You probably spend a lot more time thinking about commodities than you realize—from
the cup of coffee you drank for a morning boost to the fuel that helped get you to work.
Commodities are raw materials that get harvested and refined into things people use every day,
from soybeans to cooking oil, crude oil to gasoline, precious metals to jewelry, and
much more.
Commodities can be an important part of an investment portfolio because they often perform
differently than other assets, which can provide greater diversification.
They may also help protect a portfolio from inflation because commodity prices often rise
when costs spike.
And for active traders, the volatile nature of commodities can offer potential opportunities
by speculating on their price movement.
However, this volatility which can be extreme at times, means investing in commodities isn’t
appropriate for everyone.
There are several ways to invest in commodities, but first, it’s important to understand
what drives commodity prices.
Commodity prices rise and fall depending on supply and demand, which are influenced by
the U.S. dollar and supply shocks.
The strength or weakness of the U.S. dollar influences commodity prices because many commodities
around the world are traded in dollars.
A stronger dollar can put pressure on other countries’ currencies, which can lead to
economic slowdown and suppress demand for commodities.
So, if the dollar is strengthening, commodity prices tend to fall.
If the dollar is weakening, commodity prices tend to rise.
This chart compares the S&P Goldman Sachs Commodity Index, or GSCI, to the U.S. Dollar
Index from 2002 to 2022.
Notice the inverse relationship commodities have with the dollar.
However, other factors can outweigh the influence of the dollar, especially supply shocks.
Supply shocks arise when there’s trouble getting enough supply to meet demand.
During the COVID-19 pandemic, commodities had two supply shocks.
First, as pandemic news was emerging, economic activity was halted, and commodity prices
cratered.
Oil prices even went negative briefly while companies tried to sell tankers full of oil.
Second, as the economy started moving again and demand rose, many workers couldn’t leave
home to harvest or ship commodities.
Some supply chains were completely shut off, causing commodity prices to rise quickly.
Supply chain issues aren’t new, but they usually occur during extreme weather or other
natural disasters.
Supply chain issues can also be stirred up by political factors, such as the turmoil
caused when Russia invaded Ukraine in 2022, upending Ukraine’s commodity-driven economy.
Sanctions from countries in the European Union that blocked Russian oil and gas added to
the commotion.
Other factors can also restrict the supply of commodities, such as competition and specialization.
For example, not many companies specialize in the extraction of lithium in part because
of the high barrier to entry.
This constraint on supply, combined with greater demand as more people bought electric vehicles,
caused lithium prices to rise dramatically in 2021 and 2022.
Additionally, government policies can restrict supplies by limiting the number of drilling
and mining permits, blocking access to government lands, or banning harvesting in certain areas.
When supplies are limited and demand is high, commodities can experience a bull market.
Sometimes these bull markets can be extended into what’s called a supercycle, meaning
prices stay high for a long time.
According to the National Bureau of Economic Research, a supercycle can last 20 years or
longer.
During a supercycle, commodities often outperform stocks.
This chart compares the GSCI to the S&P 500® from 2000 to 2022.
Below the chart, the relative strength indicator gives you an easy comparison of the two indexes.
When the relative strength line rose in the 2000s, commodities were doing better than
stocks.
There are lots of ways to get exposure to commodities.
Your goals will likely influence the investment vehicle you use.
For example, you could choose to own stocks in sectors that harvest and sell commodities,
such as energy and basic materials.
If you’re forecasting a prolonged bull market, you could also invest in industrial stocks
because heavy machinery is needed to harvest, move, and refine materials.
There are also mutual funds and ETFs that focus on specific commodities, as well as
funds that focus on stocks in the energy or materials sectors.
Some active traders might be interested in speculating on specific commodities with futures
contracts.
A futures contract is an agreement to buy or sell a commodity at a specified price sometime
down the road.
The buyer or seller of the contract makes a profit or loss, depending on the changes
in price.
These traders are often attracted to futures because they’re highly leveraged and can
result in large gains, but it can also quickly lead to very large losses with small price
movements.
However you might choose to invest in commodities, remember they're usually more volatile than
other more traditional assets, which can add greater risk to a portfolio despite potentially
improving diversification.
Carefully consider how much of your portfolio you want to devote to commodity-related investments
keeping in mind that higher allocations may reduce the diversification benefits.
No matter how hot or cold commodities get, it’s important to focus on your individual
goals and risk tolerance when investing in this asset class.