Written by Brenda Nakalema

Disadvantages of Commodity Investing

Characteristics of the commodity markets Similar to other financial markets, the commodity market also functions on the principles of demand …

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Commodity Investing has been around since humans created systems to support trade but still, it remains important for investors to know the disadvantages of commodity investing. Commodities are divided into different categories: Agricultural, Energy, Metals, and Digital. The commodity market is highly sophisticated and regulated with multiple ways a person can invest in the various commodities; commodity futures contracts, Exchange Traded Funds (ETFs), options, and direct purchases of the physical commodity.

Characteristics of the commodity markets

Similar to other financial markets, the commodity market also functions on the principles of demand and supply. A change in the supply pattern impacts demand and vice versa. When the demand rises and supply is low, prices skyrocket. In instances where the demand is low and supply is high, prices slump.

Disruptions in the supply of commodities caused by natural disasters, wars, or other geopolitical factors have caused major disruptions in the supply of vital commodities. This was the case during the Covid-19 global lockdown and the Russian invasion of Ukraine.

Commodities are traded on highly regulated markets. Buyers and sellers simultaneously participate and enter into spot transactions. These lead to the immediate delivery of the physical commodity or derivative transactions with forwards, futures, and options instruments.

Commodity investing is also conducted through auctions and bilateral contracts that facilitate price determination outside of the known commodity exchanges. Commodity auctions result in the delivery of the physical commodity.

Derivatives like forwards, futures, swaps, and options are important because they help determine prices. They also assist in managing risk in the commodities trade. Commodities traders can negotiate spot transactions for cash. Alternatively, they can enter into forward contracts specifying delivery of a specific commodity and a certain future time and price.

Disadvantages of commodity investing

Leverage

Investors must remember to apply leverage with caution despite its possible benefits. Like a double-edged sword, leverage can benefit or harm an investor’s portfolio. Through leverage, an investor can take a huge position with little capital paid upfront.

For instance, supposing the initial margin requirement is 5%, an investor can buy commodity futures worth $100,000 with only $5,000. With this deal, even a small change in price can have significant repercussions on their gains or losses.

Leverage also encourages excessive risks owing to the low margin requirements.

Volatility

Commodity prices depend on the forces of demand and supply, which makes them highly volatile. The demand and supply of commodities are price inelastic.

Price inelasticity refers to the phenomenon where while the price increases or decreases, the supply of the commodity remains relatively the same. For instance, increasing production by harvesting new crops, extracting natural gas, or mining iron deposits from iron ores takes a lot of time and investment.

All the while, because commodities are essential in daily life, the prices continue to fluctuate. A good example is the automobile industry; despite the increasing interest in fuel-efficient or electric vehicles, it’s not economical or feasible to make a switch from petrol or diesel cars.

In some instances, it takes some time for the effects of natural or political disasters to reflect in the prices of commodities. This makes these volatile for many investors to predict reliably.

Not ideal for diversification

The general belief is that there is a negative correlation between the prices of commodities and the prices of stocks. For this reason, many investors use their investment in commodities as an avenue for diversification.

However, in 2008, during the Global Financial Crisis, stocks and commodities alike suffered. Pricing plummeted to levels that had previously been considered impossible. This was made worse by the fact that during the crisis, unemployment hit all-time highs across the globe.

Oil and natural gas prices crashed during this time, leaving investors’ portfolios open to the possibility of being wiped out. Because of this, investors must remember that although commodities are often touted as the best way to diversify a portfolio, they are not always 100% effective.

Speculation

A market so affected by natural disasters, geopolitical forces, and pandemics naturally attracts players looking to make quick gains. They do this by predicting the possible direction prices will follow. These market speculators can easily affect market prices by simply mass buying or mass selling. A lot of the time all this is based on nothing more than hearsay.

Environmental degradation

Despite the recent trend towards environmental protection and sustainability, it is becoming increasingly evident that mining, drilling, and constant planting on the land has had drastically adverse effects on the environment. Scientists estimate that it will take human beings a long time to reverse the damage done to the environment as a result of mineral extraction.

The oil and crude oil refining industry have numerous examples of the adverse economic effects caused by mineral exploration. For investors that are environmentally conscious, this is an excellent deterrent to investing in the commodities market.

Foreign and emerging market exposure

In addition to the other risks associated with commodity investing, investors also have to contend with risks that arise from investing in foreign and emerging markets, especially volatility that comes from political, economic, and currency instability.

Derivative risk

Funds focused on investing in commodity stocks may participate through futures contracts to track an underlying commodity or commodity index. These types of instruments are highly speculative and are not always an accurate reflection of the commodities they track. Trading these securities can be extremely volatile, potentially affecting the entire fund’s performance.

In conclusion, the disadvantages of commodity investing include negative leverage, high market volatility and speculation, environmental degradation, and derivative risks associated with commodity investing. Before parting with your money, research thoroughly to understand how the market works.