SPECULATIVE INVESTMENTS: YOU BOUGHT PIGS?
Commodities futures trading is one of the earliest vehicles because it was created to help individuals in the industries that create these commodities to protect their business investments. The commodity exchanges trade the actual commodity products. This is different from the stock exchanges that trade on the shares of the companies that operate in a commodity-based industry. For example, if you want to trade in hogs, you would invest by buying or selling bets on the price of hogs going to market at a future date. These bets are called “futures”. These transactions are done on the commodity exchanges. If you want to invest in a company that processes commodities, like Tyson Foods or Barrick Gold or Exxon Oil, you would purchase stocks on the New York Stock Exchange.
Commodities are distributed across multiple exchanges that specialize in three areas:
- agricultural products from grains and wood to the various meat products;
- precious and industrial metals; and
- the energy commodities of oil, gas and electricity.
When you invest in the companies operating in these areas, you are buying partial ownership in the company that grows, mines or processes commodities. But when you invest in the commodities directly, you are speculating on the prices of those assets at a point in time in the future.
Commodities are the base products that we pull from the earth to have the standard of living that we have. But the success of these core agriculture and mining businesses are impacted by a variety of external forces ranging from the weather to the international trade and tariff structures. Economic supply and demand relationships are more obvious in this asset class than any other, and because of the effort and timelines necessary to acquire these products, the cycles tend to be long and often extreme.
Short-term impacts like war, extreme weather and now pandemics that lead to world-wide shut-down can have an unexpected and extreme impact on the flow of these cycles, creating short-term and long-term impacts that are felt throughout the global economy. To protect the operators of businesses in these assets, the futures market was created to provide a hedging mechanism. If it was expected that the quantity of the product was high for a cycle – like a bumper crop, the farmer could bet that the price of his grain would go down. That way his investment would earn the difference that he lost in the price of the product he was selling. However, if there was a sense that the weather would be severe then he could purchase a future on the fact that prices would likely increase because of a shortage of product going to market. While he was working to do best to grow his own crops, the bet was placed against the overall market in his industry.
It has become popular to speculate in the futures market, and the variety of investments is worldwide – from betting on the cost of coffee in Costa Rica, to the cost of oil coming out of Russia to the cost of gold coming out of South Africa. This asset class more than any other is dependent on knowing and understanding the business and the wide range of impacts that can disrupt the supply and demand relationship in a specific commodity. Therefore the best futures investors either work in the industry they are investing in, or have made it their life’s work to learn everything they can about the industry.
This is a serious business. If you make a mistake and have not hedged well, you can find yourself in a situation where you must take delivery on the actual asset. This became very visible in the oil industry when the governments around the world shut down everything for the pandemic. Oil has a long and complicated process that starts from the oil rig, passes through multiple transportation and processing steps from cross-country piping to refineries, and then on to distribution centers around the world via rail and ship tanker systems. There is no switch that turns this off, so when the world stopped moving, the oil continued to flow. Anyone holding a position in oil was required to take delivery. With no customers at the end of the delivery line, the oil needed to be stored – at billions of gallons per day. For a week in March, people were paying others to take the oil off their hands. The cost of oil dropped to a negative value. If you were an owner of excess storage capacity in the form of an oil tanker ship or oil storage containers, you could be paid to take ownership of the oil and just wait for the world to start moving again. Anyone with capacity had a bonanza day at the expense of the futures investor who got caught on the wrong side of the bet and had to pay for someone to take the oil off their hands.
You can see that if you are in the business, this may have been a stressful few days until a plan could be implemented, but could have resulted in an extremely lucrative bonus depending on which side of the transaction you were on. However, if not in the business, it could have been a disaster as 100 barrels of oil were schedule to deliver to you the investor, at your expense. For the most part, the logistics protects an investor from the physical delivery, but the cost to extricate yourself from the problem can bankrupt an investor who doesn’t understand the underlying business of the commodities market they are playing in.
As with all speculations that we discussed this month, the key is to know what you are investing in. Create a plan for when to get in, but more importantly when to get out. Remember that some speculations can wait for a long time to take off and require patience. Once they take off, they can make large gain but only if you don’t get too greedy and end up sitting on them all the way back down again. Whether cryptocurrencies, gold companies or commodities, learn everything you can, and then invest with the understanding that you don’t know everything.
This investment strategy requires a strong apprenticeship. It is costly whether you learn through education or experience, so if you are intending to trade in the futures market, I encourage you to find a mentor with a proven track record and willing to introduce you to the movers and shakers within the commodity that you are interested trading.
Next month we will return to our conversation around gold. As the world becomes more precarious, gold should be included in your considerations. Today, gold is in a bit of a pull back, which could give you a good entry point, especially if you don’t have any at this time.
Until then, remember, your future is what you create.
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