Chapter 1

Investors, Start Your Engines! The Basics of Commodities

IN THIS CHAPTER

Defining the commodities markets

Determining the best ways to trade commodities

Identifying the major commodities

The commodities markets are broad and deep, presenting both challenges and opportunities. Investors are often overwhelmed simply by the number of commodities out there: more than 30 tradable commodities to choose from. How do you decide whether to trade crude oil or gold, sugar or palladium, natural gas or frozen concentrated orange juice, soybeans or aluminum? What about corn, feeder cattle, and silver? Should you trade these commodities as well? And, if you do, what’s the best way to invest in them? Should you go through the futures markets, go through the equity markets, or buy the physical stuff (such as silver coins or gold bullion)? And do all commodities move in tandem, or do they perform independently of each other?

With so many variables to keep track of and options to choose from, just getting started in commodities can be daunting. But have no fear — this book provides you with the actionable information, knowledge, insight, and analysis to help you grab the commodities market by the horns. Maybe you’ve heard a lot of myths and fantasies about commodities. I shatter some of these myths and, in the process, clear the way to help you identify the real moneymaking opportunities.

The commodities universe is large, and investment opportunities abound. In this book, I help you explore this world inside and out. By exploring this fascinating universe, not only do you get insight into the world’s most crucial commodities — and catch a glimpse of how the global capital markets operate — but you also find out how to capitalize on this information to generate profits.

Defining Commodities and Their Investment Characteristics

Just what exactly are commodities? Put simply, commodities are the raw materials humans use to create a livable world. Humans have been exploiting earth’s natural resources since the beginning of time. They use agricultural products to feed themselves, metals to build weapons and tools, and energy to sustain themselves. Energy, metals, and agricultural products are the three classes of commodities and the essential building blocks of the global economy.

For the purposes of this book, I present commodities that fit a very specific definition, which I define in the following list. For example, the commodities I present must be raw materials. I don’t discuss currencies — even though they trade in the futures markets — because they’re not raw materials; they can’t be physically used to build anything. In addition, the commodities must present real moneymaking opportunities to investors.

All the commodities I cover in this book meet the following criteria:

• Tradability: The commodity has to be tradable, meaning that there needs to be a viable investment vehicle to help you trade it. For example, I include a commodity if it has a futures contract assigned to it on one of the major exchanges, if a company processes it, or if an exchange-traded fund (ETF) tracks it. Uranium, which is an important energy commodity, isn’t tracked by a futures contract, but several companies specialize in mining and processing this mineral; by investing in these companies, you get exposure to uranium.
• Deliverability: All the commodities have to be physically deliverable. I include crude oil because it can be delivered in barrels, and I include wheat because it can be delivered by the bushel. However, I don’t include currencies, interest rates, and other financial futures contracts because they’re not physical commodities.

  COMMODITIES THROUGHOUT HISTORY

  
  

  History reveals that the most devastating battles have been fought over crude oil, gold, uranium, and other precious natural resources (all covered in this book). When Francisco Pizarro’s first expedition to South America in 1524 led him to the discovery of vast amounts of gold deposits, his conquistadors proceeded to wipe out the whole Inca civilization that stood between them and the gold. As a matter of fact, it’s probably unlikely that Christopher Columbus would have come across to the North American continent in the first place were it not for an unquenchable desire to find the shortest and most secure route to transport spices and other commodities from India to Europe.

  At the end of the 19th century, this continuous quest for commodities resulted in the deadly South African Boer Wars, which pitted the British Empire’s armed forces against local fighters in a bloody battle over South Africa’s precious metals and minerals. The 20th century, which heralded a new historical phase — the Hydrocarbon Age, shortly followed by the Nuclear Age — marks a turning point in humans’ ability to utilize and exploit the earth’s raw materials and the extent to which they will go to preserve this control. The Persian Gulf War of 1991, which, at its essence, was an effort to stabilize global oil markets after the Iraqi invasion of oil-rich Kuwait in the Middle East, is another manifestation of this historical reality.

  To this day, international players in the geopolitical world consider access to the world’s vast deposits of oil, gold, copper, and other resources. Commodities have, thus, determined the fate and wealth of nations throughout history and will continue to do so in the future.

• Liquidity: I don’t include any commodities that trade in illiquid markets. Every commodity in this book has an active market, with buyers and sellers constantly transacting with each other. Liquidity is critical because it gives you the option of getting in and out of an investment without having to face the difficulty of trying to find a buyer or seller for your securities.

Going for a Spin: Choosing the Right Investment Vehicle

The two most critical questions to ask yourself before getting started in commodities are the following: What commodity should I invest in? How do I invest in it? I answer the second question first and then examine which commodities to choose.

The futures markets

In the futures markets, individuals, institutions, and sometimes governments transact with each other for price-hedging and speculating purposes. An airline company, for instance, may want to use futures to enter into an agreement with a fuel company to buy a fixed amount of jet fuel for a fixed price for a fixed period of time. This transaction in the futures markets allows the airline to hedge against the volatility associated with the price of jet fuel. Although commercial users are the main players in the futures arena, traders and investors also use the futures market to profit from price volatility through various trading techniques.

One such trading technique is arbitrage, which takes advantage of price discrepancies between different futures markets. For example, in an arbitrage trade, you purchase and sell the crude oil futures contract simultaneously in different trading venues, for the purpose of capturing price discrepancies between these venues. I take a look at some arbitrage opportunities in Chapter 13.

The futures markets are administered by the various commodity exchanges, such as the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE). Investing through the futures markets requires a good understanding of futures contracts, options on futures, forwards, spreads, and other derivative products. I examine these products in depth in Chapter 13.

The most direct way of investing in the futures markets is to open an account with a futures commission merchant (FCM). The FCM is much like a traditional stock brokerage house (such as Schwab, Fidelity, or Merrill Lynch) except that it’s allowed to offer products that trade on the futures markets. Here are some other ways to get involved in futures:

• Commodity trading advisor (CTA): The CTA is an individual or company licensed to trade futures contracts on your behalf.
• Commodity pool operator (CPO): CPOs are similar to CTAs, except CPOs can manage the funds of multiple clients under one account. This pooling provides additional leverage when trading futures.
• Commodity indexes: A commodity index is a benchmark, similar to the Dow Jones Industrial Average or the S&P 500, that tracks a basket of the most liquid commodities. You can track the performance of a commodity index, which allows you to essentially “buy the market.” A number of commodity indexes are available, including the Goldman Sachs Commodity Index and the Reuters/Jefferies CRB Index, which I cover in Chapter 12.

These examples are only a few ways to access the futures markets. Be sure to read Chapter 12 for additional methods.

A number of organizations regulate the futures markets, including the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). These organizations monitor the markets to prevent market fraud and manipulation and to protect investors from such activity.

Trading futures isn’t for everyone. By their very nature, futures markets, contracts, and products are extremely complex and require a great deal of mastery by even the most seasoned investors. If you don’t feel that you have a...