Here’s How to Navigate the Commodity Investing Waters

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In the past couple of years, commodities have not been a good place to put your money. However, longer term, they have been outperforming stocks. Since the turn of the century, there are many commodities that have increased several multiples in price:

  • Oil has risen from $20 per barrel to more than $100 per barrel.
  • Corn has risen from $2 per bushel to nearly $5 per bushel.
  • Gold has risen from $250 per ounce to $1,250 per ounce.
  • Copper has risen from less than $1 per pound to more than $3 per pound.

This strong performance is due to a couple of factors. The first is rising demand, particularly from emerging market countries with economies that are growing rapidly. This rising demand has put upward pressure on prices. The second is a lack of supply. When commodities are in a bear market, there is less investment in mining, and this means that there is lower supply. Throughout the 1980s and 1990s, there was a bear market in commodities, and therefore there was less production.

While commodity prices have corrected and consolidated over the past couple of years, I suspect that the uptrend is about ready to continue. Demand is still strong in emerging economies, and yet commodities are still not very profitable to produce. These factors will drive prices higher. But how should you invest in commodities? For retail investors, there are two options: commodity ETFs and commodity stocks. Both have advantages and disadvantages. Commodity ETFs are a relatively new investment vehicle, and they make it easy for investors to get exposure to commodity prices. If you are bullish on the price of oil, for instance, you can buy the United States Oil Fund LP (NYSEARCA:USO), and this fund will rise and fall with the price of oil.

In many ways, this is a great alternative to investing in oil-producing companies. I will get to the disadvantages of investing in oil producing companies in a bit, but what is great about a fund like USO is that it gives you relatively straightforward exposure to the price of oil without the risks of investing in the stock market. There are a couple of negative to investing in commodity ETFs, though. The first is taxation. These funds are taxed in various ways, and not all of them are beneficial to investors. For example, gains earned on the SPDR Gold Trust (NYSEARCA:GLD) are taxed at the “collectible” rate, which is 28 percent.

This is substantially higher than the capital gains rate, which is either 15 percent or 20 percent. The second negative deals with the ways in which they get exposure to commodities. While a commodity-producing company produces and then sells a commodity, a commodity fund has to hold the commodity or futures contracts representing that commodity. This can be a problem. For instance, the USO has underperformed the spot price of oil because at the end of every month, the fund has to roll over its position, meaning that it has to sell old futures contracts in order to buy new ones. The new ones generally cost slightly more than the old ones because they expire later, and the added cost is a naturally built-in fee to cover storage costs. For these reasons, many investors prefer investing in commodity-producing companies. These have several advantages. First, gains on commodity producing companies are taxed at the capital gains rate if you hold them for at least a year. Second, commodity-producing companies are businesses that can reinvest profits into their businesses or return capital to shareholders.

There are oil producers, for instance, that have substantially outperformed the price of oil because they have not only been able to sell oil at a higher price but they have taken those profits and used them to produce even more oil in the future. Third, commodity-producing companies offer leverage to the price of the commodities that they produce. Say, for instance, that a copper company needs $2 to produce a pound of copper, and that the copper price is $3 per pound. If the price of copper rises to $4 per pound, the company’s profit on each pound of copper produced jumps from $1 per pound. to $2 per pound.

This means that the company’s ability to generate profits has doubled while the price of copper rose just 33 percent. Despite these advantages, though, there are drawbacks. The first is that the aforementioned leverage works in both directions. Using the above example, if the copper price drops to $2.50 per pound, then our example company’s profits drop by 50 percent, even though the copper price drops by only 17 percent. The second is that a company has to deal with many risks that can hurt the company even if the price of commodities that they produce rise. For instance:

  • Commodity production can fall.
  • The company can have problems with the government.
  • The company can suffer because of an unforeseen disaster (e.g., BP (NYSE:BP)).
  • The price of commodity production can rise.

Given all of these points, it turns out that many commodity producers underperform the prices of the commodities that they produce. For instance, Barrick Gold (NYSE:ABX) is trading at about the same level it traded at back in 2001, when the gold price was below $300 per ounce. The bottom line is that there are risks and benefits to either strategy, and the best approach is to hedge your bets and take positions in both ETFs and in producers.

You also have to be very selective when you pick your ETFs and producers. Different ETFs give investors exposure to commodity prices in different ways, and different companies have various production costs, geopolitical risks, and growth potentials. But while all of this sounds complex, you can make a lot of money if you sort through all of these variables.

There are some ETFs that are very straightforward. There are also commodity producers with a lot of growth and with low production costs that will make investors a lot of money. These are the assets you want to own when you expose yourself to commodities, as they will make you the most money without complications.

Disclosure: Ben Kramer-Miller does not own any of the assets mentioned in this article. More From Wall St Cheat Sheet