How Does Commodities Business Work

3.1.Introduction

Commodities have traditionally been considered the black sheep in the family of asset classes — no one wanted anything to do with them. This traditional lack of has generated a lot of misinformation about commodities. As a matter of fact, probably no other asset class has suffered through so much misunderstanding and misconception. A lot of investors are, quite frankly, scared of venturing into the world of commodities.

In recent years, commodities as an asset class have received a lot of attention from the investor community. Many investors are turning to commodities because they are disappointed with the returns that other investments have offered and, more importantly, because commodities have performed extremely well recently.

Since the fall of 2001, commodities have been running faster than the bulls of Pamplona. The Reuters/Jefferies CRB Index nearly doubled between 2001 and 2006. And further rallied in recent times. During this period oil, gold, copper, and silver all hit all-time highs. Investors who understand this market can benefit from the gains this asset class can make

3.2.Why Commodites  Are  Unique?

As an asset class, commodities have unique characteristics that separate them from other asset classes and make them attractive, whether as independent investments or as part of a broader based investment strategy.

Inelasticity- In economics, elasticity seeks to determine the effects of price on supply and demand. The calculation can get pretty technical but, essentially, elasticity quantifies how much supply and demand will change for every incremental change in price. Goods that are elastic tend to have a high correlation between price and demand, which is usually inversely proportional: When prices of a good increase, demand tends to decrease. This makes sense because you’re not going to pay for a good that you don’t need if it becomes too expensive. Capturing and determining that spread is what elasticity is all about. Inelastic goods, however, are goods that are so essential to consumers that changes in price tend to have a limited effect on supply and demand. Most commodities fall in the inelastic goods category because they are essential to human existence. There is no way around this.

For instance if the price of ice cream were to increase by 25 percent, chances are you’re going to stop buying ice cream. Why? Because it’s not a necessity, but more of a luxury. However, when the price of unleaded gasoline at the pump increases by 25 percent you’re definitely not happy about the price increase, but you still go out there and fill up your tank. The reason? Gas is a necessity — you need to fill up your car in order to go to work, school, run errands, and so on. The demand for gasoline isn’t absolutely inelastic, however — you won’t keep paying for it regardless of the price. A point will come when you decide that it’s simply not worth it to keep paying the amount you’re paying at the pump; and so you begin looking for alternatives. But the truth remains that you’re willing to pay more for gasoline than for other products you don’t need; that’s the key to understanding price inelasticity.

Most commodities are fairly inelastic because they are the raw materials that allow us to live the lives we strive for; they allow us to maintain a decent standard of living. Without these precious raw materials, you wouldn’t be able to heat your home in the winter; actually, without cement, copper, and other basic materials, you wouldn’t even have a house to begin with! And then of course, there’s the most essential commodity of all: food. Without food we would not exist.

Safe Heaven:

During times of turmoil, commodities tend to act as safe havens for investors. Certain commodities, such as gold and silver, are viewed by investors as reliable stores of value. And so investors flock to these assets when times aren’t good. When currencies slide, when nations go to war, when global pandemics break out, you can rely on gold, silver, and other commodities to provide you with financial safety. For example, after the horrible acts of September 11, 2001, the price of gold jumped as investors sought safety in the metal. It’s a good idea to have part of your portfolio in gold and other precious metals so that you can protect your assets during times of turmoil.

Hedge against inflation

One of the biggest things you need to watch out for as an investor is the ravaging effects of inflation. Inflation can devastate your investments, particularly paper assets such as stocks. The central bankers of the world — smart people all — spend their entire careers trying to tame inflation, but despite their efforts, inflation can easily get out of hand. This is why you need to protect yourself against this economic enemy. Ironically, one of the only asset classes that actually benefits from inflation is, you guessed it, commodities. Perhaps the biggest irony of all is that increases in the prices of basic goods actually contribute to the increase of inflation.

For example, there’s a positive correlation between gold and the inflation rate. During times of high inflation, investors load up on gold because it is considered a good store of value. One way to not only protect yourself from inflation, but also to actually profit from it, is to invest in gold

3.3.Commodities and business  cycle

Commodities are cyclical in nature. Returns on commodity investments are not generated in a vacuum — they are influenced by a number of economic forces. In other words, the performance of commodities, like that of other major asset classes, is tied to general economic conditions. Because economies move in cycles, constantly alternating between expansions and recessions, commodities react according to the current economic phase.

The performance of commodities as an asset class is going to be different during economic expansions than during recessions. As a general rule, commodities tend to do well during periods of late expansions and early recessions. The reason is that as the economy slows, key interest rates are decreased in order to stimulate economic activity — this tends to help the performance of commodities. Stocks and bonds, on the other hand, do not perform as well during recessions. This means that as an investor seeking returns across all phases of the business cycle, opening up to commodities will allow you to generate returns during good and bad economic times.