The constant fear of inflation and an ever rising cost of living has pushed many people to resort to other forms of investments.
Commodities have come up as an interesting option among investors looking to generate a profit.
Commodities are raw materials used to produce consumer goods, and they’re a great way to diversify your investments and spread risk across various asset classes.
Commodities are fungible so you have to worry about differentiation between supply from various sources.
If you are looking to venture into this field, here are some things you need to know before you make the jump.
1. Understand the Risks
Every investment carries a degree of risk.
In the case of commodities, volatility is one of the biggest risks.
Prices can change drastically in the world of commodities leaving your portfolio open to major price swings.
While it can be an opportunity under the right circumstances, it can also present a huge risk.
Commodities are also a risky investment in that they are largely speculative.
Unlike other investments, hoping to generate profits primarily from the price of a commodity is speculation.
Assets don’t generate any underlying cash flows and how much profit you get depends on the current prices of your commodity.
Geopolitical events also play a major role in commodity investment.
A good example would be the cost of natural gas and oil following the invasion of Ukraine by Russia.
You can manage the risk by working commodity market analytics services like Arrowhead.
These companies provide insights into future commodity markets to streamline your decision making.
2. Price Spikes
As time passes, the commodities prices will shift toward an equilibrium price that aligns with the current demand and supply trends.
In the short-term, however, commodity prices tend to exhibit volatility and can rise or drop past the equilibrium prices.
As a result, the markets tend to overcorrect as investors look to rectify the deficit in supply.
However, they can stick around for much longer to recoup their investment.
This pushes the commodity price to an unsustainably low level.
It is important to note that price spikes, whether positive or negative, are often short-lived.
Marginal suppliers show up during the price spikes and move out during price declines.
3. The Lowest Cost Is Always Best
Companies that enjoy success in the commodities industry are those that can significantly cut production costs.
Lower production costs allow for higher profit per unit even with declining commodity prices allowing for business sustainability as long as the market remains open.
Companies that produce at a higher cost are at a higher risk of failing.
A decline in prices means that they cannot produce while remaining profitable.
Similarly, their price-taker nature means that they cannot increase production pushing them into bankruptcy.
As a commodity trader, you can have questions about producers but you could get higher prices if supply drops.
4. The Supply and Demand Rule
Supply and demand runs the commodities industry.
Most commodities industries share the same product making the producers price takers who cannot affect the prices.
An increase in demand or a drop in supply often results in higher prices while the vice versa is also true.
Before you can invest in commodities, you need to understand the supply and demand trends. Prices can fluctuate quickly.
Investing in commodities is a great way to diversify your portfolio.
You can get into the industry in many different ways but make sure to research the risks and benefits of each option before choosing.
Note that prices are extremely dynamic making commodities an unsuitable investment for people looking to buy and hold.