Since we started this decade we saw how it was strong from the beginning. Both the pandemic and the different geopolitical conflicts that have emerged over the previous year, the war between Ukraine and Russia has only added fuel to the fire. One of the asset classes that have benefited the most from these events has been raw materials, which have seen their prices skyrocket during the course of 2022. So today we are going to give you investment training on the main raw materials and how to operate efficiently with each of them.
How does the raw materials market work?⚙️
Raw materials are basic products used to produce agricultural products, fossil fuels and minerals. Commodities are assets that are bought and sold in markets, unlike assets such as bonos or the shares that we can only acquire with contracts. Within raw materials we can differentiate between hard ones (resources that are extracted, such as gold, oil...) or soft ones (commodity products, such as coffee, animals, wheat...). It should be noted that the conditions of each type of raw material can vary depending on several factors (climatological, political, social or geographical, for example).
What are the main raw materials?
Within the trade of raw materials we can differentiate them between 4 main sectors:
Sustainable
The energy sector is made up of assets such as oil or natural gas. They are assets necessary for the functioning of sectors such as basic consumer or industrial sectors. The price of oil can be measured with the reference price in the US (West Texas Intermediate/CL1!) or with the European reference, Brent (BRN1!). Oil prices fluctuate depending on supply and demand (announced by OPEC meetings or IEA crude inventories) and geopolitical events, such as is currently happening with the war in Ukraine.
The same thing happens with natural gas, depending on the region you are in we can consult it with different references. We can see the reference in Europe with the dutch gas (FTT), in the USA with the Henry Hubs (NG) or in Asia with the Asia Global Price (PNGASJPUSDM). Natural gas prices fluctuate like oil through supply and demand and is also sensitive to climatic or geopolitical events.
Precious metals⛏️
The precious metals sector is mainly made up of metals such as gold, silver, palladium or platinum. These are governed by the limited supply they have and the high demand they always have over time. They are usually traded with futures contracts, such as currency futures. physical (GC1!), The plata (YES1!), the palladium (PA1!) or the Platinum (PL1!). The price of gold tends to rise in times of uncertainty due to its safe haven quality. Silver, palladium and platinum also benefit, although to a lesser extent since their use extends more towards the industrial sector.
We can also find metals necessary for industrial production, such as iron (UNCLE1!), the copper (HG1!) , he aluminum (ALI1!), the zinc (ZNC1!) or nickel (NICKEL1!). The price of these metals is usually a great indicator of economic health since their use is focused on industrial production. In turn, the main precious metal exporting countries are affected by price variations, such as Chile, which concentrates 28% of world copper production.
Farm products
The agricultural sector is the one that includes edible products such as cocoa (CJ1!), cereals (ZC1!), sugar (SB1!), soybeans (ZS1!) or wheat (ZW1!). We can also find non-edible products such as cotton (CT1!) or palm oil (OJ1!). This sector is sensitive to weather problems, problems in supply chains or debates about the prices at which trade is carried out between different regions. As with precious metals, the currencies of countries that control a good part of the market share of these raw materials will also be benefited or affected. For example, the production of 65% of the world's coffee is concentrated in 5 countries; Brazil, Vietnam, Colombia, Indonesia and Ethiopia.
livestock products
This sector is made up of animal consumption products, such as pigs or cattle. It is a sector that has a constant demand, but at the same time it also harms the environment due to the overconsumption we make of these and the impact of feeding these living beings. Possibly in the following years, measures will be taken regarding these raw materials to reduce their environmental impact in accordance with the 2030 agenda against climate change.
What factors do we have to control in the raw materials market?️
As we have been commenting previously, the raw materials market moves on different characteristics than those we are used to in stocks or other asset classes. Let's see what are the main features that we have to take into account for your training in raw materials investment:
Offer and demand⚖️
When the market flows in equilibrium, raw material prices remain in stable ranges. But at times when supply may fall below expectations or production cuts are announced, prices for such raw materials may fluctuate up or down. A clear example can be the possible gas supply cut that Europe may suffer due to the conflict in Ukraine, which has led natural gas to skyrocket 10 times its value during the last year 2022.
Correlation with currencies
The raw materials market also has certain correlations with different currencies that see their movements correlated depending on the geopolitical events that may occur. For example, the Canadian dollar (CAD) is correlated with oil movements since this country is one of the main oil exporters, or the Australian dollar (AUD) as it is one of the main gold exporters. Although it should be noted that a large part of raw materials measure their value against the US dollar, so we give you a trick for your training in investing in raw materials; You can follow the dollar index (DXY) to see what situation we are in.
Stocks and inventories
This is one of the factors that directly affect raw materials. The production of raw materials is usually directly influenced by events such as bad weather, a poor harvest, production difficulties due to lack of personnel or distribution, economic and political conflicts that can alter the prices of raw materials with the incorporation of taxes, trade laws or other measures. For example, OPEC meetings or IEA Crude Inventories are events that report oil stocks and inventories, causing an increase in volatility before and after the event.
Inflation
One of the most talked about topics during this year 2022, inflation can also both benefit and harm some raw material sectors. For the energy sector it can be beneficial given that in periods of inflation raw materials usually benefit from the rise in inflation, although for other sectors of industrial or agricultural production it can be detrimental by increasing their production costs and, consequently, the costs of other sectors.
Volatility
Historically we know that the raw materials market is one of the markets that suffers the most volatility throughout the year. On average, the commodities market tends to move 30% annually. That is, over the course of a year, the price of raw materials fluctuates on average 30% up and down. It should be noted that the points that we have mentioned previously for your training in raw materials investment are highly influenced by volatility, which we can measure with the VIX index, better known as the “fear index”.
How can we operate with raw materials?路♂️
Commodity futures
The most common way to operate with raw materials is through the futures market. Futures trading involves contracts in which the future price of a commodity is speculated. For example, we can open a futures contract to buy 5.000 barrels of oil at $95 a barrel in 30 days. At the end of the contract, we will not be sent home the 5.000 barrels, but we will close our contract by taking an opposite position through the spot trading market.
In this example, when the futures contract reaches its expiration date, our position would be closed by entering another contract to sell 5,000 barrels of oil at the current market price. If the spot price ends up being higher than our contract price of $95 per barrel, we make a profit, and if it's lower, we lose money. The largest market that hosts commodity futures trading is the Chicago Mercantile Exchange (CME).
Buy raw materials directly
When we trade futures contracts, we do not buy or sell the commodity itself. Futures investors don't actually take delivery of millions of barrels of oil or herds of animals. Futures markets are based on speculating about the direction that the price of a commodity may take over a period of time. However, for precious metals such as gold and silver, investors can take possession of physical assets themselves, such as gold bars, coins or jewelry.
Shares of companies in the raw materials market
Another option we have is to directly buy shares of a company with exposure to raw materials. To give a few examples, we can buy shares of Occidental Petroleum (OXY) or Exxon Mobil (XOM) to gain exposure to oil, Stocks Newmont (NEM) o Barrick Gold (GOLD) to gain exposure to gold, Royal Dutch Shell (SHEL) or BP (BP) to gain exposure to natural gas or Cofco (1610) to gain exposure to wheat.
Investing in commodity stocks is less risky than investing directly in commodities since we are not just investing in the value of the commodity, because a well-run company can continue to generate income even if the commodity loses value. There are also other factors such as the company's administration and total market participation that can end up influencing their price.
Options Trading
Within the derivatives markets we not only have futures, we can also operate with raw materials through purchase or sale options. This type of investment allows us to operate with the price fluctuation of a product without having to buy it. We can find two types of options:
- Call options: We have the right but not the obligation to buy a contract at a set price (strike price) before a certain date (expiration date).
- Put options (pull): Unlike call options, puts give us the right but not the obligation to sell a contract at the strike price before the agreed expiration date.
This trade works similarly to futures; If the price in the future rises higher than the strike price, we can sell a call option to make a profit. The opposite would be with put options, where we have to sell them at a price lower than the strike price.
Investing in commodity exchange-traded funds (ETFs)狀
Exchange-traded funds diversify their investments across different asset classes to maximize returns and minimize risks. One of the main advantages of ETFs is the diversity they offer us by being able to gain exposure to different asset classes such as commodities, stocks, bonds or other types. Although it offers us a very favorable risk/reward ratio, we can also miss out on large movements that may be generated in specific assets. The main ETF that we recommend to gain exposure to the commodities sector is the Invesco DB Commodity Index Tracking Fund (DBC), which gives us exposure to the global raw materials market. Looking deeper, we can also try to gain exposure to ETFs in specific commodity sectors. For example, we can invest in the iShares Oil & Gas Exploration & Production UCITS ETF (SPOG) to gain exposure to oil and natural gas. With gold we can gain exposure through SPDR Gold Shares (GLD). For agricultural raw materials, we can buy the iShares MSCI Global Agriculture Producers (VEGI). For livestock raw materials we can buy the iPath Series B Bloomberg Livestock Subindex Total Return (COW).
Exchange-traded funds allow us to diversify our investment within each commodity sector to minimize risk in our portfolios.
So, is training in raw materials investment advisable before starting??
Commodity investing is a strategy that is best for sophisticated investors. Before carrying out any operation, we have to understand the price charts of raw materials and correctly analyze the data and events that may affect their prices. Since market price movements can generate large profits and losses, it is also necessary to have a high risk tolerance, that is, being able to withstand short-term losses in favor of long-term profits. Investors without training in investing in raw materials can end up being part of the 79% of retailers who lose money investing... Of course, we recommend that raw materials do not make up the total of your portfolio. Due to its characteristics and its risk/reward ratio, it would be advisable to allocate 20% or less in your portfolios to maintain a good balance. On occasions such as geopolitical events we can redistribute our investment and replenish our allocation towards raw materials. In conclusion; We recommend that you do training in raw materials investment before starting to invest in this asset class. What did you think of this article? Do you think it will be useful for your training in raw materials investment?