Advantages and disadvantages of investing in commodities

3 min. reading
Commodities / 20 July, 2021

Edgar Mondragón Tenorio Journalist

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What are raw materials?

Raw materials are objects that we obtain from nature and that serve as inputs in the production of derived products. For example, cotton is the basis for the textile industry, or petroleum for the polymer industry.

Classification of raw materials

As for the market segmentation of these products, they can be divided into two main groups, soft raw materials and hard raw materials, according to their characteristics.

  • Soft raw materials. Practically refers to agricultural products, such as corn, cotton, wheat, sugar and soybeans. It also includes livestock products such as cattle and hogs.
  • Hard raw materials. These are those related to industry, extraction and reserve assets such as gold, silver, oil, copper, nickel or natural gas, among others.
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In another approach, raw materials can be segmented into six main groups for greater clarity of the market to which they belong.

  • Agricultural products with the highest demand and, therefore, the highest production, such as corn, cotton or wheat.
  • Other agricultural products with high demand, but lower production compared to the agricultural product family, such as coffee, sugar, cotton, cocoa or orange juice.
  • Usually live livestock lots such as pigs or cattle are traded.
  • This includes the production of crude oil in its various qualities such as North Sea Brent or West Texas International, as well as its derivatives such as gasoline, diesel, boiler oil and natural gas,
  • Precious metals. Mainly associated with jewelry and as reserves of value, gold, silver, platinum, palladium.
  • Industrial metals. Associated with various industries such as manufacturing or construction, e.g. copper, nickel, tin, aluminum or steel.

Advantages of investing in commodities

Wide variety of options. There are many options to diversify in terms of products, while in terms of instruments there is the possibility of investing in stocks or ETFs, options or futures.

  • They smooth volatility. These assets are usually not directly correlated to other assets or to each other, so, in the event of having positions in gold and cattle, and gold were to fall, this would not have to affect the cattle market. Thus, smoothing volatility in a portfolio.
  • Inflation protection. Being inputs for production, regularly when inflation goes up, the price of commodities follows the same trend, so some commodities, such as gold, are also used as a store of value.
  • Supporting economic growth. Emerging economies are the largest producers of raw materials, so by investing in them, we support the growth of trade in these raw materials and, therefore, global economic growth.

Disadvantages of investing in commodities

High volatility. Although the price of raw materials depends on supply and demand, both supply and demand are affected by external factors such as natural phenomena or political circumstances that abruptly alter the prices of raw materials.

Speculation. Unfortunately, the high volatility of commodity prices attracts those who seek short-term profits and based on the mass movements of these speculators, the price of these assets can be affected.

In contrast to equities. Although it is not a rule, the profitability of commodities usually goes in the opposite direction to the trends of the equity market, i.e., when the stock market shows a boom period, the commodities market usually shows a stagnation or drop in its yields and vice versa.

Damage to the environment. Despite legislation around the world on sustainable practices in livestock farming, agriculture, mining and extraction, procedures and mechanisms continue to be used to produce raw materials that have a high negative impact on the environment. The clearest example is the oil and crude oil refining industry.

Investing in raw materials has pros and cons, as well as risks and benefits, however, having them is always a good option that contributes to the diversification and good health of our portfolios.

 

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