.4 trillion annually, or $61 billion on an average business day. London recently overtook the US in trading North Sea Brent crude oil with over 715,000 contracts traded per day. London is also one of the main global centres for commodities trading along with New York and Chicago. That’s an awful lot of gold and oil!