What are commodity stocks?

Commodity stocks are investments in companies that produce, refine, or distribute materials used in other businesses.

How do commodity stocks work?

Commodity stocks (like all stocks) are ownership interests in a company. Commodity stocks are influenced by the price and demand for the materials produced by the company and by the industries that use them. Energy companies like Exxon/Mobil, mining companies like Rio Tinto, and agricultural firms like Archer-Daniels are considered commodity stocks.

Ordinary investors typically cannot buy raw commodities in large quantities. Even if you could buy commodities like barrels of oil or bushels of wheat, you would need to invest in transportation and storage.

Example of a commodity stock

Gold mining stocks can be attractive because they offer a “leverage effect” on the price of gold. A gold miner has a cost to extract the metal, which includes the cost of running the business. When the price of gold is above the extraction cost and continues to rise, gold mining profits rise faster.

For example, if the cost of extracting the metal is $1,000 per ounce and the price of gold is $1,100 per ounce, the company has a profit of $100. If the price of gold rises from $1,100 per ounce to $1,120 per ounce, that represents a price increase of approximately 2%. The profits of the gold miner, however, rise from $100 per ounce to $120 per ounce, which is a 20% increase in profits.

The share price of the gold miner rises based on the increase in its profits, which is 10 times greater than the increase in the price of gold. Leverage can also have negative effects. For example, if the price of gold falls by 2% to $1,080 per ounce, profits would drop by 20%. The share price of the gold miner will drop to reflect the decrease in profits.

Advantages and Disadvantages of Commodity Stocks

Advantages

Accessibility: All you need to buy commodity stocks, ETFs, and mutual funds is a brokerage account. Commodity accounts require margin and often have higher fees and limits, and may require financial qualifications.
Diversification: Commodity stocks provide an opportunity to invest in the commodity market without directly investing in volatile, short-term commodity futures contracts.
Income and capital appreciation: Like many other stocks, commodity stocks may offer ownership value and the potential for income and capital appreciation.

Disadvantages

Volatility: The commodity market is volatile, and that can reflect on the individual commodity stock.
Correlation: Commodities are a means for diversification in your portfolio, as their prices typically do not correlate or move in the same direction as other asset classes like stocks and bonds. However, the prices of commodity stocks are not only affected by the price of the materials; they are also influenced by broader trends in the stock market and the economy as a whole, as well as company-specific news and events.

Types of Commodity Stocks

Commodity stocks are divided into three categories of commodities: agricultural, natural resources, and financial instruments.

Agricultural

Agricultural stocks provide feed, fertilizers, grains, seeds, and bio-materials for companies that grow, refine, and distribute foods and other products, such as natural health and beauty products. Examples of large-cap agricultural commodity stocks include Archery-Daniels, Cargill, and Bunge.

Natural Resources

Natural resources stocks include energy and minerals.

Energy commodity stocks: These companies supply, refine, and distribute oil, gasoline, and natural gas products. Energy commodity stocks include Exxon/Mobil and ConocoPhillips.
Minerals: There are two types of mining commodity stocks. Mining companies explore for and extract minerals. Mining stocks include companies like Rio Tinto and Barrick Gold. Smaller mining companies explore for new mineral sources, while larger mining firms have established reserves. Royalty-based commodity stocks provide capital to mining companies in exchange for a portion of the production.

Financial Instruments

Finance

Financial instruments include commodities, currencies, and cryptocurrencies, as well as financial index products such as S&P 500 futures. Unlike other financial instruments, some cryptocurrencies, such as Bitcoin, use a process called “mining” to create and distribute new cryptocurrency.

Note: Digital mining companies like Marathon Digital Holdings and chip manufacturers that support mining data centers like AMD and Nvidia are ways to invest in cryptocurrencies without actually buying and holding them.

How to Invest in Commodity Stocks?

Buying Stocks Directly

All you need is a brokerage account to buy individual commodity stocks. Many brokerage firms provide research resources to help you identify and analyze individual stocks, ETFs, and mutual funds.

Investing in ETFs and Mutual Funds

ETFs and mutual funds are ways to diversify and buy shares in many different commodity stocks. ETFs and mutual funds often have low minimums. ETFs and mutual funds are purchased using a brokerage account. The expenses for ETFs and mutual funds can vary based on whether they are actively or passively managed. Always do your research before investing.

Note: Profits from ETFs sold after holding for a year are usually taxed at long-term capital gains rates of 0%, 15%, or 20% depending on your income. However, ETFs that contain precious metals such as gold or silver may be taxed at 28%.

Investing in Derivatives

Derivatives such as stock options derive their value from underlying assets. Stock options are a way to control large amounts of stock for relatively small cash amounts. Stock options can be used to speculate on the direction of a commodity’s price or another stock.

What Does This Mean for Individual Investors?

Ideally, a portfolio should be diversified and include assets that are not correlated or move in the same price direction. Commodities are attractive because their prices are generally not correlated with stocks and bonds. Commodity stocks can provide portfolio exposure to commodities, along with the benefits of dividends and capital appreciation. However, some research suggests that commodity stocks closely track the broader equity market rather than actual commodity prices. ETFs and mutual funds in commodity stocks are low-cost ways to gain diversification and exposure to many different commodity stocks.

Frequently Asked Questions (FAQs)

How can you buy commodity stocks?

All you need is a brokerage account. Many brokerage firms offer no-minimum brokerage accounts, as well as extensive research and educational resources.

What do higher commodity prices mean for stocks?

Commodity prices do not directly affect stock markets, but they have larger feedback effects on the economy that indirectly impact stocks. Commodities account for about 40% of the Consumer Price Index. When commodity prices rise, it reflects in inflation, which the U.S. Federal Reserve aims to keep within a certain range. When the Federal Reserve raises interest rates to combat inflation, it restricts borrowing and consumer spending. This, in turn, affects corporate profitability and causes stock prices to fall.

Source: https://www.thebalancemoney.com/what-are-commodity-stocks-6826168