Commodities 101: Why invest in commodities?

Illustration by Melanie Lambrick

What are commodities?

Commodities are the raw materials that go into the manufactured or processed goods we use or consume every day. They include metals, fossil fuels, forest products and foodstuffs. They are typically standardized – with names like West Texas Intermediate crude oil and spring wheat – and undifferentiated, and so are priced roughly the same the world over. That makes the producers of commodities price takers rather than price setters, but there are advantages to holding them as investments nonetheless.

Why invest in commodities?

The main reason to invest in commodities is to diversify your investment portfolio away from the standard core holdings of stocks and bonds. Specific materials have their own supply and demand cycles, and therefore the potential to zig when the bulk of your portfolio zags.

The other appealing aspect of commodities is that they promise to combat or at least keep pace with inflation. Being real assets, they will tend to hold their value against depreciating currencies over the long term, though short-term moves may be unpredictable. Say you have a defined-benefit pension that is not indexed for inflation and you’re concerned it may lose a lot of its purchasing power by the time you retire. Holding commodities is one way to hedge against this inflation risk.

The return of inflation in 2022 “makes commodities particularly relevant in today’s macroeconomic environment,” says Kristy Akullian, Americas senior strategist, iShares for BlackRock. “A commodity allocation can serve as a portfolio ballast in what is likely a bumpy path ahead.”

How can I invest in commodities?

With the exception of precious metals, it’s impractical for retail investors to own commodities in their physical state. Even gold bullion or jewellery pose a risk of theft or loss if your house burns down, or incurs the cost of storing them in a vault. For that reason most investors seek exposure in either of two ways: by owning, directly or indirectly, commodity futures or stocks of commodity producers.

Commodity futures are securities you can buy on a commodity exchange. They represent a contract from a seller to deliver a set amount of soybeans, natural gas, aluminum and so on to a certain place (a trading hub, usually) at a certain time. “Trading commodities can be complex and operationally burdensome,” Ms. Akullian points out. An easier way for retail investors to invest in commodities is to buy units of mutual funds or exchange-traded funds that hold futures, the physical commodity in storage or a combination of the two.

Alternatively, you can invest in commodity producers, which are classified in the materials and energy sectors on stock exchanges. Investing in commodity stocks does not provide as much of a diversification benefit as investing in physical commodities does; as you might expect, they are still highly correlated to the stock market. As for-profit enterprises, however, they do offer the potential for value creation over and above changes in the commodity price. Some commodity stocks even pay a dividend. Commodities themselves, by contrast, offer no prospect of investment income.

You can also find ETFs that hold stocks of companies exploring for and producing specific commodities, such as lithium, or invested in the broader energy or materials categories or in commodity producers generally. These may either track an index or be actively managed.

“Stocks give you a little more leverage,” Nick Piquard, portfolio manager with Horizons ETFs, points out. “When a commodity does well, stocks do even better.” For example, oil increased in price approximately 50 per cent from 2021 to 2022, but many exploration and production stocks doubled or even tripled over the same period, reflecting the increase in their profitability.

Natural resource stocks divide between producers with commercial operations and junior companies whose value lies in the prospects of their exploration properties for future development. The latter have an especially high level of risk and potential return. Another subset of commodity stocks, royalty streaming companies, specializes in investing in other companies’ raw material production (without the exploration or operational risk of owning the mines or wells) and passing the proceeds on to investors. They are a good option for investors who want to combine commodity exposure with income.

How much commodity exposure should you have?

In 1996, Ray Dalio, founder and co-chief investment officer of hedge fund Bridgewater Associates, sought to create a more sophisticated alternative to the traditional 60/40 portfolio (60-per-cent equities, 40-per-cent fixed income). He wanted something that would hold up in almost all market conditions. To further that goal, Dalio’s All-Weather Portfolio included a 15-per-cent allocation to commodities. That’s higher than most advisers recommend. (Five per cent to 10 per cent would be more common.) Still, 2022 proved to be the kind of year when all-weather assets prove their worth as equities and fixed income declined in tandem.

Whether you need to increase your commodity exposure will depend in large part on how your portfolio is allocated now. If your equity holdings are dominated by U.S. stocks, you will have very little commodity exposure – the S&P 500 includes just one gold producer and one copper miner, and only a handful of oil and gas names. In that case you should consider increasing your commodity exposure.

If, however, you have more than a quarter of your portfolio in Canadian stocks, you will already have substantial exposure to commodities, given the heavy weighting of energy and materials producers in our domestic market. If this is you, there is less need to raise your commodity allocation, unless you’re specifically looking for an inflation hedge in the form of physical commodities or futures.

What’s the outlook for commodities?

Commodities have underperformed other assets for the past decade, during which time inflation and interest rates have been at modern-day lows. Should inflation stay elevated beyond 2022 – and many strategists think it will – commodities will likely enjoy a better run in the foreseeable future. “The risk/reward is pretty compelling right now,” says Mr. Piquard at Horizons ETFs, which offers several commodity funds.

Considering the multiyear time frame it takes to ramp up the supply of most commodities and stored supplies (such as the U.S. Strategic Petroleum Reserve) having been drawn down, “we do not see supply pressures alleviating meaningfully in the near term,” BlackRock’s Ms. Akullian adds. The risk to commodities lies mostly on the demand side; a global recession would cause their prices to decline.

Keep in mind that not all individual commodities will move in the same direction at any one time; each has its own supply and demand dynamics. Niche commodities including uranium or potash with only a handful of producers will be less predictable than high-volume commodities with a multitude of producers, such as oil or grain.

What are some examples of commodities worth investing in?

  1. Gold: The yellow metal is primarily used as a store of value, not for any useful purpose. But it has been an incorruptible store of value for thousands of years and so serves as a handy inflation hedge. Gold bugs will note that about the same weight in gold would have bought you a house 100 years ago as today.
  2. Oil: Love it or hate it, black gold is still the world’s No. 1 source of primary energy. That most of the world’s supply comes from undemocratic countries with nationalized resources ensures geopolitics is a major factor in its oscillations. Underinvestment in Western supply since 2014 is helping keep prices high.
  3. Lumber: Demand for lumber is closely tied to housing markets, which are in turn affected by interest rates. Within interest rate cycles there are smaller supply and demand dynamics, often influenced by the perennial softwood lumber trade action between the United States and Canada.
  4. Grain: Global crop output is dependent on weather, which is impossible to predict. But this is one commodity barely affected by economic conditions – we all gotta eat. As we witnessed in 2022 with Russia’s invasion of Ukraine, though, food supplies and prices can be affected by geopolitics as well.
  5. Critical minerals: This list of minerals, which ranges from widely used copper to lithium, cobalt and rare earth minerals, has been the cause of a lot of excitement among investors in recent years. These are the commodities we’ll need a whole lot more of as the world transitions its sources of energy from fossil fuels to renewables. Production of some critical minerals will have to increase 10 times or more to effect the energy transition, by various estimates. Day to day, however, the prices for many of these elements are volatile.

What are the risks and drawbacks of investing in commodities?

In general, commodity prices are more volatile than stock prices. Their prices are easily affected by geopolitical events or natural phenomena such as droughts and disease. So any commodity holdings are best used as a smaller offsetting position to one’s core stock and bond holdings.

As mentioned earlier, commodities themselves and the majority of stocks of commodity producers also generate no income. This makes them unsuitable for investors such as seniors, for whom income takes a high priority. Compared to stocks and bonds, many commodities are thinly traded and less liquid. You may have to pay an intermediary a substantial commission or storage or management fees to own them. It’s unlikely your financial adviser or broker knows a lot about commodity trading and strategy, either.

Further, global demand for commodities is not constant; it can change over time. As humanity enters an energy transition to limit climate change, there are differing projections around the demand for oil, coal and natural gas. These and other commodities, such as beef or tobacco, may not meet some investors’ environmental, social and governance standards right now.