With the recent surge in oil and wheat prices due to the ongoing war in Ukraine, we take a closer look at what makes them tick, whether it’s an asset worth investing in, and more
Gold, a commodity, has long been regarded as a safe haven asset. Based on historical trends, gold prices have seen upticks, usually amid macroeconomic uncertainties and market turmoil.
Since the onset of the Covid-19 pandemic in 2020, gold prices have surged due its perception as a safe haven asset by investors. During the height of the pandemic that year, the price of gold saw its highest level since 2012 as the world experienced a second wave of Covid-19 infections.
The last significant surge in gold prices occurred at the end of 2018, amid uncertainty in global equities, the partial shutdown of the US government, as well as concerns over the outlook for 2019.
In March this year, analysts predicted that the price of gold may reach as high as US$2,100 ($2,857) per oz. Gold prices surged above US$2,000 after US President Joe Biden announced the ban on Russian oil imports to the US on March 8.
Other commodities like wheat and oil also saw spikes in prices after Russian President Vladimir Putin invaded Ukraine on Feb 24. Both Russia and Ukraine are major crop producers, accounting for a quarter of global wheat exports.
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On March 8, wheat prices climbed to their highest levels ever amid fears of food shortage; the second highest level achieved was in end-February 2008.
Russia, meanwhile, has another lynchpin role as a key oil and gas exporter too. Upon the outbreak of hostilities, oil prices surged to as high as US$130 per barrel before settling down to just over US$100. Amid global calls to embrace sustainable energy sources and cut the use of oil, this trend marks a remarkable change from the downtrodden oil market from just two years ago.
As consumers feel the pinch from higher prices of these basic goods in the food they eat and the petrol they pump, investors, meanwhile, can try and take advantage of having more such commodities as an asset class as part of their overall portfolio.
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What is a commodity?
A commodity is an economic good that is interchangeable with other goods of the same type, or a fungible good. A commodity is also widely used by many people, and it is a material that can be traded on its own.
Some of the most widely-traded commodities include corn, sugar, wheat, oil, crude palm oil (CPO), coffee, cotton, gold and natural gas.
For investors, commodities are a type of asset class. This means they are often traded in the form of futures contracts, or derivatives, since trading the actual goods (such as several barrels of oil) may be cumbersome in itself.
Given the close correlation, commodities are also used as a means to diversify portfolios and as a hedge against inflation.
However, commodities suffer from their unique set of risk factors, which makes them at times more volatile than equities. Such factors include the weather, geopolitical uncertainties, new technologies and inflation. Some of these risks can be foreseen and managed. However, just like in the case of Russia’s invasion of Ukraine, too much volatility is ultimately hinging on just one man.
Historical returns
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Historically, the returns for commodities vary based on the type of commodity. These can be divided into three main types — agricultural products, metals and energy products. Some examples of agricultural commodities include sugar, soybeans and wheat. Crude oil, natural gas and gold are examples of energy commodities; while metal commodities include gold, silver and copper.
Chart 1 shows the 10-year returns for agricultural commodities, while Charts 2 and 3 show the returns of energy commodities and metal commodities respectively over the same time period.
We can see that not only do the returns of these commodities vary based on type, but may also differ widely within the same category. This implies that different commodities have different cycles, as some have strong positive returns while others have negative returns over the same time period.
Furthermore, some commodities have larger volatility compared to others, represented by its upper and lower bounds, which denotes higher risk to the investors.
How and when will commodity prices increase?
Commodities are governed by a basic rule of thumb: supply and demand. Where there is higher demand than supply, prices go up. Conversely, when there is a glut or higher supply than demand, prices will naturally go down.
How are commodities affected by events such as bad weather or inflation?
While commodities are regarded as yet another asset class, investors should remember that they are actual goods. For instance, a commodity like wheat can be subject to war or bad weather conditions, which can affect supply.
Commodities are also great assets to have in times of inflation. As prices for goods and services rise, the price of commodities will, naturally, increase accordingly too.
What are commodity cycles?
Commodities are usually cyclical, with prices going through similar cycles over the past 50 years.
On average, these cycles usually last for six years. A commodity supercycle is an event that lasts for usually over a decade, where increased demand for commodities is seen.
How to buy and sell commodities?
There are several ways to do so, including owning a physical good, such as a gold coin.
One way to trade in the asset class is through a futures contract, or exchange-traded funds (ETFs).
Another way to buy into the asset class is to buy commodity stocks such as Wilmar International, Olam International, Rex International, First Resources and RH PetroGas, all of which are listed on the Singapore Exchange (SGX).
How much should one invest in commodities?
That depends. If you’ve invested in the asset class through a futures contract, these contracts tend to have set deadlines.
However, commodities can be seen as a long-term investment as well. In that instance, most advisors recommend a percentage of between five and 10.
Ultimately, it depends on the investor. Firstly, understanding the commodity is key, where factors such as commodity cycles and how macroeconomic factors such as economic growth, inflation and interest rates affect the movement of commodity prices are important themes to look at. If the investor is able to understand this, then they should be able to gauge the expected returns and risk, which varies based on the commodity type and investment horizon.
To reiterate, it would be wiser to invest or have investment exposure to commodities than any other asset class if the investor is able to understand commodities better, relatively.
What is the correlation between commodities and equities?
The historical correlation between commodities to equities or stocks is generally low to negative; when prices for stocks and bonds go down, prices for commodities go up, everything else being equal. This implies that investing in commodities can be a good diversification tool to reduce concentration risk.
However, that is not a rule that fits all situations. Should economic growth decline, stocks and bonds may fall, but if demand for goods such as oil, corn and sugar fall, commodity prices will decline as well. Different commodities have varying correlations with traditional assets such as equities and bonds as they have idiosyncratic elements affecting the returns, for example, the factors affecting the demand and supply of soybeans vary from gold, which explains why the historical returns of soybean vary largely.
Common terms in commodities trading
These are some of the common terms to look out for when trading in commodities.
- Barrels: Used as a unit term to measure oil, one barrel of oil is equal to 42 US gallons or 159 litres. A barrel is sometimes abbreviated to bbl. Other common terms include one million barrels (mmbbl), one kilobarrel (kbbl) and one thousand barrels (mbbl).
- Benchmark crude: A means of reference for crude oil. Benchmark oils include Brent crude, West Texas Intermediate (WTI) and Dubai or Oman crude.
- Bullion: This refers to highly pure gold or silver coins, bars or ingots. Bullion can also be considered legal tender at times and is kept in the reserves of central banks.
- Bushels: A means of measurement in the imperial and US customary system. Used for measuring produce such as wheat, barley, and soybeans. One imperial bushel is equivalent to eight imperial gallons or 28.44kg, whereas one US bushel is equivalent to eight US dry gallons or 25.40kg.
- Derivatives: A commodity derivative is a form of investment in which investors can profit from certain commodities without actually possessing them.
- Fresh fruit bunches (FFB): A unit of measurement used for palm oil fruit.
- Futures contract: A contract where the buyer or seller can buy or sell a commodity at a pre-fixed price on a set date.
- Futures gold: A trade where the delivery of the product will be made at an agreed-upon date after the transaction.
- Physical delivery: Refers to the actual asset being delivered on the stipulated delivery date, instead of the asset being traded in the form of a contract.
- Spot gold: Gold that is traded, well, on the spot, where the price is determined almost immediately.
