How to start investing in commodities

Australia is one of the world’s biggest commodity producers in the world, so it makes sense to wonder how one can invest in commodities and what the best commodity shares are.

Investing in commodities entails purchasing securities with exposure to an interchangeable basic good or raw material like gold, oil, natural gas, iron ore, aluminium, copper, wheat, soybeans, and so on.

Commodities are interchangeable in the sense that oil extracted in Brazil will work just as fine in running one’s car as oil extracted in Russia.

One can typically invest in four commodity categories: metal, energy, livestock/meat, and agricultural.

There are also different ways one can invest in commodities.

One can own shares in companies like BHP Billiton Ltd [ASX:BHP], for instance, who produces and processes commodities such as coal, iron ore, and copper.

Or one could invest in ETFs that gives a broader exposure to a commodity segment.

Finally, one could participate in the commodities futures market. These options will be explored further below.

Australia and commodities

Australia is the largest producer of iron ore and coal in the world. It is also the third-largest producer of gold, and a significant producer of ‘base metals’, including copper, zinc, and nickel.

Thanks to the construction of several liquid natural gas (LNG) plants in Queensland, Australia has also become one of the largest exporters of natural gas in the world.

This means that a large part of the Aussie market is made up of commodity, or ‘resource’, stocks.

The RBA estimates that commodities account for two-thirds of the value of Australia’s exports.

Before you invest in commodities

Investing directly in a commodity by, for example, buying a barrel of oil, is not a usual or realistic investment option.

Instead, one can use financial instruments to gain indirect exposure to commodities. But before doing that, one must understand both the commodity itself and the financial instrument.

One must understand the market for the underlying commodity but also how the financial instrument will expose one to the commodity.

For instance, when contemplating crude oil as an investment, one must know the key drivers of the oil market. What themes and macro factors impact the price of oil?

One must then understand how owning shares, ETFs, or futures contracts gives exposure to physical oil.

Commodity investing risks

Commodities can be risky investments because the market for them frequently depends on macro events difficult to predict or foresee.

Inflation, weather, political unrest, natural disasters, or new technologies can heavily impact commodity prices and one’s investment.

For instance, oil prices fell dramatically in the early stages of COVID-19, with the World Bank reporting oil prices have still only partially regained pre-pandemic price levels.

Best commodity ETFs

One way to diversify one’s risk and retain a wide exposure to commodities is investing in an exchange traded fund.

An ETF is a managed fund that one can buy and sell on a stock exchange whose role is to track the value of a particular index or a commodity like gold.

As the ASX explains, ETFs allow investors to take a view on the market rather than on particular shares.

Commodity ETFs typically expose investors to underlying resource assets via physical backing or using a synthetic structure.

Physically-backed commodity ETFs hold the underlying commodity itself.

For instance, when the BetaShares Gold Bullion ETF issues new units in the ETF, it actually buys gold bullion, which is then stored by a custodian in a vault.

However, just as it can be impractical for an individual investor to physically hold a commodity asset, in most cases it is likewise impractical and cost-inefficient for an ETF to physically hold and store commodities.

Most ETFs generally track an index instead.

These synthetic commodity ETFs aim to track a commodity index.

For instance, the BetaShares Crude Oil Index ETF tracks the performance of the S&P GSCI Crude Oil Index, which in turn is based on a crude oil futures contract traded on the NYMEX.

It is important to note that an ETF tracking an index based on a commodity futures contract may perform differently to the physical commodity itself.

This is because a commodity futures contracts may not match commodity spot prices.

If one wishes to peruse a list of ETFs, they can check out Finder’s roundup of what it thinks are the best performing ETFs in Australia and search for ETFs with a commodity focus.

Best commodity shares

Some of Australia’s largest and most established commodity stocks include the likes of BHP Billiton Ltd [ASX:BHP] and Rio Tinto Ltd [ASX:RIO].

For instance, BHP reported $42.9 billion in total revenue in FY20, with profit after tax of $7.9 billion.

But while BHP and Rio Tinto are well known, there are hundreds of smaller resource companies, with many of these involved in exploration and development.

That is, these companies are not actually making any money, as they are looking for a resource or developing one they previously discovered.

This means there are huge opportunities for gains in this sector. If you can find a stock before it finds the mother lode, you could make huge returns.

But there are also significant risks. Many companies spend millions looking for a valuable resource — one which they may never find.

One must also contend with the cyclical nature of commodities and their investment proxies.

For instance, lithium prices shot up in 2018 before plummeting and remaining moribund until late 2020 when demand for electric vehicles picked up again.

Coming out of a recession and into a reinvigorated economy, cyclical commodities can flourish. We’ve seen this with record highs for copper and iron ore in 2021.

In a reenergised economy, demand for steel or chemicals or oil goes up. But when economic tailwinds turn into headwinds, cyclicals can suffer.

And that is something investors must keep in mind when contemplating commodity investments and researching which are the best commodities to invest in.

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