What are commodities? Commodity market for beginners presented by XTB. Commodities as a means of inflation and diversification
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Commodities - what exactly are they?
Commodities or raw materials are goods that are used to produce other goods or services. It is a product derived from extraction (industrial goods) or cultivation (agricultural goods). Generally, semi-processed raw materials are called commodities, although in the case of investments, the two terms are used interchangeably. Raw materials are real, not contractual, as in the case of stocks, currencies or even the increasingly popular cryptocurrencies. This makes trading commodities different from investing in other asset classes and much more interesting.
Commodity prices are primarily determined by the interaction between supply (production + inventory) and demand (consumption + inventory), both locally and globally. The basic factors that affect the prices of goods, i.e. supply and demand, depend on many factors, such as the economic situation, natural resources of individual countries, weather, geopolitical events or supply and demand shocks, which we have recently witnessed more and more often (pandemics, wars).
Do you know that?
The history of commodity trading basically goes back to the beginning of commerce in society. The original form was barter, i.e. a form of exchange "goods for goods". Around 4000 BC in Sumer, the first primitive form of money was invented in the form of clay tablets, which began to be exchanged for goods and raw materials. However, the real milestone for modern trading was the opening in 1848 of the first commodity exchange - the Chicago Board of Trade (CBOT), which in 2007 merged with the CME Group, creating one of the most popular electronic markets for exchange and trading of contracts. Today, there are many commodity markets in the world, but the vast majority of trading is based on futures contracts, which are traded in markets in the United States.
The basic groups of goods include:
- energy commodities (e.g. crude oil, natural gas, coal);
- industrial metals (including copper, steel, aluminum, nickel, zinc);
- precious metals (e.g. gold, silver, platinum, palladium);
- cereals (e.g. wheat, corn);
- oilseeds (e.g. soybean, rapeseed);
- edible oils (e.g. palm oil, soybean oil);
- soft raw materials (e.g. coffee, cocoa, sugar);
These are just some of the basic groups of raw materials, but there are also groups such as rare earth metals (lithium, cobalt), electricity or carbon dioxide emission allowances, which are difficult to classify into a specific group.
Trading in the commodity market is primarily focused on futures contracts, although this is not the case for all commodities. However, exposure to most assets can be obtained through these contracts, stocks of companies involved in the production or trading of commodities, and ETFs. Of course, there is also the possibility of physical investments, although this is reserved primarily for the largest players who have the infrastructure to store the purchased goods.
Why goods?
Are commodities really a passing trend?
Over the past few years, commodities have been losing ground as a mature and "out of fashion" asset class that has failed to keep up with the changing world. It was often characterized by low price volatility and more stable rates of return, especially when compared to the strongly growing stock market or cryptocurrency market . As a result, the valuation of many commodities was almost "dormant", and globalization allowed investors to believe in continuous growth and underestimate the role of commodity availability in the global economy. Meanwhile, it is the reserves and prices of raw materials that determine the real condition of the economy and the strength of its industry. Crude oil, natural gas and uranium gained strategic importance, the true scale of which became apparent only as geopolitical and economic tensions increased.
The year 2022 was full of unforeseen events that continue to have a strong impact on the commodity market and cause above-average price volatility. Crises in supply chains, trade blockades in China, the war in Ukraine, friction between the USA, China and Russia, and the outflow of investors from the risky technology sector. All of these factors have brought commodities to the attention of the markets as an essential safe-haven asset class, and they continue to grow in popularity with traders and long-term investors alike.
The increased interest in the commodity market increased the volatility not only of the commodity contracts themselves, but also of the prices of listed companies. This contributed to the great return of the bull market in the commodity market.
Commodities as a means of inflation and diversification
Inflation protection - inflation and commodity prices are very closely related. Numerous studies are still unable to determine exactly what has a greater impact on what. However, it should be noted that rising commodity prices may be passed on by producers to consumers to some extent. In particular, when factor prices often rise by tens or hundreds of percent during times of demand or supply shocks. It is worth noting that the relationship between inflation and commodity prices depends on the period we are considering. Commodity prices have a huge impact on inflation in the short term (usually in the event of large price changes), while in the long term this impact becomes increasingly limited.
Influence of goods on inflation
Goods Other factors
Source: Bloomberg, XTB
Portfolio diversification - the aforementioned stable rates of return may also be desirable in the financial market. Commodity returns historically have a very low or even negative correlation with other key markets, especially the stock market. Therefore, commodities are a great way to diversify your portfolio. We often see situations where commodity prices react very differently to the stock market. If there is an oil shortage in the market despite a weak economy, oil prices should rise even if the stock market is falling.
Source: Bloomberg, XTB
It is worth remembering that commodities can also give exposure to the business cycle, globally or in a selected economy that is known for producing a given commodity or is its large consumer (e.g. you can look for a positive or negative exposure in the case of expectations of strong or weak economic growth in China - the world's largest consumer of raw materials). In addition, the goods can be used as a hedge against geopolitical or weather events (a war in a production region, e.g. in the Middle East, is often associated with an increase in oil prices, and if drought or floods are expected, we can expect an increase in the prices of e.g. wheat or corn) .
is not always viewed positively by many seasoned investors, such as Warren Buffett and Charlie Munger, and may limit a portfolio's growth potential, it is an optimal risk-reducing solution, especially for novice investors.
The commodities market can be an important part of a diversified investment portfolio, especially in 2022, when the topic of the commodity crisis is almost constantly present on the headlines. However, it may be important to divide the commodities sector in advance into assets that gain when market sentiment towards risk decreases and an aggressive part that increases with investors' appetite for risk. Some commodity companies, such as Occidental Petroleum, survived the recent downturn in very good shape and were able to generate profits even in the face of declines in the broader market. Exposure to the commodity market may prove to be a risk-mitigating solution to investing in the tech sector, which tends to rise when investor sentiment is positive and fall when markets are fearful.
In this way, the shares of the world's largest commodity companies, such as Rio Tinto (RIO.UK) or BHP Billiton, can be included in the defensive portfolio (BHP.UK), companies from the fuel sector, such as Chevron or ExxonMobil, and companies involved in the mining and sale of metals, including precious metals, such as Wheaton Precious Metals . On the other hand, the aggressive part of the investment portfolio may include stocks from sectors that attract speculative growth and high volatility, such as uranium and rare earths companies.
