Consider Commodities as an Investment - dummies

By David Stevenson

The global commodity business is absolutely enormous. It encompasses a huge assortment of individual commodities, ranging from stuff everyone knows about and despairs paying for (look at the recent price of oil and gold, for example) to more esoteric markets such as coffee beans or rare earth minerals used as components on electronic circuit boards.

Two aspects link all these diverse commodities:

  • They trade internationally.

  • Each one has a market price, that is, a spot price.

The market price varies greatly and isn’t necessarily the same all over the world; the spot price of a barrel of oil in London for instance may not be the same as the price in Juno, Alaska.

To add to the confusion, the spot price is only one price among many. The spot price only alludes to the price someone will pay for actual physical delivery at that specific point in time. Most participants in the global commodity markets (centred on London, New York and Chicago) don’t want or even need that price.

They need a price in the future (called the future price) when they can plan to deliver or transport their commodity.

Futures prices vary greatly and may bear only a passing resemblance to the spot price.

Consider commodities as a great inflation hedge. The significant number is the correlation between a key commodity index, the Commodity Research Bureau (CRB) index, which tracks the overall movement in commodity prices, and the US Consumer Prices Index (CPI), which measures how much the US dollar is worth, a key factor in determining inflation rates.

A comparison reveals that the value of the US dollar and the overall movement of the commodities market are significantly and negatively correlated; that is, when one goes up the other goes down.

If you look at the numbers, the correlation is –0.78 per cent for the broad index (a correlation value of –1.0 means that the assets demonstrate a perfect negative correlation); if you look at just the livestock sector of the commodities market, the correlation rises to –0.85 per cent).

Thus commodities can work wonders in ‘stagflationary’ markets (when economic growth is slow, unemployment is high and prices are rising), with gold likely to do especially well.