Commodities explained: what they are and how to invest

Written by the Tactfolio research teamPublished 6 min read

Commodities are basic raw goods, like oil, gold, wheat and copper, that are the same no matter who produces them. A barrel of crude oil from one supplier can be swapped for a barrel of the same grade from another. Businesses buy commodities to use them. Investors buy them to protect against rising prices or to bet on where prices go next.

Key points#

  • Commodities fall into four main groups: energy, metals, farm crops and livestock.
  • Most big commodity trading happens through futures contracts on exchanges. In the US, the CFTC oversees them.
  • Most individual investors use funds instead, such as GLD for gold or DBC for a mix of commodities.
  • Commodity prices can swing hard. In April 2020, a US oil futures contract fell below zero for the first time.
  • Commodities pay no interest or dividends. Their return comes only from price changes.

What are commodities?#

A commodity is a raw material or farm product that is bought and sold in bulk (Investor.gov). The key idea is that one unit is as good as another. Traders call this being interchangeable. A bushel of wheat of a set grade is a bushel of wheat, whoever grew it.

That makes commodities different from stocks. A share of Apple is not the same as a share of Ford. But an ounce of gold is an ounce of gold.

What are the main types of commodities?#

Commodities are usually split into four groups:

GroupExamplesWhat moves prices
EnergyCrude oil, natural gas, gasolineEconomic growth, supply cuts, wars, weather
MetalsGold, silver, copper, aluminumIndustry demand, interest rates, fear in markets
Farm cropsCorn, wheat, soybeans, coffee, sugarWeather, harvests, trade rules
LivestockLive cattle, lean hogsFeed costs, disease, demand for meat

Traders sometimes call energy and metals hard commodities, because they are mined or drilled. Farm goods are called soft commodities, because they are grown.

How does commodity trading work?#

Most commodity trading uses futures contracts. A futures contract is an agreement to buy or sell a set amount of a commodity at a set price on a future date (CFTC).

Here is a simple example. In spring, a farmer expects to harvest wheat in the fall. A bakery needs wheat in the fall. They agree today on a price of $6 a bushel for delivery in September. Now the farmer knows what they will earn, and the bakery knows what it will pay. Neither has to guess about the price in September.

Most futures traders never touch the actual goods. They close their contracts before the delivery date. Speculators use futures to bet on prices. Businesses use them to lock in prices. In the US, commodity futures must trade on an exchange through firms registered with the Commodity Futures Trading Commission (CFTC).

Futures use leverage. You put down only a small deposit, called margin, to control a large amount of the commodity. CFDs work in a similar way. Leverage makes losses bigger as well as gains. You can lose more than you put in.

How can you invest in commodities?#

There are four common ways:

  1. Buy the real thing. This works for gold and silver coins or bars. You have to store and insure them.
  2. Trade futures. This needs a futures account and comes with leverage and delivery dates. It suits experienced traders.
  3. Buy a commodity fund. Some funds hold the real metal. SPDR Gold Shares (GLD) holds gold bars in a vault (SPDR Gold Shares). Others hold futures. The Invesco DB Commodity Index Tracking Fund (DBC) holds futures on a mix of energy, metals and crops.
  4. Buy commodity company stocks. Oil producers and mining companies tend to move with commodity prices, but they also carry business risks of their own.

Futures-based funds have a catch. They must keep selling contracts that are about to end and buying later ones. This is called rolling. When later contracts cost more, each roll costs a little. So the fund can lag the price you see in the news.

Why commodity prices can go wild: oil below zero#

On April 20, 2020, the main US oil futures contract traded below zero for the first time since trading began in 1983 (EIA). At one point it hit about −$40 a barrel.

How can a price go below zero? That contract was about to end. Anyone still holding it had to take real oil in Cushing, Oklahoma. Demand had collapsed during the pandemic, and storage space was nearly full. Some holders paid others to take the contracts off their hands.

The lesson: a futures price is not the same as the price of the goods. Contract dates, storage and delivery all matter.

Do commodities protect against inflation?#

Sometimes. Inflation is the general rise in prices across the economy. Commodities are part of what gets more expensive, so their prices often rise with inflation.

2022 is a recent example. US consumer prices rose 9.1% in the 12 months to June 2022. That was the fastest pace in about 40 years, according to the Bureau of Labor Statistics. Stocks and bonds both fell that year, while many commodity prices rose.

But the link is loose. Commodities can also fall for years at a time, even when inflation is normal. Their price swings are often bigger than those of stocks.

Common mistakes#

  • Expecting a futures fund to match the commodity’s price. Rolling costs can make it lag.
  • Using leverage without a plan for big losses.
  • Buying after a huge price spike, often driven by news that has already played out.
  • Forgetting that commodities pay no income while you wait.
  • Putting too much in one commodity. Single commodities can swing more than a broad mix.

Try it on Tactfolio#

Many classic portfolios hold a slice of gold or commodities for balance. The All Weather Portfolio holds gold and a broad commodity fund next to stocks and Treasuries. The Permanent Portfolio and the Golden Butterfly each keep a fixed slice in gold. You can open each one, read every rule, and see how it did in its hypothetical backtest, including 2022. To compare a commodity mix with stocks, read what the S&P 500 index is. Commodities also show momentum, which some momentum strategies use to decide when to hold them.

Common questions#

What are examples of commodities?#

Crude oil, natural gas, gold, silver, copper, corn, wheat, soybeans, coffee, sugar, live cattle and lean hogs are all commodities. Each is sold in bulk, and one unit of a given grade is as good as another.

Is gold a commodity?#

Yes. Gold is a metal commodity. Many investors also treat it as a store of value, because it has held purchasing power over long periods. It can still fall a lot in the short run.

Are stocks commodities?#

No. A stock is a share of ownership in one company, and each company is different. A commodity is a raw good where every unit of the same grade is the same.

How do beginners invest in commodities?#

Many beginners use a fund. A gold fund like GLD tracks the price of gold. A broad fund like DBC holds futures on many commodities. Read each fund’s own pages for its fees and how it works before buying.

Do commodities pay dividends?#

No. A barrel of oil or an ounce of gold produces no income. Commodity funds may pass along small amounts of interest from cash they hold, but the main return comes from price changes.

Sources

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