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Commodity Investments

Forms of investments and strategies

What investors need to know

10 minute read

Commodities, or natural resources, are in high demand worldwide. After all, they play an important role in the economy. From operating cars to manufacturing smartphones all the way to producing food – no one can make do without them. Private investors can profit from the high demand for natural resources. Caution is advised, however, since investments in natural resources are complex.

All commodities can be traded on financial markets. Nowadays, private investors can add nearly any natural resource to their portfolios. Before doing so, however, they should get an overview of the most important ones.

 

 

Energy resources

Energy resources generally comprise all fossil and nuclear fuels used for energy production. Besides crude oil, coal, gas, and uranium also belong to the class of energy resources. Crude oil is, nonetheless, the most important energy resource traded on the markets.

Crude oil is the lifeblood of the modern economy. Its price has a decisive influence on the economy. A low price often boosts the economy and vice versa. The most important crude oil prices are Brent (the most important type of oil in Europe) and Western Texas Intermediate (WTI; the most important type of oil in the USA).

The price of oil always refers to one barrel (159 liters, or 42 gallons). After years of rising oil prices, they are currently in a low phase. While the price of oil in 2011 was 110 dollars per barrel, it fell rapidly in the following years and was less than 45 dollars in 2016. The low prices were caused by an excess of supply.

This was due particularly to the rising production rate in the USA, triggered by a fracking boom. The USA is expected to replace Russia and Saudi Arabia as the largest oil producers by 2019 at the latest. In 2016, the Organization of Petroleum Exporting Countries (OPEC) agreed to curb oil production in order to stop the price drop. The price of oil has risen again since then. It currently is around 65 dollars per barrel with a rising trend.

 

Precious metals

Precious metals are among the most important commodities next to crude oil. The most important precious metals are gold, silver, and platinum. This category also includes the platinum alloys ruthenium, rhodium, and palladium as well as the elements osmium and iridium.  Precious metals are particularly popular among investors. Gold and silver, in particular, were used as means of trade for centuries and are appreciated on financial markets for their stable value. They are also used in the jewelry and electronic industries.

Gold is the most sought-after precious metal. Investors either invest in physical gold (bars and coins) or in paper gold (gold stocks and gold funds). The latter are indirect investments in the precious metal; for example, the investor purchases stocks of a gold mining company. There are clear advantages and disadvantages for investments in gold that investors should consider. One advantage: The price of gold usually develops in the opposite direction of the stock market, wherefore it can serve as a useful means of portfolio diversification.

 

Industrial metals

Industrial metals are all metals that have established their own industry due to their importance. Broadly speaking, this term applies to all metals generally used in industry. They are used, for example, in mechanical engineering, the automotive industry, construction industry, electrical industry, steel industry, jewelry industry, and almost all areas of the metal processing industry.

The most important industrial metals include iron, aluminum, copper, bronze, nickel, tin, and zinc. Nickel is required for the production of stainless steel and for superalloys for gas turbines or jet engines. Bronze is used for electrical contacts, bearing shells, and gears. Zinc is used for surface treatment and die casting. Tin is used as corrosion protection in tinplate or cylinder blocks and in other components of the auto industry.

Aluminum is the most abundant metal in the earth’s crust and has become indispensable in modern industry. It is used in the auto industry (e.g. modern car bodies), in the packaging industry (e.g. beverage cans), and in the construction industry. Copper is also one of the most important industrial metals. It is needed to make electrical conductors and heat exchangers, for example. The price of copper was one of the fastest rising commodity prices in 2017. The price per kilogram went up from about 5.75 dollars to 6.53 dollars (+13%).

 

Critical metals

Critical metals include lithium, cobalt, graphite, tungsten, and rare earth metals. Cobalt is an essential component of electric car batteries. Lithium is a core component of lithium-ion batteries used for laptops, cell phones, and electric cars. Graphite is a mineral used for the manufacturing of electrodes and which plays an important role in steel production. It is also used for the production of batteries and electric motors and can be artificially made.

Due to their use in battery production, cobalt and lithium are increasingly important natural resources and are sometimes referred to as the “oil of the future.” Cobalt and lithium were also among the best investments of 2017. Cobalt more than doubled in one year from 33 euros per kilogram to 82 euros per kilogram (+256%). According to Statista, the price of lithium increased around 2,300 dollars (+121%) between December 2016 (11,009 dollars per ton) and August 2017 (13,324 dollars per ton).

Rare earth metals are also critical metals. They are 17 exotic metals that exist in very limited quantity and are used in key technologies. They are used in the manufacturing of special glasses, polishes, plasma televisions, electronic motors, hybrid engines, radar sets, and wind turbines to name a few. They are also used in medicine, especially as contrast agents in radiology.

 

Soft commodities

Soft commodities are all natural resources created in agrarian production and which are used in the production of food or animal feed. They are traded on futures exchanges (also derivatives exchange or options exchange) in form of futures contracts and options. These are transactions that are processed in the future. Farmers want to protect themselves against possible price drops while investors try to make profits by speculating on future prices.

Major agricultural commodities include grains (wheat, rye, millet, oats, barley, corn, triticale, and rice), oil plants (soy, rape, peanut, and palm oil), and root crops (potatoes, sugar cane, sugar beet, and cassava). Additionally, renewable commodities (fast-growing woods, Chinese reed, cotton, rubber) are also soft commodities used, for example, to generate energy from biomass. Not included in the category of agricultural raw materials are forestry products such as wood and all types of fruit and vegetables, which are primarily intended for direct consumption.

 

The most important factor for commodity prices is global economic growth. When the global economy booms, the demand for and processing of natural resources increases, which raises prices. Developments in the USA, the EU, and China are particularly important. Weather conditions also have a major impact on the price of agricultural commodities, as droughts or floods can lead to crop failures.

Prices for commodities are driven not only by demand but a variety of other factors, too. Commodity producers can only respond to demand changes with slight delays. For this reason, production capacities play a particularly decisive role in pricing. Increasing demand for an industrial metal such as copper, for example, inevitably leads to an expansion of exploration activities and, in the medium term, to increased production in copper mines. However, years can go by in the meantime, causing prices to react to the expansion with a considerable delay.

There are various commodity indices that give investors a good overview of the commodity market. The S&P GSCI, calculated since 1991 with a strong focus on energy, is particularly relevant. It contains 24 resources and the composition is adjusted to the output each year. The J.P. Morgan Commodity Curve Index (JPMCCI) also provides a good overview of global commodity price trends. The CRB Index of Thomson Reuters, the Bloomberg Commodity Index, and the Rogers International Commodity Index (RICI) are also well respected.

 

Natural resources can be traded on commodity futures exchanges such as the Chicago Mercantile Exchange. So-called forward transactions are concluded there, i.e. all possible goods are traded at a certain point in the future (futures market). Livestock can be traded there in addition to soft commodities. Contracts on futures exchanges are standardized in terms of delivery quantity, delivery date, and quality of goods. The contract's place of loading and performance are also firmly defined. However, since real physical commodities are involved, commodity futures exchanges are completely unsuitable for private investors.

Commodity stocks are more suitable for private investors. These are shares of companies whose business is directly or indirectly related to the production or trading of natural resources. A popular example is the Swiss company Glencore, the world’s largest commodity trader. One of the largest mining companies is the Australian-British group BHP Billiton Plc., which specializes in the extraction of iron ore, natural gas, copper, and coal. Also among the largest mining companies are Rio Tinto, Anglo American Plc., and Mondi Plc. However, commodity stocks are very volatile and require a high level of investment experience.

Other ways for private investors to profit from commodity performance are so-called contract for difference (CFD) contracts. In a contract for difference, the investor directly participates in the development of the commodity price without physically owning it. However, these are highly speculative and high-risk financial products because of the risk of losing money through an obligation to make additional contributions greater than the total loss. A ruling by the BaFin on 10 August 2017 has done away with the obligation for private investors to make additional contributions. Nonetheless, only well-informed investors should participate in this form of commodity investment.

Lastly, private investors can invest in almost any commodity via certificates. Certificates are bonds with derivative components, meaning that their performance depends on the performance of other financial products. They do not have fixed interest rates; instead, they allow investors to participate in the success and failure of transactions on the stock exchange. Therefore, they are also highly speculative financial products and are only suitable for very professional investors. They are associated with issuer risk, meaning that if the issuing bank goes bankrupt the certificate is worthless.

 

Investments in natural resources are risky and therefore unsuitable for beginners. These investments are often made in derived financial products such as derivatives or certificates, which are highly speculative forms of investment. Commodity stocks are also extremely volatile and not appropriate for investors looking for security. “Generally speaking, commodity investments are suitable for long-term asset accumulation – but only as an add-on in one’s portfolio,” says Niels Nauhauser of Verbraucherzentrale Baden-Württemberg.

 

Have you made experiences investing in commodities? Let us know in the comments below!

Status as of 15.03.2018 10:43


 

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André Jasch

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