Commodities: What are they and how do they work?

When inflation surged to 9.1% in the United States in June 2022, cash and bond holdings lost purchasing power rapidly while commodity prices soared. Oil reached $120 per barrel and wheat climbed 40% year-over-year, highlighting why commodities remain important for portfolio diversification.

Commodities are basic goods and raw materials that are interchangeable with other goods of the same type. Unlike stocks or bonds, commodities are physical assets like gold, crude oil, wheat, or copper that form the foundation of the global economy.

Understanding Commodity Markets

Commodity markets trade physical goods through specialized exchanges like the Chicago Mercantile Exchange (CME) and London Metal Exchange (LME). These exchanges standardize contracts and provide liquidity, allowing investors to participate without physically handling commodities.

Prices respond to global events—droughts in Brazil affect coffee, Middle East tensions impact oil, and U.S. harvests influence grain prices. Unlike stocks reflecting company performance, commodity prices depend purely on supply and demand, making them highly volatile. Weather, geopolitics, and economic cycles can cause dramatic price swings.

Major Categories of Commodities

Energy Commodities

Energy commodities include crude oil, natural gas, heating oil, and gasoline. Oil remains the world's most actively traded commodity, with prices responding to OPEC decisions, geopolitical tensions, and global economic growth. Energy commodities typically perform well during economic expansions but can decline sharply during recessions.

Precious Metals

Gold, silver, platinum, and palladium comprise this category. Gold is both an industrial metal and a safe-haven asset that often moves inversely to stocks and the dollar. Silver serves dual roles as precious metal and industrial commodity. Platinum and palladium are primarily used in automotive catalytic converters.

Industrial Metals

Copper, aluminum, nickel, and zinc serve as economic indicators since demand rises with construction and manufacturing activity. Copper, often called "Dr. Copper," is used in construction, electrical systems, and manufacturing. Prices are sensitive to developments in major economies like China, which consumes roughly half of global copper production.

Agricultural Commodities

Agricultural commodities include grains (wheat, corn, soybeans), livestock (cattle, hogs), and soft commodities (coffee, sugar, cotton, cocoa). Prices fluctuate based on weather, growing seasons, harvest yields, and global demand. Climate change has increased volatility as extreme weather events become more frequent.

How to Invest in Commodities

Physical Ownership

Purchasing physical commodities works practically only for precious metals like gold and silver. Investors can buy bars or coins from dealers and store them in safe deposit boxes or vaults. This provides direct ownership without counterparty risk but involves storage costs, insurance, and authentication concerns. Physical ownership is impractical for other commodities due to storage requirements and perishability.

Futures Contracts

Futures contracts are the most direct way to trade commodity prices. Investors post margin, typically 5-15% of contract value, using leverage to control large quantities. This magnifies both gains and losses, making futures risky for inexperienced investors.

Contracts must be "rolled" forward at expiration, creating costs or gains depending on contango or backwardation.

Commodity ETFs and Mutual Funds

ETFs and mutual funds provide commodity exposure without futures complexity. Some hold physical assets (like SPDR Gold Trust), while most use futures contracts. Futures-based funds must roll expiring contracts, which can reduce returns in contango markets but enhance returns in backwardation. These funds offer accessible exposure but charge management fees.

Commodity Stocks

Investing in companies that produce or process commodities provides indirect exposure. Mining, energy, and agricultural companies offer dividends and growth potential that raw commodities lack. However, they introduce company-specific risks like management decisions, operational problems, and regulatory issues. Mining stocks, for example, tend to amplify commodity price movements due to operating leverage.

Benefits of Commodity Investing

Inflation Protection

Commodities historically provide inflation protection because rising raw material prices typically drive overall inflation. During the 1970s, when inflation averaged 7.4% annually, the Bloomberg Commodity Index returned over 14% annually while stocks struggled. Unlike bonds with fixed payments or stocks that struggle with rising costs, commodities directly reflect rising price levels.

Portfolio Diversification

Commodities often move independently of stocks and bonds. Research suggests that adding 10-15% commodity allocation can reduce portfolio volatility. Gold demonstrates low or negative correlation with stocks during market stress—in 2008, when the S&P 500 fell 37%, gold gained 5.5%.

Global Growth Exposure

Commodity prices reflect global economic growth, particularly in developing economies. China's industrialization from 2000-2010 drove a commodity supercycle with oil, copper, and iron ore reaching historic highs. As emerging markets develop, commodity demand typically strengthens, balancing portfolios weighted toward developed market stocks.

Risks and Challenges

High Volatility

Commodities rank among the most volatile asset classes. Oil prices have ranged from negative $37 (April 2020) to over $140 per barrel (2008). This extreme volatility stems from inflexible supply—oil fields take years to develop, crops grow once yearly, mines require extensive development—combined with rapidly shifting demand based on economic conditions, weather, and technology.

No Income Generation

Unlike stocks or bonds, commodities generate no income. Returns depend entirely on price appreciation. Over long periods, dividend reinvestment has accounted for roughly 40% of stock returns. Commodities miss this compounding benefit, making them more suitable for tactical allocations rather than core long-term holdings.

Contango and Roll Costs

Futures-based ETFs face costs from rolling expiring contracts. In contango markets (where future prices exceed current prices), this reduces returns. Between 2008 and 2020, the United States Oil Fund returned -96% while oil prices declined only 30%, with much of the difference attributable to roll costs. Markets spend more time in contango than backwardation for most commodities.

Storage and Other Costs

Physical ownership involves storage costs (1-3% annually for precious metals), insurance, and transportation. For ETFs backed by physical assets, these appear as management fees and expenses.

Geopolitical and Weather Risks

Geopolitical tensions can disrupt supply chains, causing sharp price spikes. The Russia-Ukraine conflict in 2022 demonstrated rapid impacts on energy and agricultural prices. Weather events—droughts, floods, freezes—can devastate crops, with climate change increasing frequency and severity. These unpredictable factors make commodity prices difficult to forecast.

Implementing Commodity Investments

Most financial advisors recommend limiting commodity exposure to 5-15% of a portfolio given their volatility. Investors can choose strategic allocation (maintaining consistent exposure) or tactical allocation (adjusting based on economic outlook and inflation expectations).

Rather than selecting individual commodities, most investors benefit from broad exposure through diversified ETFs that spread risk across energy, metals, and agriculture. Gold often receives separate consideration due to its role as both commodity and monetary asset.

Getting Started:

1. Clarify goals: Determine if seeking inflation protection, diversification, or growth exposure
2. Start broad: Begin with diversified commodity ETFs like Invesco DB Commodity Index (DBC) or iShares S&P GSCI (GSG)
3. Consider gold separately: Use physical-backed ETFs like SPDR Gold Shares (GLD) to avoid futures complications
4. Review costs: Compare management fees and roll strategies between similar funds
5. Rebalance regularly: Establish quarterly or annual rebalancing to maintain target allocations

Key Takeaways

Commodities are physical assets like gold, oil, and agricultural products that offer distinct portfolio benefits and challenges:

• Diversification and Inflation Protection: Commodities move independently of stocks and bonds while rising with inflation, providing valuable portfolio diversification and historically effective hedging against rising price levels

• Multiple Access Methods: Investors can use physical ownership, futures contracts, ETFs, mutual funds, or commodity stocks, each with different risk profiles and complexity levels

• High Volatility: Inflexible supply, variable demand, and sensitivity to weather and geopolitics create extreme price swings, requiring careful position sizing (typically 5-15% of portfolio)

• No Income Generation: Commodities produce no dividends or interest, depending entirely on price appreciation, making them better suited for tactical allocations than core long-term holdings

Frequently Asked Questions