Mention the word "commodities" and one of three images usually pops into mind. Some people immediately think of Trading Places, of Louis Winthorpe and Billy Ray Valentine cornering the orange juice market and issuing a false crop report to the Duke Brothers, leaving the Dukes high, dry, and utterly broke. (The story has a happy ending. The Duke Brothers make a comeback in Coming to America.)
Others maintain a lovely blank stare.
And then there are those that immediately think of pork bellies, and know a guy who knows a guy who knew a guy that lost everything trading pork bellies.
The truth is that commodities don't have to be — in fact, shouldn't be — scary. Especially if you have a long-term perspective on things. Sadly, they're merely misunderstood. To add to their elusiveness, most brokers and financial advisors aren't licensed to buy and sell commodities; so, Wall Street has a bias against commodities.
I don't plan to change everyone's opinion on commodities; but, this 3-part article should shed some light on what goes into long-term investing in commodities.
Understanding Commodities
I won't get too detailed on defining the term "commodity." Suffice it to say that commodities are items like corn, wheat, copper, oil — items that are substantially the same no matter who produces them. (See more traded commodities.) Whether it comes from Chile or Saint Vincent and the Grenadines, copper is copper.
If you were to invest directly into commodities, you would be buying futures contracts — basically, you'd be securing a price on a commodity at some point in the future. For example, copper trades in 25,000 pound "units." The September 2009 futures contract on copper is right around $2.00. If you needed 25,000 lbs of copper in September, and you were worried that the price of copper would be higher than it is today (right around $2.00), you could buy a future on copper.
Come September, no matter where copper was trading, you would get 25,000 pounds of copper for $2.00 a pound.
You can see how that would be beneficial to a business owner that needed to plan his or her future cash flows.
As an investor, you probably wouldn't want 25,000 pounds of copper delivered to your door. Fortunately, there is a commodities market in which you could sell your contract to another investor, a speculator, or the business owner/end user. If the price of copper was substantially higher, your futures contract would be more valuable.
