How to Invest in Commodities?

Trading in commodities offers an immense potential for a separate class of asset

investment and portfolio diversification. Though trading in commodities might be
considered as an unfathomable market by some retail investors, yet it is easy to
understand trading in commodities taking into consideration, the fundamentals of
demand and supply concerns. For those who want to diversify their investments beyond
equities and real estate, commodity trading is the best option! The investors can now
trade in commodity futures on the multi-commodity exchanges in the country, without
carrying any physical stocks. However, before taking a leap, the interested prospects
should understand the risks and advantages of trading in commodities.
Gold As an Investment Instrument:
Gold is traded worldwide based on the intraday spot prices. Derivatives including
forwards, futures and options can also be traded on various commodity exchanges all
over the world. In India, gold futures are traded on the MCX and NCDEX division. The
exchanges have a national presence which enable electronic trading and settlement
systems. The investors can also trade in gold ETFs which represent physical gold in a
paper or dematerialized form. The gold ETFs are traded like a companys stock whose
price is approximately equal to one gram of gold. On the MCX, gold is traded in different
contract sizes offering you an opportunity to trade as per your risk appetite. The
investors can trade in gold main contract, gold mini contracts, gold petals or gold
guinea.
Major Bear and Bullish Run in Golds History:
Gold Bear Market (1980-2001): Gold prices ran into a 20 year long bear market from
1980 to 2001. The US treasury limited the money supply due to which there was severe
recession and higher unemployment in the US economy for a short term. The central
banks policy controlled inflation and gradually stabilized the economy. In 1999 the gold
rates in London stood at its multi-year low of US $ 252.80.
Gold Bulls Market (2001-2012): The beginning of 21st century witnessed a prolonged
bull rally in the gold prices which were seen rising from $265 per ounce to $1800 levels
in August, 2011. US national debt and its extensive monetary easing policy resulted in
weakening of US dollar and increasing gold prices. The ultra low interest rates also made
gold an attractive investment.
Some important factors affecting gold prices:
i)
Physical Buying and Industrial Demand: the demand for jewellery
constitutes two-thirds of the annual gold production, with India accounting for almost
27% of the total physical demand worldwide. The industrial demand stands for 12% of
the entire gold demand. Furthermore, the emerging markets such as China, Brazil and
most importantly India have significantly boosted the gold demand.
ii)
Stock Markets: when the stock markets plummet, the investors sell-off gold
for cash, to yield higher returns from equity investments. However, a significant drop in
the prices motivates the investors to make purchases at discounted prices.
iii)
Speculation and Price Manipulation: traders find gold trades as a quick
way to make money. Speculators prefer to trade in futures and options to benefit from
the futures price expectations so as to profit disproportionately from the price
movements. Gold prices are negatively correlated to the US dollar which
means if dollar becomes weaker, gold prices tend to increase as it becomes
more valuable.

iv)
Central Bank Policies: Gold is usually considered as an effective hedge
against inflation. The interest rate decisions of the central banks have a significant
impact on the gold prices. If the interest rates are high i.e the investors get a higher rate
of interest on their savings it diverts the investment into currency however, a decline in
the interest rates increases gold purchases.
Risks Related to Gold Trading
i)
Exchange Related Risks: risks which are related to the exchange where gold
is traded can be termed as exchange related risks. A change in the margin requirement or
the money which is needed to trade in the futures market is the first exchange related
risk. Halt trading is another risk, whereby the exchange halts the trading in case of
volatile movements in the commodity prices in either direction.
ii)
Volatility of Gold: gold is highly volatile where predicting its long term trend
can be next to impossible. Sensitivity of gold prices to natural disasters, interplay of the
international financial systems, discovery of new gold deposits and irrationality of
investors exposes long term investments to high frequency risks. Consider, if someone
had bought gold in late 70s, he would have to wait 30 years to avoid any net loss in his
position so as to get back to his break even prices.
iii)
Market Manipulation: when the market equilibrium is distorted purposely, it
is regarded as market manipulation. In 2007, the markets witnessed excessive short
selling by the small mining companies to drag the stocks lower.
Crude Oil As an Investment Instrument:
Crude oil is the worlds most actively traded commodity and the largest traded futures
contract in terms of volume. Did you know that crude oil is the most widely used among
all other forms of energy resources in the world? The crude oil prices are highly volatile.
Increase in the oil prices leads to inflationary pressures which thereby increase the cost
of inputs. It hence reduces the non-oil demand lowering the investment in the oil
importing countries. Crude oil is graded into three forms
i)
WTI: it is high quality crude oil which is physically traded in the US markets.
ii)
Brent Crude Oil: its a grade from the North Sea, used as a benchmark for
crude oil from Europe and Africa.
iii)
Middle East Crude Oil: it is taken as the arithmetic average of Oman and
Dubai crude grades with a large physical market in the Gulf regions.
Crude oil contract on the MCX division is quoted in Rupees per barrel and the trading
unit for 1 lot is 100 barrels.

Major Events in Crude Price History

The Israel war in mid 70s quadrupled the oil prices from $3 to $12 in the later half of
1974. Another revolution in 1979 sky rocketed the oil prices to $1979 with the economys
oil production plummeting significantly to 2.5 million barrels per day. The oil prices
which had peaked to $35 dropped to $10 per barrel in six years as a result of
overproduction and oil conservation. In the post inflation gulf-war period the crude
prices traded below $25 per barrel eventually escalating after 2003 due to the following

factors:
i)
peak oil concerns causing changes in petroleum reserves
ii)
Middle East supply concerns
iii)
Quantitative Easing by the central banks
The crude prices surged to $140 levels before the 2008 financial crisis, which led the oil
prices bleed from its all time high to trade near $40 levels by the year end. However, the
Libya crisis and aggressive monetary easing measures by the US government added back
the strength to the oil prices.
Some important factors affecting crude oil prices:
i)
OPEC supply, output and spare capacities
ii)
US crude inventories and stockpiles data
iii)
Changes in the currency factor
iv)
Weather conditions affecting the potential demand concerns
v)
Speculative Buying and Selling in Crude Oil
vi)
Increased demand from developing nations amid positive global growth
scenario
vii)
Supply concerns related to geopolitical factors
viii)
Financial markets and macroeconomic data
Risks Related to Crude Oil Trading
i)
Extremely Volatile Market: The oil futures market is a highly volatile
market. Even if the investors expect an increase in the oil prices, you might not know
how quickly the prices would advance.
ii)
Difficult to Forecast the Potential Demand: Oil prices are extremely
difficult to predict. For eg; if the demand for crude oil increases, it increases the prices of
crude. Eventually it places more burden on the consumers whereby the general state of
the economy forces the consumers to reduce their oil demand hence dragging the prices
lower.
iii)
Global Oil Production: despite OPEC carefully regulating the oil
production there exist numerous market factors which influence the oil prices. Wars and
emergencies can drastically hamper the oil production resulting in skyrocketing oil
prices.

Copper As an Investment Instrument

Copper is one of the most common and oldest forms of metal used in cable and wire
industries. The biggest factor affecting the price of copper is its demand Copper is
majorly found in Australia and South Korea. China has had a construction boom due to
which the demand for this industrial metal from China stands the highest. The major
exchanges which trade in copper are the London Metal Exchange ( London), Comex
division of the NYMEX (New York) and Shanghai Exchange( China). There is more
buying of copper in the early start of the year on increased production orders. The metal
usually trades sideways in the mid-year when the prices of copper rely more on the
supply side while the prices are influenced more by the inventories status in the later
part of the year. You can generally classify the life cycle of this industrial metal based on
the major demand and supply patterns throughout the year.

Some important factors affecting copper prices:

i)
Supply and Demand Factors: demand and supply is the primary driving
force of the metals prices. The major consuming nations of copper are China, the United
States, Europe, Russia and Japan.
ii)
Supply Disruptions: strikes and lockouts in industrial units have a
significant impact on the copper prices. Political unrests, sluggishness in the
manufacturing activity and natural disasters can cause severe disruptions in supplies
causing copper futures to rally.
iii)
Inventory Stocks: Daily, Weekly and Quarterly inventory reports of the
copper stocks help in ascertaining the future price direction for the commodity prices.
iv)
Global financial crisis, recession and inflation also affect the metals prices.
How to trade in copper?
i)
On the supply side, copper remains sensitive to any unexpected events in
China, the worlds largest consumer of copper. Labor strike, political unrest, shipping
problems cause supply disruptions hence leading the prices higher.
ii)
The investors should carefully track the inventories report released by the
LME and Comex exchanges. A drop in the stockpiles implies increasing demand, which
lifts the prices higher and vice-versa.
iii)
Any major developments in China and US manufacturing activity accounts for
an increase in the total demand for copper. Hence, the major economic data must be
kept a record of.
Silver As an Investment Instrument
Silver is considered both as an industrial and a precious metal used for consumption and
investment purposes. The sharp upward rally in the gold prices has also spurred the
silver prices massively with the industrial demand for the metal rising at a faster pace.
Silver is one of the most volatile commodities traded on the exchange. Many traders
leave the silver markets disgruntled by the excessive price movements in the silver
prices. However, here we would highlight some fundamentals that would assist you safer
silver trading strategies. The price pattern remains intact in gold and silver. Trading
silver for a short term period is not an easy task since the price movements are actively
guided by the big market players, whose movements are detriment to the small
speculators. An example for long term investors would suggest that Warren Buffet had
purchased 4000 metric tons of silver at approximately $4.50 in 1997, while in 2006 he
announced that his company no longer held any silver position when the metal was
trading near $8 levels.
Some important factors affecting Silver prices:
i)
Large Traders or Investors: The gold markets is much more than silver
in terms of value hence some big institutional funds had enough capacity to cause high
volatility in the prices. For eg, Morgan Stanley had caused silver prices to move much
when it had short position its holdings.
ii)
Industrial, Consumer and Commercial Demand: the physical demand
for silver is supported by the multi-variant uses of silver. Consumer demand implies

traditional way of investing in silver in forms of bars and coins. Silver can be traded in
form of physical silver, ETFs , Certificates and Accounts. Derivatives are another mode
of trading in silver such as silver futures and options.
iii)
Price movements in Gold: Silver is highly sensitive to the movements in
gold prices. It moves in tandem with the prices of gold, though the volatility in terms of
price movements might be different. The US dollar rate against the euro also has a
significant impact on the gold and silver prices.
Natural gas
Natural gas is an important component of the worlds energy heads. It is likely to play a
wider role in the total energy requirements as it is relatively lower in terms of carbon
emissions and polluting elements. The natural gas prices have ranged from $15.4 mmBtu
in 2005 to $1.1 mmBtu in 1992. The natural gas prices quoted on the NYMEX division
serve as a benchmark for the national energy price. In India, the natural gas futures are
traded on the Multi Commodity Exchange (MCX).
There are mainly two kinds of factors that affect the natural gas prices; short term and
long term factors.
i)
Short term factors include the weather conditions. Natural gas in used as an
effective heating fuel hence the demand for this energy fuel rises in colder temperatures.
More natural gas is demanded in cold weather conditions, for obvious reasons. On the
other hand, the demand for natural gas can also spike higher in times of extreme hot
weather conditions as the fuel is used as an energy source for air conditioning systems.
Also, if there exist some alternative sources of power; it can create a downturn in
demand for natural gas if the other sources of energy are cheaper.
ii)
In the long run, the state of the economy impacts the natural gas prices. The
demand for the fuel would be affected by the industrial take-off and the number of uses
this energy fuel can be put into.
How to trade in natural gas?
i)
Demand and Supply: natural gas prices move much in tandem with the
demand and supply factors. Whenever, there are cold weather forecasts made in the
effective demand regions, the prices surge higher in natural gas. Both, industrial and
residential demand, have an impact on the natural gas prices.
ii)
On the supply side, the inventory results have a dramatic impact on the
natural gas prices. The investors need to stay cautious ahead of the US inventory report
which is released every Thursday for the weekly analysis in the natural gas stockpiles. An
increase in inventories signifies lesser demand, hence lowering the prices and viceversa.
iii)
Market Sentiment: Natural gas prices also track the overall sentiment in
the energy prices. Though there is no significant impact of any major macro economic
data on the natural gas prices, at least in the short run.

Key Data Points Affecting Movement in Commodity Markets:

i)
Employment Data: a good employment data is usually positive for the
base metals and energy prices while it has a negative impact on the precious metals.
ii)
Manufacturing PMI: positive manufacturing data (especially from US and
China) boosts the crude oil prices and copper futures. However, a positive
manufacturing data has an opposite impact on the precious metals.
iii)
Inventories Data: Inventories data has a dramatic importance in the base
metals and crude oil pricing. An increase in the inventories implies low demand for the

commodity which has a negative impact on its prices. However, a drop in stockpiles
means an increase in the demand factors hence lifting the prices higher. While trading in
Crude oil, copper and natural gas the investors must stay cautious on days of inventory
reports release.
iv)
Other Macro-economic data: Consumer sentiment, industrial production,
Retail Sales data are some of the other economic indicators which if report a growth in
the economy, are negative for precious while positive for the base metals and energy
prices.
v)
Currency factors: Currency movements have a dramatic impact on the
commodity prices. If the domestic currency appreciates against the US dollar, we see a
negative impact on the Indian commodity prices.
vi)
Macro-economic events: monetary easing, policy decisions are very
important factors which can have a superfluous impact on the commodity prices. A
recent example was the quantitative easing implemented by the US government which
rallied the gold prices to its all time high. Interest rate decisions and monetary stimulus
have direct impact on the currency factors that eventually influence the commodity
prices.