Risks of commodity investing

Introduction

Commodities can provide exposure to markets and economic forces that differ from traditional stocks and bonds, but they also come with distinct risks. Prices can change quickly because of weather, geopolitics, supply disruptions, currencies, inventories, and shifts in global demand.

The investment vehicle matters just as much as the commodity. Physical gold, an oil futures fund, a mining stock, and a leveraged futures position may all provide commodity-related exposure, yet their risks are very different.

Understanding these differences is essential before using commodities as part of an investment portfolio.

Commodity price volatility

Commodity prices can be highly volatile. Unlike a diversified business that sells many products or services, an individual commodity market can be strongly affected by a relatively narrow set of supply-and-demand factors.

A drought can reduce crop production. Political conflict can disrupt energy supplies. A new mine can increase metal output. Changes in economic activity can alter industrial demand. These developments can lead to large price movements over short periods.

Volatility varies by commodity and market conditions, but investors should not assume that physical assets are inherently stable simply because they are tangible.

Supply and demand risk

Commodity prices depend heavily on the balance between physical supply and demand. Both sides can change unexpectedly.

Supply may be disrupted by weather, strikes, equipment failures, wars, sanctions, disease, or transportation problems. It may also expand when high prices encourage producers to increase output.

Demand can change because of recessions, consumer preferences, technological developments, substitution, efficiency improvements, or government policy. A commodity that appears scarce today may face very different conditions in the future.

Geopolitical and policy risk

Many important commodities are produced or transported through a limited number of countries and regions. Political instability, wars, sanctions, export restrictions, tariffs, and changes in government policy can therefore have a major effect on supply and trade flows.

Energy markets are particularly sensitive to geopolitical developments, but metals and agricultural commodities can also be affected.

Policy can influence demand as well. Environmental rules, agricultural subsidies, biofuel mandates, trade agreements, and industrial policy can change the economics of producing or consuming particular commodities.

Weather and natural-event risk

Weather is an especially important risk for agricultural commodities and livestock. Drought, flooding, frost, excessive heat, storms, and other events can affect crops, animals, transportation, and storage.

Energy markets can also be affected when severe weather disrupts offshore production, refineries, pipelines, electricity demand, or transportation.

Weather forecasts themselves can move prices before the final effect on physical supply is known, adding another source of short-term volatility.

Futures and leverage risk

Commodity futures are leveraged instruments. Traders generally post margin rather than paying the full economic value of the contract upfront.

Leverage magnifies exposure. A price movement that appears small relative to the commodity’s value can create a much larger percentage gain or loss relative to the capital committed. Adverse moves may require additional margin, and positions can be closed if margin requirements are not met.

This makes direct futures trading significantly different from buying an unleveraged stock or fund. Losses can develop quickly, particularly in volatile markets.

Contango, backwardation, and roll risk

Futures contracts expire, so investors seeking continuous exposure must replace contracts over time. The price relationship between the expiring contract and the new contract can affect returns.

When longer-dated contracts are more expensive than near-term contracts, a market is commonly described as being in contango. Repeatedly replacing cheaper contracts with more expensive ones can create a return drag.

When longer-dated contracts are cheaper, the market is in backwardation. Rolling can be more favorable, although the market structure can change over time.

Because many commodity exchange-traded products use futures, an investor’s return can differ significantly from the change in the commodity’s spot price.

Tracking and product-structure risk

A fund with a commodity in its name does not necessarily hold that commodity physically or reproduce its spot-price return. Products may use futures, swaps, physical holdings, shares of commodity companies, or combinations of assets.

Expenses, trading costs, collateral returns, futures roll effects, and portfolio rules can all create differences between the performance of the product and the price an investor expects it to track.

Before investing, it is important to understand the structure described in the fund’s documents rather than relying only on its name or recent performance.

Physical ownership risks

Physical commodity ownership avoids some financial-product risks but introduces practical ones. Precious metals, for example, need to be stored securely and may require insurance.

Dealer spreads mean the purchase price can be above the quoted market value while the resale price can be below it. Authenticity and counterparty selection are also important when buying bullion.

For most other commodities, physical ownership is impractical. Oil requires specialized storage, while crops can deteriorate and livestock require ongoing care.

Commodity-related stock risk

Investing in a mining company, oil producer, or agricultural business is not the same as owning the underlying commodity. These companies face normal business and stock-market risks.

A producer may suffer from rising costs, operational failures, poor management decisions, excessive debt, regulatory problems, or disappointing reserves. A company may also hedge commodity prices, limiting its exposure to a price increase.

Commodity stocks can therefore underperform even when the commodity they produce is rising. They may also be affected by broader equity-market conditions.

Currency risk

Many major commodities are quoted internationally in U.S. dollars. Currency movements can affect commodity demand, producer economics, and the returns experienced by investors whose home currency is different.

The relationship between the dollar and commodity prices is not fixed. A stronger dollar can sometimes create pressure on dollar-priced commodities, but supply and demand may be more important at other times.

Investors using foreign funds, foreign-listed securities, or overseas commodity companies can also face additional currency exposure.

Concentration risk

A single commodity can be exposed to a narrow set of risks. An investment focused only on crude oil, silver, or wheat may experience much larger swings than a broadly diversified portfolio.

A broad commodity fund can spread exposure across multiple markets, but it may still be concentrated in particular sectors depending on how its index is constructed.

Commodity exposure should therefore be considered in the context of overall portfolio diversification rather than viewed in isolation.

Inflation-hedge risk

Commodities are sometimes presented as protection against inflation. Rising energy, food, and raw-material prices can contribute to inflation, and commodities may perform strongly during some inflationary periods.

That relationship is not guaranteed. Commodity prices can fall while consumer prices continue rising, and individual commodities can respond to industry-specific supply and demand rather than broad inflation.

Relying on a commodity solely because inflation is high can therefore produce unexpected results.

No inherent cash flow

Physical commodities do not generate earnings, dividends, or interest simply by being held. An investor in bullion or direct commodity exposure generally depends on future market prices for a return.

This differs from productive businesses that can generate profits or bonds that may make contractual interest payments. Holding costs can further reduce returns for some commodities.

The absence of inherent cash flow can also make valuation more difficult because there is no stream of future earnings or interest payments to estimate.

Comparing major commodity risks

Managing commodity risk

Risk begins with understanding the investment structure. Investors should know whether they own a physical asset, a futures-based product, or shares of a company and what factors determine its return.

Diversification can reduce dependence on a single commodity or market factor, although it cannot eliminate losses. Position size also affects how strongly commodity volatility influences an overall portfolio.

Costs, liquidity, leverage, and the time horizon of the investment should be considered before gaining exposure. Our guide to how to invest in commodities compares the main investment methods.

Key takeaways

• Commodity prices can be highly volatile because supply and demand respond to weather, geopolitics, economic conditions, inventories, and other factors.
• Futures introduce leverage, margin requirements, expiration dates, and roll risk.
• Futures-based funds can perform differently from spot commodity prices.
• Physical ownership introduces storage, security, insurance, and transaction costs.
• Commodity-related stocks add business and stock-market risks that the physical commodity does not have.
• Commodities are not guaranteed inflation hedges and generally do not produce inherent cash flows.