A commodity is a basic good that is interchangeable and uniform between producers. For example, natural gas is a commodity as there is little differentiation on the final product. This uniformity allows commodities to be traded, usually through future contracts on an exchange. Future contracts are an agreement to buy or sell an asset at a future data at a specified quantity, quality and price.
Investors make money from commodities through futures contracts when the price of the commodity that they hold a futures contract for, rises. This makes the futures contract more valuable and so can be sold at a higher value. As an example:
- An oil producer wants to lock in a selling price for oil at the end of the month. An investor believes the price of oil will go up in that time.
- An oils futures contract is drawn up to commit the investor to buy oil at today’s price ($40 dollars per barrel) from the producer at the end of the month. This locks in the price the producer will receive and so eliminates oil price fluctuation.
- At the end of the month, the price of oil has risen to $60 dollar per barrel. The investor still has a futures contract agreement to buy the oil at $40 dollars per barrel (the price at the beginning of the month).
- Due to the increase in oil prices, this futures contract is now worth more at the end of the month and can be sold by the investor for profit.
Investors can also make money on commodity futures contracts in the opposite scenario where there is an agreement to sell in the future at a certain price and the price of the commodity falls in the intervening period. It is important to note that usually, when investors buy or sell commodity futures contracts, no physical good is transferred.
Investors like commodities for two reasons: 1) as can help reduce risk in a portfolio by diversifying away from equity and bonds and 2) due to their inherent volatility large gains (and losses) can be made on commodities. For The Virgin Investor, commodities have to be considered very carefully purely for the above reason that losses can be huge.