Introduction to Commodities Investing

Module 6: Start Building Your Wealth

Learning Objectives:

• Learn how to invest in commodities.

• Determine the best options for you to invest in commodities.

There is perhaps no one single best way to invest in commodities. Every opportunity needs to be evaluated individually based on its particular merits and characteristics. Taking delivery of barrels of crude oil, for example, is typically highly impractical and expensive. But taking possession of actual silver coins may be highly desirable.

Outlined below are several of the options you have when it comes to investing in commodities and profiting from the opportunities this asset class presents.

Physical Exposure

This is the most basic way of achieving exposure to a commodity. Buy it and store it! This method ensures that investors have exposure to changes in the spot price of the commodity. Importantly, you would also need to consider storage options, costs and insurance. You should also have an idea of how to sell the commodity if/when that time comes. Taking possession of the commodity obviously provides you with quick and direct access to it when required. It also makes it difficult for authorities to confiscate it from you.

Commodity-Intensive Stocks

You can gain exposure to commodities indirectly by buying shares of certain companies. These companies can be engaged in the production or extraction of the commodity, or they can in some way serve the companies that do this production or extraction. Should you wish to invest in oil, you could invest in drillers, refineries, tanker companies, or diversified oil companies. With regard to gold, you could buy into mining companies, smelters, refineries, or generally any firm that deals with bullion. Because the profitability of these companies generally depends on the market price for their goods produced, their outlook will tend to improve when the relevant commodity price increases, and vice versa. It is important to note that these investments include all the additional risks that come with investing in companies.

Invest in Countries or Areas that are Rich in Commodities

This point will be explained with a true example: South Africa’s biggest city, Johannesburg, was established in 1886 following the discovery of a gold deposit. The city is now the one of the largest economic hubs in Africa, based on annual total nominal GDP per city. Where an economy has potential for significant growth and expansion, investment opportunities may abound.

Exchange-Traded Funds (ETFs) and Exchange-Traded Notes (ETNs)

ETFs and ETNs, which trade like stocks, allow investors to participate in commodity price fluctuations without investing directly in futures contracts.

Commodity ETFs usually attempt to track the price of a particular commodity or group of commodities that comprise an index by using futures contracts. ETNs are unsecured debt designed to mimic the price fluctuations of a particular commodity or commodity index.

A special brokerage account is typically not required to invest in ETFs or ETNs.

Mutual Funds and Index Funds

A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus. Typically, mutual funds cannot invest directly in commodities; they can invest in stocks of companies involved in commodity-related industries. Like the stocks they invest in, the fund’s value may be affected by factors other than commodity prices, including stock market fluctuations and company-specific events.

An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index. They adhere to specific rules or standards that stay in place no matter the state of the markets. A small number of commodity index funds invest in futures contracts and commodity-linked derivative instruments.

Forward and Futures Contracts

Forward contracts are not standardised and do not trade on an exchange.

Futures contracts are standardised and do trade on exchanges. Typically, a futures contract is not bought with the intention of actually taking delivery of the underlying commodity. Investors/traders usually sell the contract before expiration.

If you do not already have a broker that also trades in futures, you will need to open a brokerage account that allows you to do so. You can expect to be required to fill out a form acknowledging an understanding of the risks associated with futures trading.

Each commodity contract requires a different minimum deposit (depending on the broker) and the value of your account will increase or decrease daily with the value of the contract. If the value of the contract decreases past a certain level, you will be subject to a margin call and will be required to place more money into your account to keep the position open.

Most futures contracts will also have options associated with them.

Take Action

Assume that after completing sufficient due diligence on your commodity of choice, you have concluded that you wish to invest in it. Before pulling the trigger, answer the following important questions:

1. Which is the most practical and suitable way for you to invest in the commodity?

2. Which form of investment suits your investment goals the most?

3. When it comes time to liquidate your investment, how do you plan to do so? In other words, who will you sell to, and how will you access this buyer?