Commodities are unprocessed physical goods that come from mining, drilling, or agriculture. Besides having a big impact on the cost of living, commodity prices also affect portfolios – whether you invest in them directly or not. As a major input cost for many businesses, commodities often have a significant impact on companies’ profits and therefore their share prices.  

Hard commodities – metals and energy – have to be mined or extracted at some expense and tend to have long shelf lives. 

Longer production lead times mean supply is generally slower to respond to demand changes and takes longer to recover from either demand or supply shocks.

Energy includes crude oil, coal, gasoline, heating oil and natural gas. Energy products are the most liquid and heavily traded commodities which means they often constitute a large proportion of commodity funds and indices.

Economic growth, government policies, and the Organization of the Petroleum Exporting Countries (OPEC) are some of the drivers of the energy market.

Base metals are non-ferrous industrial metals like aluminum, copper and lead. 

Precious metals are gold, silver, platinum and palladium. These metals are found in mineral ore deposits around the world. 

Both base and precious metals have a wide range of physical and industrial uses. 

Precious metals may be viewed as a safe-haven physical holding (this is especially true with gold). US dollar strength, market uncertainties and inflationary fears are key drivers of price.

Hard commodities are affected by a number of factors, including levels of industrial activity, availability of substitutes or synthetic variants, supply chain disruptions, variations in production cost, environmental regulations, and more. 

Soft commodities are agricultural products and livestock. These serve as a source of food or an industrial ingredient. In some cases, such as corn, they could serve both purposes. 

This group of commodities is affected by weather, including floods, drought, and freezing conditions, changes in dietary preferences, government trade policy, planting decisions, arable land availability, and more

Soft commodities also have shorter shelf lives. They’re also produced over a shorter time frame than hard commodities and can therefore respond more rapidly than hard commodities to changing supply and demand dynamics.

The key difference between commodities and other goods is that commodities, broadly classed by type and origin, are bought and sold on public exchanges just like stocks and bonds. 

Individual producers therefore compete predominantly on cost, with little ability to influence prices themselves. 

Commodity prices are, however, much more volatile than most other asset classes – and unlike stocks or bonds, commodity investors have no claim to future cash flows. They may even have to factor in future storage costs.

Despite their volatile prices, including commodities in a portfolio may potentially diversify returns and reduce volatility overall. Commodities historically have a low correlation with other asset prices, meaning they can do well when other parts of your portfolio underperform.

Commodity prices are affected by changes in two main areas: supply and demand. But since demand is typically more predictable, you’ll find that most major shifts in the price of a commodity occur because of changes to supply. 

The nature of this relationship is illustrated by the “supply curve”. 

Every commodity’s supply curve looks different, dictated by the industry’s cumulative costs of production – and commodities with a steep supply curve are more likely to experience significant price volatility if the level of supply (or demand) changes. 

Many factors can affect supply. Weather events, geopolitical shifts, and changing regulatory and tax environments can all have an impact on commodity’s production. 

Existing stockpiles might dictate how severely short-term supply disruption influences a commodity’s price. 

For instance, technological advancements often have long-lasting effects: shale drilling in the US, for example, significantly lowered the cost of local oil extraction but also created a supply glut. 

Oil is also one of the few commodities where global supply is heavily impacted by the actions of OPEC nations and their decisions in terms of increasing or decreasing crude supply.

Certain commodities, such as gold, may be a desirable investment when markets are volatile. This is because such assets are viewed to be able to retain or even appreciate in value during challenging economic conditions. 

Volatility in commodity prices could enable investors an opportunity to take advantage of price movements in liquid markets.

Changes in demand can also influence commodity prices, although these tend to be slower-paced and more predictable than supply changes. 

Demand for commodities is usually a function of economic and population growth, although industry-specific developments can have an impact too. New battery technology, for instance, has led to much greater demand for certain metals like lithium in recent years.

Since commodities are generally priced in US dollars, commodity prices are also influenced by the strength of the dollar relative to other world currencies. A stronger dollar can cause prices of commodities to fall as commodities become more expensive overseas, dampening global demand. 

Commodities are not suitable investments for everyone. They are more volatile than traditional investments are best left to sophisticated investors. 

Along with the usual risks of investing, commodities are commonly purchased with leverage – borrowed money - to increase the potential return. This significantly increases the risk of losses well beyond the initial investment.  

There are two different types of investors in commodities – speculators who are hoping to benefit from price movements and hedgers who are trying to hedge against the risk of price movements. 

Hedgers, like farmers or manufacturers, usually produce or consume the physical commodity itself. Speculators, such as hedge funds or individual traders, usually have no intention of actually owning or taking physical delivery of the actual commodity.

There are several ways to invest in commodities: buying individual “spot” commodities directly, investing in derivative futures and options contracts, or diversifying across several commodities or contracts through mutual, exchange-traded, and index funds. Taking physical delivery of commodities is, however, best left to those who use them as an input.

Investors may also invest in a particular commodity indirectly by buying shares of companies that produce or process that commodity. Returns are, however, unlikely to follow commodity prices exactly, since they’re taking on extra risks associated with owning the company’s stock. 

These come in addition to the usual risks associated with investing in commodities as outlined below. Ultimately, deciding whether and how to invest in will depend on the role investors see commodities fulfilling as an asset class in their portfolio and are comfortable with the risks involved.

There are three key risks associated with commodities:

1. Heavy influence of supply and demand dynamics: As explained earlier, commodity prices are heavily influenced by supply and demand. So commodities may be viewed as more volatile than other investments. The volatility of commodities may also mean that investors could stand to lose a substantial amount when prices move against their expectations.

2. Leverage risk: Commodities trading enables leverage, where a small initial investment, called a margin, allows an investor to gain access to substantial trades in foreign currencies. Small price fluctuations can result in margin calls that require the investor to pay additional margin. During volatile market conditions, aggressive use of leverage may result in substantial losses, that could far outweigh the initial investment.

3. Counterparty risk: This refers to the risk that the offsetting counterparty, or other participant in a transaction, will default on their obligations, and is applicable to trades that are not guaranteed by an exchange or clearing house. Should the counterparty default, the investor may incur substantial losses.

4. Additional risk factors: Commodities are exposed to numerous other risk factors, including, but not limited to: shifts in industrial activity, supply chain disruptions, production cost variations, governmental and regulatory compliance, weather conditions, and more.