Now, I must stress this article isn’t intended as investment advice, far from it. It’s merely to highlight how you could trade in commodities if you wanted to gain exposure to that sector: in order to hedge your long-term investments or to trade short-term moves.
What are commodities?
In a nutshell, commodities are things that we use or wish to hoard. If you want to see raw supply and demand speculation in action, you can’t get any better than commodities.
Oil is probably the hottest commodity at the moment, with Gold also in the news. Here’s a quick summary of some of the major commodities and how much they’ve risen in recent years:
Lead – Doubled since 2003.
Copper – Double since 2003.
Silver – Trebled since 2003.
Gold – Doubled since 2003.
Wheat – Doubled in the last two years.
Some things haven’t followed suit in recent times, like orange juice and coffee, but the general trend of commodities (and metals in particular) is up. Some commentators say that we’re smack bang in the middle of a commodity super cycle, a once in a 50-year event. The demand and growth rate from emerging economies has been compared to the industrial revolution and the American turn of the century boom.
While this theory also has its critics, it’s also worth noting that a recent Merrill Lynch analyst tipped oil to reach $150-$200 within the next two years. The same analyst was derided when he made his $100 oil prediction a couple of years ago.
There are a number of ways you can gain access to commodities. Some are better than others, depending on your time frame and the commodity you wish to trade.
Spread Betting
Most spread betting firms allow you to trade commodities, but there can be complications for longer-term trades or investments. Spread betting prices are based on the spot price for day trades, or quarterly contracts for longer term traders. These quarterly contracts are based on the underlying futures contract such as Oil June 2008 or Gold September 2008. This date is when contract would be due to expire and often Gold June will be trading at a different price to Gold September. The problem is that sometimes the future contract can be trading at a different price to the current spot price because traders factor in various things like interest rates and where they expect the price to be in six months, not where it is now. Also with the longer term spread bets, you get wider spreads meaning you have to get more movement before you can even break even. The trade off, of course, is that over 6 months you are most certainly going to get some movement.
The advantage of spread betting commodities is the fact that any profits are free from capital gains tax. This is a significant advantage, provided of course, that you manage to make a profit in the first place. You could of course choose to short a commodity such as oil if you think the boom is over.
In my opinion with spread betting, you can make some fantastic long-term moves, but do be careful you are not putting the horse of tax before your cart. Major commodities such as oil and natural gas can make for great trading vehicles intraday. http://www.millennium- traders.com hosts a live trading room for commodity futures which I have used in the past and found to work very well. The trades come thick and fast and you can end up making and losing lots of money very quickly. I found it a good education in trading oil prices intraday.
CFDs
CFDs or Contracts for Difference operate in a similar manner to spread betting and you can trade many of the same commodities. One interesting point to note is that unlike equity CFDs, there are no commissions to be paid on commodity CFDs.
The upside of CFDs is that you can get closer to the spot price for your longer term trades. However, there are other charges that you do not get with spread betting, such as the financing cost. As CFDs are effectively a loan, to allow you to purchase an asset on leverage, you’ll be charged a ‘financing fee’ on all your open trades where you are long, and rewarded with a financing fee where you are short. This charge varies from firm to firm but it is usually in the region of LIBOR (or the interbank base rate) + 3%. The financing fee is apportioned daily. This means that if you go long on oil, it has to make at least 8 or 9% before you break even over a year. However, if you go short, you could make an extra bit of money on your position.
Futures & Options
Options can be a very good way to make explosive short-term profits with a known risk from the start. However, with options you do have a time delay so long-term trades may not be too great. You also have the problem of the contracts with the longer time value being more expensive.
You will have to pay commission with futures but you can get the actual futures prices, unlike with spread betting. You still have the problem of price differences between spot and future contract prices, but you can roll over positions as time goes on. There is no ongoing maintenance cost with futures, but as with options, they are subject to capital gains tax should you make a profit.
Commodity Shares
The traditional way to gain access to commodities is to buy shares in companies that are active in this area. You may not be able to leverage positions as you do with spread betting etc, but are rewarded with dividend payments which in the long-term contribute significantly to total returns.
One way to explore the commodity sector is to use the excellent free tools available at www.digitallook.com. If you click on the investment tab you can view the performance of the various UK sectors. Clicking on the heat map tool allows you to see which stocks have been the top performers within that sector over a particular period of time. The hottest stocks are dark blue, while the worst performing stocks are dark red.
The relevant sectors for the UK commodity sector are:
Industrial Metals: Sector gain since start of year: 40%.
Mining: Sector gain since start of year: 28%
Oil & Gas Producers: Sector gain since start of year: 2%
Oil Equipment & Services: Sector gain since start of year: 16%
For comparison, the FTSE has lost 3% during the same period.
Commodity Funds & ETFs
There are various specialist managed funds and unit trusts on the market. One of the best performers over the last few years has been the Merrill Lynch World Mining Trust, but now there is a new breed of investment vehicles available to investors & traders.
ETF stands for Exchange Traded Fund. They are effectively like a fund that trades like an individual share. Their purpose isn’t to beat the underlying market they are tracking, but to simply match it. Consequently their costs are tiny compared to traditional managed funds. The greatest variety of ETFs is available over in the US and if you have a direct access account it means you can easily short a particular market, though you may be charged dividends if you hold for a long time.
The most liquid dollar denominated ETFs are as follows:
OIH – Oil service companies
XLE – Energy companies
USO – Relatively new on the scene, this ETF directly tracks the price of oil.
GLD – ETF tracking the price of gold.
Purchasing in Dollars can create a currency risk, but as oil has had an inverse correlation with the dollar, it could be hedged.
The UK is catching up quick with a raft of commodity ETFs hitting the market from specialist sites such as http://www.etfsecurities.com and http://www.lyxoretf.co.uk
The Lyxor Gold Bullion ETF allows you to buy gold as if it was an individual share (http://www.lyxorgbs.com). They also have ETFs for oil and other commodities.
ETF Securities have some interesting commodity ETFs including Agricultural commodity ETFs or specific ETFs that track the price of wheat.
Capital Asset: http://www.capitalasset.com/
One interesting service that I came across recently is Capital Asset. They allow you to purchase the actual commodity via leverage, which means you can buy £10,000 worth of gold, but you only need to put down £2,000.
Unlike futures, your losses are limited to your initial investment. Crucially there are no price differences between the spot value and the future contract price because you are purchasing the actual asset. You can purchase gold, silver, platinum, palladium, aluminium, copper, lead, nickel, tin or zinc.
There are costs of course – a 2% commission on the way out and spread of 1% applied to the actual spot price. There is a cost for storage which is around 0.6% per month, though this may be waived depending on the size of the position.
This may suit anyone who likes to feel like they have ownership of the actual asset. You can also sign up for their free market report, which I must say is highly useful considering it is completely free. The technical analysis and fundamental commentary has been quite accurate over the last few months.
Bottom Line
Again, I stress that this article isn’t advising you to buy commodities. However I hope I have provided some useful information should you wish to look into the sector more. There’s a non-stop stream of bad news coming from central bankers at the moment and most of it is inflation related. On the other hand if you believe all the doom mongers are wrong, you could take the opposite view and use one of the methods I have mentioned to short commodities.
