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How to trade commodities
Commodities trading is a popular way to speculate on a wide number of different markets and assets. Here, we take a look at what it entails and how you can get started.
What are commodities?
The term Commoditiesis a broad umbrella that covers many products that are pretty much essential to everyday living. In this case, it’s raw, naturally occurring materials that are then processed in thousands of different ways, before turning into products everyone uses in their daily lives.
Crude oil, metals, gold, crops, sugar and so on are all part of the commodities family. These raw ingredients are taken away and turned into food, energy, and clothing.
One thing that sets commodities apart from other tradeable products is pricing. There is a higher degree of standardisation on prices worldwide. It doesn’t matter who is producing the asset or material in question.
For instance, gold produced in a Russian gold mine or Brazilian gold mine would have the same price.
This does change from asset to asset, however. It’s not a hard or fast rule. For example, certain crude oil blends are priced differently using different benchmarks, such as Brent Crude or West Texas Intermediate (WTI).
Why do traders like commodities?
There are a number of reasons why traders like commodities.
- Variety – With plenty of markets to choose from, traders can select to trade across a wide variety of markets.
- Safe havens – Some commodities, like precious metals, are strong value stores. They retain their physical value – even in times of global economic turbulence.
- Speculation potential – Prices of some commodities can be quite volatile. Just look at how oil has changed over 2020-2021 for instance. That means there is a lot of potential for high profits if you speculate correctly. However, this does mean you could lose more money too.
- Hedging against inflation – Commodities’ value is not pegged to currencies. If a currency’s value falls due to inflation, then a commodity may hold its value in contrast. As such, many traders and investors use them to hedge against inflation.
Adding commodities to an investment or trading portfolio is also a great way to increase diversification. A diverse portfolio, in theory, is more insulated against the risks inherent to financial trading. If one instrument or asset, say equities, falls, then the commodities could help cover those losses.
What commodities can you trade?
We briefly touched on this earlier, but there are lots of different options available to would-be commodity traders.
Generally, commodities can be split into four categories:
- Metals – This incorporates precious metals like gold and silver, as well as more common, industrial ores like iron, copper, nickel, and lithium.
- Agricultural products – This category includes both edible and non-edible products. Wheat, grain, cocoa, and sugar are edible commodities. Cotton, palm oil, and rubber are examples non-edible commodities.
- Energy – The energy market covers crude oil, gasoline, natural gas, coal, and heating oil. It also include renewable energy like wind power and solar.
- Livestock – Cattle, hogs and other live animals fall under the livestock category.
What drives commodity markets?
Price action in commodities markets is defined by supply and demand. Generally, the higher the demand the higher the price and so on. Low supplies coupled with high demand can lead to high prices too.
We’ve seen this recently with oil markets. Crude oil output had been negatively affected by the COVID-19 pandemic. Demand was low and output was minimal. As of October 2021, demand is high, but output is being kept relatively scarce by producers such as the OPEC+ nations to protect prices.
However, commodities prices can be more versatile than other assets. This is because there are lots of factors at play relating to their production. For example, livestock levels may be impacted by health issues, such as foot and mouth disease. A bad harvest will impact wheat prices. Weather can affect production of commodities, such as a hurricane shutting down natural gas infrastructure in the Gulf of Mexico.
Global economic trends can affect prices too. China and India’s emergence as industrial powerhouses has caused the availability of metals like steel to drop off in other nations.
The above trends make commodities prices hard to predict. Prices can show high levels of volatility. As such, it can be seen as riskier than trading or investing in other assets. Remember: you should only invest or trade if you can afford to take any losses.
How are commodities traded?
Commodities are typically sold on exchanges, in the same way stocks are traded on exchanges. In fact, many would say the birth of trading as we know it started with 18th and 19th century merchants trading crops.
At Markets.com, we offer commodities trading through contracts for difference (CFDs). These allow you to speculate on commodity price movements without owning the underlying asset. These are leveraged products, which means you can take a position with only a fraction of the trade’s value. This means your profits can be amplified – but so can your losses.
There are also commodity exchange traded funds (ETFs). These group together a number of assets into a single basket. Some ETFs will hold the physical assets they’re cover, for example a gold ETF might hold a certain amount of bullion or coins. Some are more complicated and synthetically mimic their underlying market.
A Markets.com account will give you access to a wide range of commodity markets, as well as thousands other assets. Open yours today and start trading your way.
Thematic investing: mining stocks
With the recent commodities boom, and even before, traders and investors alike have been adding fresh seams of mining stocks to their portfolios.
Unfamiliar with what they offer and how to pick them? Take a read of our thematic investing guide to the world of mining.
How you can invest in mining stocks
Digging into the mining sector
Metals and minerals are key components of modern economics and manufacturing. The world can’t turn without them.
As such, mining firms’ goods often go through periods of intense demand. We’re seeing this with right now lithium, for instance, thanks to the increasing global shift away from ICE-powered cars toward electric vehicles. Lithium is an important ingredient in battery construction, so the metal is in high demand.
Taking a wider view, the mining industry is forecast to grow worldwide at a CAGR of 7% from now until 2025, according to Research & Markets. By that time, the sector will be worth a total of approximately $2.5 trillion.
For 2021, y-o-y growth is looking particularly strong, forecast at 12.4%, giving the mining sector a value of $1.8 trillion by the year’s end.
But there’s the rub. Mining is a cyclical industry. It rises and falls according to the whims of the market. If manufacturing is down, for example, then demand for metals and minerals usually falls too.
Mining is also capital intensive. It can cost hundreds of millions, even billions, of dollars to set up new operations or to refurbish existing mines. Timing is everything. In the past, mining firms have poured money into new mines, only for them to come online just as a market downturn kicks in.
Mining stocks, therefore, require a bit of deeper digging before investors or traders start buying. In the long term, you’d need ideally be investing in miners that are capable of weathering economic storms. Strong balance sheets and low production cuts are key markets to watch for.
If you’re pursuing a short-term strategy, then you’ll need to do some more immediate research.
Gold mining stocks, for instance, will be tied in with the gold price. Prices hit record highs in August 2020, reaching over $2,000, but have subsequently retreated, although gold did crack the 100-day moving average to take prices above $1,800 on May 6th, 2021.
At the time of writing, copper is breaking all-time high records as part of a global commodities rally. Iron ore and steel are at peaking too, and aluminium continues to build on significant gains.
But while these sectors are rising, others could be looking at long term decline. Take coal stocks for instance. While coal remains an important resource in the developing world, especially China, coal’s share of global power generation is forecast to fall to 22% by 2040. That’s still quite a significant chunk, but the greener the world gets, the less it will rely on coal for power. As such, coal miners may incur substantial drops in their revenues, profits and share prices as the 21st century progresses.
Choosing mining stocks
We touched on this earlier, but two key takeaways when looking at mining stocks are:
- Low production costs – Running a mine is expensive, so “low” is a relative term here, but you should be eyeing up companies that run mines as efficiently as possible. Try and avoid those with outdated equipment or ageing extraction sites. It is not a hard and fast rule, but generally speaking, a mining firm with low production costs can stay profitable during weaker cycles.
- Strong balance sheet – A miner with a strong balance sheet will, in theory, offer competitive earnings per share. Look for those companies with investment-grade bond ratings, high borrowing capacity, manageable debt and plenty of liquidity.
Potential mining stocks for your portfolio
Canada’s Barrick Gold is one of the largest gold miners in the world and a global leader in copper production too.
Its balance sheet has been bolstered in recent years by several mine sell offs. The company instead is focussing on its “Tier One” operations. These are mines that produce more than 500,000 ounces annually with at least 10-year lifespans, delivering total cash costs per ounce in the lower half of the industry cost curve.
Feeding into this strategy is the current commodities boom with gold, and especially copper, performing strongly. Barrick’s Q1 2021 earnings, reported on May 5th, showed an 8.8% year-on-year increase for the quarter ended March 31st, totalling $2.96bn. Profit came in at $538m ($0.30 per share), against $400m ($0.22 per share) in Q1 2020.
As a gold mining stock, Barrick is the perfect example of low-operating costs combined with a strong balance sheet. But it’s also an example of how cycles can affect mining stock prices. In this case, Barrick sold less gold by volume in Q1 2021 than the previous year, but because of the increase in gold prices, it was able to turn a higher profit.
When undertaking thematic investing, don’t just limit yourself to miners and mineral extractors. Consider business areas around mining, like machinery suppliers, IT solutions and software producers, or, in the case of Australian multinational Orica, explosives.
Orica is the world’s largest commercial explosives manufacturer. The last three years have not been kind to the share price, dropping a cumulative 25% in that period.
At the start of April, Orica shares had dropped 16% y-o-y. As of May 7th, 2021, however, its share price had begun to rise once more.
This may be in line with the global mining growth forecast by Research & Markets amongst other commentators. More mining activity points towards a higher demand for mining-tooled explosives. Orica also appointed a new CEO, Sajeev Gandhi, in February 2021, which may have started to boost investor confidence.
In the long term, Orica investors are up 1.1% per year over the past five years up to 2021. Looking to the short term, the explosives mining sector is up 40% according to Simply Wall Street. Paired with expected growth in mining overall, Orica could be one to watch.
Rio Tinto is a global mining leader. With operations mining iron ore, gold, copper, diamonds, its portfolio ensures a steady supply of revenues, and its size and general management expertise helps it weather market downturns.
At the time of writing, as mentioned above, the world is experiencing a commodities boom. This has paid off for Rio Tinto, with its core businesses of copper, iron ore, and gold benefiting from the uptick in global metal prices.
In terms of shares, Rio Tinto has been building on solid gains across 2020, which are being further reinforced by strengthened commodities trading. In the six months leading up to April 23rd, RIO shares had jumped 40%, reaching around 6000p on the FTSE 100. Flash forward to May 10th, RIO was trading at approximately 6660p.
Forbes reports the Trefis Machine Learning Engine, which identifies trends in a company’s stock price data for the last ten years, has forecast similar advances for Rio Tinto over the next 6 months. Returns could potentially be as high as 12% across 2021.
Rio Tinto improved its dividend in February 2021 reflecting strong trading across 2020. The dividend hiked 26% to 557 cents per share after the miner added a special pay-out of 93 cents to the full-year dividend of 464 cents.
In addition to solid trading and the bump from heightened commodity prices, other aspects are at play helping reinforce RIO. It has made strides towards cutting carbon emissions, for example, and is even aiming at net-zero carbon emissions by 2050. That plays well with environmentally conscious investors.
Mining stocks – caution still advised
Remember: investing and trading comes with risk. You can make money, but you can also make substantial losses. When investing in gold mining stocks, or other mining company shares, be sure to do your due diligence. Only invest if you can afford to take any potential losses.