Risks with Investing in Commodities
2 of 8 in Series: The Essentials of Commodities Trading
Investing is all about managing the risk involved in generating returns. Here are some common risks you face when investing in commodities and some small steps you can take to minimize these risks.
Geopolitical risk with commodities investments
One of the inherent risks of commodities is that the world’s natural resources are located in various continents and the jurisdiction over these commodities lies with sovereign governments, international companies, and many other entities. For example, to access the large deposits of oil located in the Persian Gulf region, oil companies have to deal with the sovereign countries of the Middle East that have jurisdiction over this oil.
International disagreements over the control of natural resources are quite commonplace. Sometimes a host country will simply kick out foreign companies involved in the production and distribution of the country’s natural resources.
So how do you protect yourself from this geopolitical uncertainty? One way to minimize it is to invest in companies with experience and economies of scale. For example, if you’re interested in investing in an international oil company, go with one with an established international track record.
A company like ExxonMobil, for instance, has the scale, breadth, and experience in international markets to manage the geopolitical risk they face. A smaller company without this sort of experience is going to be more at risk than a bigger one. In commodities, size does matter.
Speculative risk with commodities
The commodities markets, just like the bond or stock markets, are populated by traders whose primary interest is in making short-term profits by speculating whether the price of a security will go up or go down.
If you trade commodities, constantly check the pulse of the markets, finding out as much as possible about who the market participants are so that you can distinguish between the commercial users and the speculators.
One source you can check out is the Commitment of Traders report, which is put out by the Commodity Futures Trading Commission (CFTC). This report gives you a detailed look at the market participants.
The risk of fraud in trading commodities
As if there weren’t enough things to worry about, you should always watch out for plain and simple fraud. Although the Commodity Futures Trading Commission (CFTC) and other regulatory bodies do a decent job of protecting investors from market fraud, there is always the possibility that you will become a victim of fraud.
One way to prevent being taken advantage of is to be extremely vigilant about where you’re putting your money. Make sure that you thoroughly research a firm before you hand over your money. Unfortunately, there are times when no amount of research or due diligence is able to protect you from fraud — it’s just a fact of the investment game.