Learn How To Invest In Commodities

[This article comes from the Learn section of our website. ETF.com will present a live webinar on commodity ETFs on Tuesday 30 June. You can sign up here]

Usually when you hear someone discuss the price of any commodity—say, gold, wheat or sugar—it’s in reference to the commodity’s spot price; that is, the price at which you can currently pay to receive the commodity immediately.

Physically receiving and owning the commodity is where the challenge comes into play. Most investors don’t want to actually take delivery on a thousand bushels of wheat. The challenges associated with buying commodities at spot prices include delivery, storage, security and perishability.

For most commodities, the challenges of buying and selling at spot and receiving physical delivery outweigh the advantages—making it simply impractical. As a result, most commodities ETPs do not offer access to the spot price of commodities—that’s where futures contracts come into play.

Metals are the exception: Gold, silver, platinum and some industrial metals are heavily traded in spot markets, and accessing spot prices in an exchange-traded product is much more feasible. There are dozens of exchange-traded products offering exposure to the spot price of gold, silver and even palladium, platinum, nickel and copper.

Physically backed metals ETPs acquire the metal at its current spot price, deposit it in a vault and sell the metal at the spot price when the time comes.

It makes sense that precious metals would be physically held and traded at spot prices, as they are non-perishable and are practical to store. It’s practical to throw gold bars into a secure vault; from a cost-benefit standpoint, it’s far less practical to throw thousands of barrels of soybeans into a refrigerated warehouse. As a result, perishable commodities are usually only physically held by their producers and their downstream users.

It’s worth noting that perishability is an issue only insofar as it adds to the storage challenge—the real issue. For example, oil isn’t perishable, but it’s also not commonly physically held outside its producers and downstream users.

This problem of storage isn’t a new one, however—for hundreds of years, producers and consumers of these kinds of commodities have had a way to handle the problem: futures contracts.

Instead of buying the commodity in the spot market, a commodities consumer—or an investor—can buy a contract that constitutes a promise to buy a specified quantity of the commodity to be delivered at a future date—presumably, when they actually need it. Producers and consumers of the commodities both get to lock in prices and ensure their demand or supply for months to come. Knowing the price in advance is valuable to commodity producers and consumers, as it allows them to focus planning efforts elsewhere.

Most agriculture, energy and broad-market commodity ETPs use futures contracts to gain their exposure rather than physically storing the underlying commodities. However, as the expiration date (delivery date) for that futures contract nears, the ETP sells the contract and purchases a new contract with a more distant expiration (delivery) date.

The idea is that the futures contracts held by the fund will appreciate as demand for the commodity increases or supply decreases, and they will be sold at a profit. The implications of using futures, contracts, however, are more complex than this—contango and backwardation can eat away or contribute to returns when buying and selling futures contracts. (For more information, see “Contango And Backwardation”.)