How to Invest In Commodities Markets
There is more than one entry route if one wants to gain an exposure in the commodities market. Positions can be built via many alternate routes. In this article we will look at some of these routes as well as their pros and cons.
Physical Purchase
Physically purchasing the commodities is the most direct and obvious way any person can invest in the commodities markets. This means that if you want to invest in gold, you simply take possession of gold and sell it when the prices increase. However, there are several limitations to this investing approach.
Firstly, a large amount of capital is required to make outright purchases. Markets provide leverage which is not available when making direct purchases.
Secondly, commodities like uranium and crude oil are not safe to take possession of. They require experts who know how to store and utilize these commodities.
Thirdly, it would not be advisable to take deliveries of large quantities of corn or meat since these commodities are perishable and need to be disposed off quickly.
It is for this reason very few investors actually take possession of the underlying commodities. Most contracts are settled in cash. In the rare case that delivery is actually taken, it is usually taken by corporations that use the given commodity commercially.
Equity Markets
Equity markets also present an opportunity for investors to gain a backdoor exposure to commodities. This is because when a person buys shares of companies like Exxon or Starbucks, they gain a huge exposure to the underlying commodity. This is because the business of the company is more or less completely intertwined with the business of the commodity. Many companies such as those that make pipelines for oil transportation are also completely dependent on the commodities market. Hence, such corporations theoretically do trade on the equity markets. However, in effect they are actually more affected by the trading activity in the commodities markets. The following companies usually provide opportunities for a backdoor entry into the commodities market.
Mining Companies: Some mining companies specialize in one single metal whereas some other companies specialize in a portfolio of metals. Therefore depending upon which metals an investor wants exposure to, they can zero down on a company. The returns provided by these companies have a high degree of correlation with the returns provided the underlying commodities.
Energy Companies: Energy companies can also provide varying degrees of exposure. For instance, companies like Exxon may be involved in every stage of the extraction process whereas other companies like Schlumberger may only be a supplier to these companies. There are other companies which are involved with only the transportation or marketing of such products and they too can be used to build a position.
Utilities: Electricity and utility companies also provide an exposure to commodities. These industries are highly affected by movements in the price of commodities such as coal.
Specialized Funds
There are many specialized funds that track the commodities market and provide an opportunity for the investor to invest their funds. For instance there are mutual funds that have been created with the sole purpose of investing in commodities. This provides investors who do not have expertise in commodities trading themselves an opportunity to do well in the markets.
There are even some hedge funds that have been created only to invest in commodities. However, these investments are usually very risky and are often not available to the average investor.
Also, many indices have been created. These indices are a composite of several c commodities. This means that they return they offer is a composite of several commodities too! Therefore, even if a person buys a single unit of such a fund, they get the advantage of buying into a well diversified portfolio. A lot of times, the money accumulated by these funds is not directly invested in the underlying commodities. It may be used to buy other commodities however the return provided by these commodities is usually mimicked.
Futures
Futures markets also allow traders to effectively use commodities to either hedge their existing positions or build new positions. Consider the case of an airline for example. They are aware that they will require a certain quantity of jet fuel in the forthcoming months. This quantity can usually be predicted with precision. However, the price of jet fuel is extremely volatile. If the airline wants to fix the price of fuel for its consumption, it can buy a futures contract in the markets. Hence they will be certain of what they will spend on fuel regardless of the vagaries of the marketplace.
At the same time, there might be a trader selling the contract. He/she may be of the opinion that price of the jet fuel will fall in the future and is therefore selling the contract hoping to gain some money. Also, it is very important to note that neither the airline nor the trader have to put down the entire amount of the transaction. A small margin can be used to hedge the exposure of a massive transaction. The futures market provides a high degree of leverage and is therefore the speculator’s favorite.
Investors can therefore choose to invest in commodities in multiple ways. Each of these ways has its own pros and cons.
source:www.managementstudyguide.com