How To Invest In Commodities

Soaring energy and food prices have dominated the headlines over the last year, with agricultural commodities, such as wheat and corn, hitting all-time highs.

It’s been a similar story in the energy sector, with the price of crude oil and natural gas rising by more than 60% in 2022.

As a result, commodities have caught the attention of investors looking to diversify their portfolios into alternative assets to equities and bonds. Trustnet reports that the commodity sector has delivered an average return of almost 60% over the last three years, the second-highest among the fund sectors.

That said, the volatility of commodity prices can make for a rollercoaster ride. While commodity funds enjoyed net inflows in the first half of 2022, Refinitiv reported a sharp exodus in the second half of the year as investors took fright at falling prices.

We’re going to take a closer look at investing in commodities, including the different options for commodity-based investments and the general outlook for the commodities sector.

Stock market investment and investment directly in commodities is speculative and returns are not guaranteed. Your capital is at risk and you may not get back any money you invest. Nothing in this article is intended to be or should be taken as advice.

What are commodities?

Commodities are natural resources or agricultural products that are grown, mined or processed and are critical inputs in the production of food, energy and clothing.

There are two main types of commodity:

  • ‘Soft’ commodities that are grown or reared: livestock and meat, together with agricultural commodities, such as coffee, wheat, soybeans, cotton and corn
  • ‘Hard’ commodities that are mined or extracted: energy products, such as crude oil, natural gas and coal, and precious and industrial metals, including gold, silver, palladium, copper, lithium and aluminium

Commodities of the same quality or grade are often described as ‘fungible’, meaning that they are interchangeable, irrespective of where they were farmed, produced or mined.

What is commodity trading?

Commodities are bought and sold in bulk on exchanges, in the same way as stocks and shares. The largest exchanges include the London Metal Exchange (LME), the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange (ICE) in Europe.

While it’s possible to trade in physical commodities, it’s far more common to trade in futures contracts. In its simplest form, a futures contract allows producers and buyers to agree a price and terms for delivery of a commodity at a set future date.

So if an airline company believes that fuel prices will rise, it might mitigate this risk by buying a futures contract in oil – a process known as ‘hedging’. This helps both the buyer and the seller to ‘lock in’ their price. If the price of oil rises, the seller has sacrificed potential profit but has received certainty in return. As with shares, the price of futures contracts varies with supply and demand. It’s possible to trade in commodity futures or spot prices via spread-betting or contracts for difference, however, these are only suitable for experienced traders due to the high risk of losses.

Why invest in commodities?

There are two primary reasons for investing in commodities, particularly in times of economic volatility and high inflation:

1. A hedge against inflation

Inflation reduces the ‘real’ value of a currency over time, in other words, £10 today buys you less than it did 30 years ago.

Inflation hit a 40-year high of more than 11% last year in the UK, which impacts the returns of certain asset classes. If companies struggle to pass on higher costs to consumers, share prices are likely to fall if profits are squeezed, while high inflation also reduces the value of income paid on fixed-rate bonds.

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Commodity returns have historically been positively correlated with high inflation, in other words, returns increase when inflation is high. This is not entirely surprising given that inflation measures incorporate the cost of commodities such as petrol and electricity in their ‘basket’ of representative items.

2. Portfolio diversification

Along with cash, shares, bonds and property, commodities are another form of asset that can help investors to diversify their portfolio. Diversification offers a form of protection against one asset class under-performing and may help smooth the overall volatility of a portfolio.

As mentioned earlier, commodities typically perform well in times of high inflation, unlike shares and fixed-rate bonds. However, commodity prices are also impacted by factors such as the weather, natural hazards and geopolitical events.

By way of example, coffee futures recently hit their highest level in a decade, with Arabica prices almost doubling in 2021 due to dry weather in Brazil and an increase in shipping and labour costs. And the price of natural gas rose by more than 30% after Russia’s invasion of Ukraine.

Which commodities have delivered the highest returns?

Darius McDermott, managing director of advisory firm Chelsea Financial Services, comments: “Commodities had a very good run in 2021 and 2022 on the back of supply chain disruption and rising prices.”

Mr McDermott points to the S&P GSCI (a broad-based index of 24 commodities) returning 42% in both years. He adds: “The index has come off somewhat in 2023, but it’s proven to have low correlation with the global equity market, underpinning its role in a wider portfolio.”

Let’s take a closer look at the top three commodities by annual returns over the last four years:

Overall, there’s been a range of different commodities in the top three, with precious metals dominating in 2020, energy products in 2021 and industrial metals in 2022.

This demonstrates the volatility of commodity returns, with coal delivering the second highest return of 161% in 2021, followed by the lowest (negative) return of -48% in 2022.

Let’s take a more detailed look at some of the highest-performing categories.

1. Precious metals

The lustre of gold shows no sign of fading for investors, with the shiny metal trading near its all-time high. High inflation, interest rates and geopolitical risk have pushed up demand for gold as a safe haven in times of uncertainty.

Indeed, investors buying gold in 1993 would have enjoyed a seven-fold price increase over the last 30 years, as show in the chart below:

Figure 1: spot price of gold (in pounds per troy ounce) from 2003 to 2023Sources: FastMarkets, ICE Benchmark Administration, Thomson Reuters, World Gold Council

That said, it’s been more of a mixed bag for silver and platinum, with prices heading largely downwards over the last decade.

Andrew Dickey, director of precious metals at The Royal Mint, comments: “Historically, gold offers that little bit more stability and gradual incremental changes, whereas silver can be a lot more volatile.“

“Platinum has the ability to surprise. It’s had a tough year because the main focus has been on gold and silver. But platinum is used in a lot of industrial processes and platinum’s time will come.“

2. Industrial metals

Industrial metals are highly cyclical, meaning that prices fall in a recession as industrial demand decreases. However, battery-related metals are expected to be long-term ‘structural winners’ due to their importance in the storage of green energy.

Lithium has been one of the stellar performers, principally due to its use in electric vehicle (EV) batteries. Prices hit a record high in late 2022, thanks to a perfect storm of rising demand and supply constraints.

However, a slowdown in the Chinese EV market triggered a subsequent fall of over two-thirds in the price of lithium, as shown in the chart below:

Figure 2: Spot lithium carbonate prices from 2017 to 2023, in Chinese YuanSource: Investing.com

For investors wanting to add lithium to their portfolio, we’ve produced a guide to our pick of the best lithium stocks.

It’s been a similar story for palladium, a key raw material in emission-reducing devices for cars, with rising demand prompting a quadrupling in its price in the decade to March 2022.

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However, its price has subsequently more than halved as supply constraints eased and car manufacturers switched to using cheaper platinum.

3. Energy products

Energy-based commodities also delivered substantial returns from 2020 to mid-2022. The relaxation of lockdown restrictions, together with geopolitical supply issues, pushed oil and natural gas prices to near-record highs, as seen in the chart below:

Figure 2: Spot lithium carbonate prices from 2017 to 2023, in Chinese YuanSource: Investing.com

That said, energy prices have also fallen over the last six months, with increasing pessimism over demand from both China and the US, two of the largest global consumers of energy.

How can you invest in commodities?

One option is to buy the commodity in physical form, although this comes with challenges in terms of storage and trading. Alternatively, investing in commodity-based shares and funds can provide indirect exposure to commodities.

Commodity funds and shares can be purchased via an investment platform, either in a general investment account, or a ‘tax-free wrapper’ such as an Individual Savings Account (ISA) or Self Invested Personal Pension (SIPP).

We’ve researched the market to find our pick of the best commodity trading platforms, ISA providers and SIPP providers.

1. Buy commodity ETFs and ETCs

Exchange-traded funds (ETFs) and exchange-traded commodities (ETCs) are a popular, low cost way of investing in commodities. ETFs typically track the performance of a basket of investments or an index, while ETCs track commodity prices. As they’re traded on the stock market, you can buy and sell them ‘live’ as with shares.

According to Trustnet, there’s over 450 commodity-related exchange-traded products to choose from, with two main types:

  • Commodity ETFs that either hold the commodities in physical form, or more usually, build a portfolio of futures contracts
  • Commodity index ETFs that track the price of a single commodity index, such as crude oil or gas, or track a broader index such as precious metals, clean energy or agricultural products

Investing in ETFs is a low-cost way of tracking a commodity or index, typically charging annual fees of around 0.2%, compared to 0.8% to 1.0% for actively-managed funds.

The following commodity ETFs have been picked by Dzmitry Lipski, head of funds research at interactive investor:

  • WisdomTree Enhanced Commodity ETF: this ETF offers a broad exposure to energy, industrial and precious metals and agricultural products, with 16% held in gold. Mr Lipski comments: “The fund is well positioned to benefit from the current market climate and potentially deliver higher real returns.” It has delivered a 5-year return of 36%, according to data from Trustnet.
  • iShares Physical Gold ETF: this ETF aims to track the spot price of gold, and has achieved a 5-year return of 62% according to Trustnet. Mr Lipski states: “Gold has performed well relative to equities and other risk assets during periods of extreme economic turbulence, market volatility and high inflation”. However, he recommends investors don’t invest more than 5% of their portfolio in gold.

2. Invest in commodity-based funds and investment trusts

Commodity-based funds and investment trusts pool money from investors to invest in a range of companies involved in the mining and production of commodities including agriculture, natural resources, clean energy and timber.

The following funds and trusts were picked by Chelsea’s Mr McDermott for investors looking for exposure to commodities (data sourced from Trustnet as at June 2023):

  • BlackRock BGF World Mining Trust (BRWM): this investment trust invests in mining and metals companies, delivering a five year total return of 103%. Mr McDermott points to its attractive dividend yield, which is currently 7% (calculated by dividing last year’s dividend payment by the current share price).
  • TB Amati Strategic Metals: this fund invests in metals with strategic importance to the global economy and future macroeconomic trends including gold, copper, nickel, silver, and lithium. It was launched in 2021 and has a one year negative return of 12%.
  • Barings Global Agriculture: this fund invests in companies in the agricultural sector, including machinery, processing and farming, achieving a five year return of 52%.
  • VT Gravis Clean Energy Income: this fund invests in renewable and sustainable energy across a range of regions and has delivered a five year return of 74%.
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3. Buy shares in commodity-based companies

Another way to invest indirectly in commodities is to buy shares in companies that produce, mine or process commodities or related businesses.

Higher commodity prices allow companies to sell their products at a higher price – if production costs remain the same, this leads to an increase in profitability. However, share prices are also impacted by company-specific factors, together with broader geopolitical and environmental issues.

Mining companies

In the mining sector, Glencore (GLEN) is an Anglo-Swiss producer and miner of more than 60 commodities, including cobalt and nickel. It’s delivered an increase in share price of almost 50% over the last two years and is currently trading on a dividend yield of 8%.

Keith Bowman, investment analyst at interactive investor, comments: “Exposure to commodities which assist decarbonisation and energy transition under climate change concerns continues to keep Glencore in the gaze of investors.”

Oil and gas companies

Looking at the oil and gas sector, Mr McDermott comments: “While the world is looking to move away from oil and gas, these markets still have a role to play for some time to come.”

He believes that oil and gas companies such as BP and Shell will “play a role in the transition to cleaner energy as they look to increase their renewable footprint.”

Shell (SHELL) is a British-Dutch company that produces and refines oil and natural gas. Its share price has increased by more than 60% over the last two years and currently offers a dividend yield of 4%.

We’ve also taken a more detailed look at how to invest in natural gas and oil along with our pick of the best renewable energy stocks.

Agricultural companies

In the agricultural sector, Mr McDermott points to companies such as John Deere (DE) and Kubota (KUBTY) “developing technologies to modernise farming practices and using artificial intelligence to provide ‘precision agriculture’.”

These include the calibrated fertilisation and watering of crops to increase production, together with the use of “artificial intelligence to differentiate between cultivated plants and weeds”.

Although the share price of Kubota has remained flat over the last two years, the share price of John Deere has more than doubled.

What is the outlook for commodities?

Commodity prices are expected to continue on a downward trend, with the World Bank forecasting that prices will fall by just over 20% this year and remain broadly stable in 2004.

However, growing geopolitical tensions, stronger-than-anticipated growth in China and supply disruptions could yet trigger another rise in prices.

Looking longer term, commodities will play a key role in the transition to green energy to meet the ambitious net zero emissions targets set at the last COP 26 summit. Clean energy technology is heavily reliant on metals such as copper, lithium, nickel and cobalt to allow storage of energy in batteries.

Tilmann Galler, executive director at JP Morgan, forecasts that demand for critical minerals could surge over the next decade. He says: “The clean technology transition is igniting a new supercycle in critical commodities, with natural resource companies emerging as winners.”

And Mr McDermott believes that agriculture could be “perhaps the greatest long-term story of all.” He comments: “Feeding the world is going to be a major task that will require significant long-term investment” with a predicted global population of nearly 10 billion in 2050.

Should you invest in commodities?

Investing in commodities may offer investors a potential hedge against inflation, together with a means of diversifying their portfolio across different assets. As with shares, commodity prices are volatile and should form part of a long-term investment strategy.

Your investment can go down as well as up, and you may not get your money back. If you are unsure as to the best option for your individual circumstances, you should seek financial advice.