Investing in Commodities; Base Metals

April 27, 2009 by Joe Ponzio

Mention the word “commodities” and one of three images usually pops into mind. Some people immediately think of Trading Places, of Louis Winthorpe and Billy Ray Valentine cornering the orange juice market and issuing a false crop report to the Duke Brothers, leaving the Dukes high, dry, and utterly broke. (The story has a happy ending. The Duke Brothers make a comeback in Coming to America.)

Others maintain a lovely blank stare.

And then there are those that immediately think of pork bellies, and know a guy who knows a guy who knew a guy that lost everything trading pork bellies.

The truth is that commodities don’t have to be – in fact, shouldn’t be – scary. Especially if you have a long-term perspective on things. Sadly, they’re merely misunderstood. To add to their elusiveness, most brokers and financial advisors aren’t licensed to buy and sell commodities; so, Wall Street has a bias against commodities.

I don’t plan to change everyone’s opinion on commodities; but, this 3-part article should shed some light on what goes into long-term investing in commodities.

Understanding Commodities

I won’t get too detailed on defining the term “commodity.” Suffice it to say that commodities are items like corn, wheat, copper, oil – items that are substantially the same no matter who produces them. (See more traded commodities.) Whether it comes from Chile or Saint Vincent and the Grenadines, copper is copper.

If you were to invest directly into commodities, you would be buying futures contracts – basically, you’d be securing a price on a commodity at some point in the future. For example, copper trades in 25,000 pound “units.” The September 2009 futures contract on copper is right around $2.00. If you needed 25,000 lbs of copper in September, and you were worried that the price of copper would be higher than it is today (right around $2.00), you could buy a future on copper.

Come September, no matter where copper was trading, you would get 25,000 pounds of copper for $2.00 a pound.

You can see how that would be beneficial to a business owner that needed to plan his or her future cash flows.

As an investor, you probably wouldn’t want 25,000 pounds of copper delivered to your door. Fortunately, there is a commodities market in which you could sell your contract to another investor, a speculator, or the business owner/end user. If the price of copper was substantially higher, your futures contract would be more valuable. If the price of copper was lower, your futures contract would be worth less.

Once you see it in action and when you learn some of the lingo (backwardation, contango, spot, etc.), you begin to realize that the commodities market is not some mysterious craps table requiring an iron constitution and a propensity for gambling.

In fact, it’s a lot like learning about investing in stocks. To many, the stock market is nothing more than a casino. To some that bother to look beyond daily price swings and headlines, the stock market is a place to value, buy, and sell businesses. The commodities market is a place to value, buy, and sell commodities.

Volatility and Leverage in Commodities

Commodities tend to be more volatile than the general stock markets, and certainly more volatile than large-cap stocks. This volatility should come as no surprise – in 2005, the New York Stock Exchange alone had more daily volume in stocks than the entire world experienced in annual futures volume.

Of course commodities will be volatile, just as thinly traded or small market cap stocks would be volatile compared to their highly liquid, mega cap peers.

Then there’s the “pork belly” factor. The guy who knew a guy who lost everything. Odds are, that “guy” lost everything because he was trading with the maximum allowed leverage. In the stock market, you can buy on margin, but you’re typically limited to as much as 50% margin. If you’ve got a $100,000 brokerage account, you can typically buy up to $150,000 in stocks. With commodities, leverage is a whole different ballgame.

If you’ve got $100,000 to trade in commodities, you can buy up to $2 million worth of futures contracts. That’s right – 20-to-1 leverage. With that kind of leverage, and considering how volatile commodities can be, you have to be right. At 20-to-1 leverage, a 5% drop wipes you out entirely. (Just ask the banks!)

Still, You Don’t Have to Be Psychotic

Then again, you don’t have to be an insane gambler to invest in commodities. The fact that you can leverage yourself 20-to-1 doesn’t mean you have to – or should. You can pay cash and relax.

And, so long as your data and reasoning are right, you needn’t fret a bit over the volatility. If your data and reasoning tells you that, for example, oil will be at $80 a barrel by the summer of 2010, and you bought it at $40, why should you care if it goes to $30…or, $20…or, $60?

Just as you can day-trade the heck out of stocks, you can trade commodities like a psycho. But, there is another approach to commodities. Take a step back, put them into five- and ten-year timeframes, and they begin to make sense.

It’s the same when we look at stocks, not as prices streaming across a computer screen, but as pieces of businesses.

Then, keep in mind: When it comes to intelligent investing, the goal is to figure out what will happen. You’ll never peg the “when;” so, figure out the “whats” and then put your money into your best ideas.

Click here to continue to Part II of this article.

A Note From Joe Ponzio

This section is for comments from F Wall Street visitors. Do not assume that Joe Ponzio agrees with or otherwise endorses any particular comment just because it appears or remains on this website.