Methods for Investing in Commodities - dummies

By David Stevenson

A vast amount of opportunity exists in the world of commodities for advanced UK investors and traders. Hundreds of hedge funds focus on the commodity markets, using all sorts of strategies, some of which the more diligent, sophisticated private investor can copy.

The long and short of it: Treating commodity markets as just another asset

The most popular strategy is go long and short key commodities, using key macro economic variables and index puts/calls. This approach uses commodity markets as just another financial asset alongside bonds and shares but with the added insight that the broader economic business cycle has a huge role to play in determining the direction of markets.

Here’s a simple example. Oil prices are heavily determined by the global economic and business cycle. If a country such as the US or China starts to slow down markedly, expecting demand for crude oil from industrial users and hard pressed consumers driving cars to diminish is reasonable.

This reaction has a knock-on, cyclical effect on crude oil prices, which probably fall back. As an investor, you may take a 1‒3-month short position on futures prices if you think that a recession is imminent.

As the price decline picks up speed you’d expect profits for large oil companies to start falling sharply and perhaps oil company share prices to fall as well, which again offers an opportunity for a short position.

Paradoxically, slowing growth or a recession may be good news for gold investors, because gold is traditionally seen as a safe asset in times of economic distress. This suggests a long position on gold.

Let’s contango! Playing the roll yield

Another very popular strategy is to play the roll yield and the ebb and flow of backwardation and contango. Commodity markets are very dynamic and can switch from contango to backwardation reasonably quickly, making savvy investors a great deal of money.

A simple trade may involve the oil markets (again) and contango, in a market where the price of a futures contract is trading above the spot price; that is, if the spot price of a barrel of oil is $100, the one-month futures contract may be at $105.

In this circumstance a hedge fund may buy lots of physical oil on the spot markets (at $100) and then sit tight, holding vast amounts in rented storage depots.

As long as the cost of that storage is less than the price difference between the futures contract (deliverable in one month’s time at $105) and the spot price (the difference in this example is $5), the hedge fund makes a profit.

Commodity markets often exhibit the same characteristics as the mainstream share and bond markets, including having their own rhythms. For long periods of time, a market may trend higher as momentum builds.

The strategy, popular with equity investors, of taking advantage of the swings between contango and backwardation can also be used in commodities and in fact has become so popular that a whole sub-species of hedge-fund managers has appeared called commodity trading advisors (CTAs).

CTAs use sophisticated software programs to track and analyse all sorts of market- and commodity-specific information and to automate trading in order to take advantage of the changes in the asset’s movement, either up or down.

Using pricing inefficiencies

Price inefficiencies (in which the price of the asset doesn’t accurately reflect the available information) also exist in commodity markets, especially if the flow of news information doesn’t keep up with market prices. Natural disasters can have a major impact on commodity production, especially foodstuffs; the massive impact on potential future output from, say, a storm may not be immediately priced-in by the markets.

This situation presents a hedge fund with an opportunity to exploit inefficiency through an aggressive trading strategy, called arbitrage in which you buy an asset at a low price in one market and then immediately attempt to resell it at a higher price in another market.

Finding niche markets

Plenty of opportunity also exists in specialist markets such as the spread crack used by the large US oil and gasoline producers.