No one discounts the human cost of the pandemic that has swept the globe. Nor has the economic outlook brightened much, as governments and the private sector wrestle with the ramifications of COVID-19. But investors must look forward and seize opportunities as they arise. The best time to invest is often when economic prospects are uncertain, and the public mood soured. Invest in the darkest nights, sell on the high-noon parades.
To be sure, anyone investing in commodities today is not buying at the top.
For most investors, there are three pathways into commodity investing, those being commodity index funds, commodity-oriented funds (and individual stocks), and the ever-challenging futures and options markets. Risks and rewards vary across the three categories, or risks can, to some degree, be “hedged” by investing across categories.
One reason to invest in commodities is to diversify investment portfolios. Even with the deep dent to global oil prices, commodity funds outperformed broad stock markets through the first quarter of 2020. The S&P 500 Index peaked this year on Feb. 19 and fell by about 30 percent by the end of the first quarter. The benchmark Bloomberg Commodity Index fell by 20 percent in the same time frame. That is hardly nirvana, but it is clear commodities offer ballast to the investor portfolio. And if the global economy recovers, the future for commodities investors, given current buy-in prices, arguably looks bright.
Looking ahead, the primary vehicles for investing in commodities are:
- Commodity index funds
- Commodity-oriented ETFs
- Commodity stocks
- Commodity futures and options
THE COMMODITY INDEX FUND
A commodity index fund pools money from investors to place into financial instruments, usually based on or linked to commodity price futures. Thus, a commodity index fund replicates the performance of one or several commodity price indexes. One considerable advantage for investors is liquidity, as they can leave a fund with a click of the mouse, and incur minimal transaction fees.
The granddaddy of commodity index funds was started by Goldman Sachs in 1991, and is now called the S&P GSCI Fund. The fund is broad-based to reflect the global commodity market, and that is worth noting: Various commodity index funds invest by different formulas in global commodities.
A commodity index fund, for example, might be more or less exposed to oil and energy, coffee or potash, or may even be limited to industrial or precious metals. Also, the larger commodity index funds usually charge between 0.75 percent to 0.85 percent in management fees. That fee is something to ponder for long-term investors, as the annual management fee is higher than for simple, stock market index funds, or the direct investing in stocks of commodity-oriented listed companies through a discount brokerage. Smaller commodity index funds can charge even more in management fees. A 1 percent management fee may not sound like a deal-breaker, but that is roughly 10 percent of a portfolio in 10 years.
A cousin of commodity index funds is the commodity-oriented exchange-traded funds (ETFs), and generally refers to ETFs that invest in commodity companies, as opposed to straight plays on indexes. This category includes ETFs that invest in the stocks of oil and energy companies, gold mining enterprises, or other natural resource or agriculture outfits.
For example, the VanEck Vectors Gold Miners ETF invests not in gold, but in the stocks of gold mining enterprises. As such, this ETF tends to magnify gains in gold bull markets, but also amplifies declines in bear markets.
Another example is the SPDR S&P Oil & Gas ETF, which invests in oil and gas-
producer stocks, and has endured epic declines in the past 52 weeks (down 75 percent) and five years (off 85 percent). For those investors bullish on oil, the present day may represent the unmatched buying opportunity of a generation. One advantage of an energy company ETF is that the fortunes of any particular fossil fuel or energy stock might be difficult to predict, but if the industry recovers, an energy company ETF will almost certainly recover also. Worth noting, the SPDR S&P Oil & Gas ETF offers a 4.22 percent dividend, meaning investors will be paid to wait for a recovery, although the dividend could take a haircut.
For investors so inclined, there is even a timber ETF, the iShares Global Timber & Forestry ETF.
In general, if there is a rebound in commodity prices, investors in commodity-
oriented ETFs should enjoy magnified results of that upside.
SIDESTEP THE MIDDLEMAN, BUY STOCK DIRECTLY
With the advent of online discount brokerages, investors can assemble a portfolio of commodity stocks for very little in transactions costs (some online brokers advertise zero in trading fees), and yet sell the bundle with a few clicks of the mouse. For long-term investors, this low-cost option is worth considering, so as to avoid fund management fees. Depending on individual investor sentiment, one might want to assemble a diversified portfolio across commodities, thus decreasing exposure to any particular stock or market.
Those with a bullish outlook for any single commodity, such as oil, may still wish to assemble a portfolio of several stocks to avoid idiosyncratic risks of any particular company. Worth remembering is the saga of BP (the former British Petroleum), the oil giant that in 2010 suffered the Macondo Blowout, the explosion of its deepwater well in the Gulf of Mexico. No one could predict such a catastrophe. BP ended up paying $18.7 billion in fines, and the oil producer axed its dividend while its stock was cut in half on Wall Street.
Still, for those expecting Saudi Arabia and Russia to patch up their oil price war, and for an economic recovery from the COVID-19 recession, BP is again intriguing, paying a 13.85 percent dividend. But as oil companies cut exploration budgets and dividends globally, there is perhaps risk associated with the reward of that dividend.
Many an investor has foundered in the future markets, where the shopworn expression eternally applies: “The markets can be irrational longer than your wallet can hold out.”
A cautionary tale: Some investors “shorted” oil in the futures market — that is, bet on oil prices falling — during the unusual petroleum gyrations of 2007–2008. Oil ultimately hit $140 a barrel in June of 2008, still the all-time peak price. To be sure, crude prices tumbled thereafter, and so investors who shorted the oil market in mid-June 2008 or nearby did fine. But many investors shorted oil in, say, February of 2008 when oil surged past $100 a barrel, at that time considered a stratospheric price. They had their heads handed to them. There might have been “good reasons” to short crude in February of 2008 — oil tankers were reported stalled in a port in Malta with nowhere to offload due to an oil glut — but logic and markets do not always line up. An investor can “be right,” but too early, and take 100 percent losses (or theoretically, even higher) in the futures markets. Oil did not stop at $100 a barrel and marched to $140.
So how does playing the futures work? In simple form, investors promise to buy or sell a commodity at a future date, called the “expiration date.” For example, investors are “long” if they promise to buy 1,000 barrels of oil in six months at certain fixed strike price, a typical futures contract. And investors are “short” if they promise to sell. Almost all futures contracts are financial obligations to be settled in cash, and not in physical product.
Let’s say oil is selling at $33 a barrel now, and an investor commits to selling 1,000 barrels in six months, also at $33 a barrel. If oil in six months is selling at $36 a barrel, then the investor will gain $3,000 (before transaction costs). They will buy oil at $33 a barrel through their contract on the expiration date, and then immediately sell 1,000 barrels at the then-current market price, at a $3 profit per barrel.
Of course, if oil prices fell to $30 a barrel, the investor would lose $3,000, or more if prices fell lower still.
So, future transactions are entirely risky. In fact, investors usually have to place deposits against losses in a brokerage account, and if deposits are exhausted, then meet “margin calls” for cash infusions along the way, if the market continues to go against the position taken. If an investor cannot meet a margin call for more cash, then the account is “closed out” before the expiration date.
The attraction of futures is the possibility for outsized gains if guessed properly. A diehard oil bull in early to mid-2020 might feel justified in playing the futures.
Of course, futures can be used to hedge positions as well. An investor might wish to load up on oil stocks mid-2020, and then conservatively “short” oil in the futures markets. In this scenario, if oil prices sink, and the main portfolio declines in value, the losses will be offset by gains in the short position in the futures markets.
Even more convoluted than the futures markets, but considered less risky, is the oil futures options market, where investors buy options to have the right — but not the obligation — to buy or sell 1,000 barrels of oil at the expiration date. Experts caution, however, that most such options expire worthless.
For example, let’s assume an investor buys a “call” option in May of 2020, for the right to buy oil at $30 per barrel in February 2021. Such an option may cost about $3 per barrel. This investor believes, or hopes, oil prices will go up, and plunks down $3,000. In this example, let us assume oil prices spike in summer of 2020, to $45 a barrel, well before the February 2021 expiration date. In this situation, the buyer of the call option can elect to sell their option in summer, before the expiration date, and make a profit immediately. Another investor will happily pay for the right to a call option to buy oil at $30 in February of 2021, if in summer of 2020 the price of a barrel is already $45. In this example, the original buyer of the option would gross a $15,000 profit, before expenses. Or the original investor can just hold on, and hope prices rise even more.
The above scenario sounds enticing, but in practice most oil-futures options “expire worthless.” That is, an investor paid $3 a barrel for the right to buy oil at $30 a barrel in the future, but prices went down or not high enough to make the option worth much. But, unlike in the futures market, the buyers of options have losses limited to their initial purchase price of the option, and do not endure margin calls if their investment flops.
Oil futures options can also be used as a hedging tool against a larger portfolio of oil stocks. For example, let us say an oil bull assembles a large portfolio of energy stocks presently. The oil bull can then also buy “put options” — the right to sell oil for a year out at current market prices. If oil prices fall, the put options become valuable, and this serves as a hedge against the larger portfolio of energy stocks. If oil is flat, or rises, the put options expire worthless, but money is made on the larger portfolio.
While many professional money advisers advocate real assets in a portfolio to add diversity, rarely have commodities been so depressed as in the wake of the COVID-19 pandemic. Aside from a brief downward spike in 2008, commodities are selling for less than at any time since the late 1980s, as measured by the S&P GSCI Index, a broad measure of the market.
In other words, to invest now in commodities is to invest near a 40-year low. If the global economy recovers, it is a near certainty commodities will also recover, as they did after 2008.
A rare buying opportunity is likely afoot in commodities markets.
Benjamin Cole (email@example.com) is a freelance writer based in Thailand.