How to invest long term in commodities?

So, you thought that commodities were for the short term? You will be surprised to know that you can actually invest in commodities as a long-term asset. Consider some illustrations.

The first major rally in gold began in 1971. Between 1971 and 1979, gold moved up from $30/oz to $900/oz. Between 2003 and 2011, gold went up sharply from $240/oz to $1900/oz. Oil has typically had much shorter rallies, but it took 18 months for Brent to move from $110 in August 2014 to $30 in Feb 2016. This has been true for most industrial metals too. The bottom-line is that commodities too have fairly long bull and bear cycles and hence it is possible to take a long-term view on commodities.

The question is whether you should take a long-term view via the spot market or the commodity futures market?

Long-term commodities: Spot vs. futures market

We all have heard of trading in the cash market vs. trading in the futures market in equities. But, did you know that there is a similar distinction with respect to commodities too?

You can buy commodities in the spot market as well as the futures market. For example, you can either buy gold in the spot market and take delivery, or you can buy gold in the futures market and decide about the delivery before expiry. Spot commodity markets are a lot more complex. For example, if you bought gold in the spot market, you need to take delivery of physical gold. Alternatively, you can buy gold futures and decide before the expiry if you want to take delivery. For long term investing, gold futures will have to keep rolling over every month or every quarter by paying the roll premium.

Let us look at the pros and cons of taking an investment view in key commodity classes.

Precious Metals: Gold, Silver, Platinum, Palladium

Gold and silver are mainly considered as investment products. In fact, they are seen as a safety hedge against volatile markets. This is because gold prices tend to appreciate when geopolitical uncertainty is rising. The objective behind long-term investments in gold and silver must be mainly to hedge your financial portfolio against future economic uncertainties as well as inflation and currency shocks.

The investment view on gold and silver differs slightly. While gold is a contra play on economic and geopolitical uncertainty, silver operates at the midway point between precious metals and industrial metals. Hence, the economics driving silver are slightly different, and you need to factor that in.

Industrial Metals: Copper, Zinc, Aluminium, Nickel

Some of the popular industrial metals or base metals that are traded in the Indian commodity exchanges are Copper, Nickel, Zinc, Lead, and Aluminium. These base metals move in tandem with the level of industrial production in India and abroad. Currently, the biggest consumer of these industrial metals is China, which accounts for more than 50% of the global consumption. So, if you are looking at a re-rating of growth in China and higher manufacturing capacity investments in China, it is a fit case for investing in these base metals. In terms of rally structure, these base metals are a lot more vulnerable to news flows and are also quite popular for short- to medium-term trading. However, for those who want to play out the long-term cycles, investing in these base metals via the futures route can be a productive choice.

Energy: Crude oil, Natural gas

Two popular energy products traded on Indian commodity exchanges are Crude oil and Natural Gas. For a long time, base metals were demand-driven, while energy was supply-driven. This is changing as energy is also getting more demand-driven. While precious metals offer a strong long-term investment opportunity and base metals a medium-term opportunity, oil can be extremely volatile due to supply, demand, and storage factors as well as global events. Even though oil has also followed patterns, these patterns and their time frames have been too erratic. Due to its volatility and vulnerability to government policy, traders, and investors prefer to take a view of 6-8 months at most on oil. Beyond that, the risk-reward is not too favourable.

Agricultural products: Jeera, Cotton, Soya bean, edible oil

NCDEX has a stronger position in agro products trading, while MCX is much stronger in energy, base metal, and precious metals. Agriculture is still vulnerable to monsoons, cropping patterns, irrigation spread, and also global supply factors. This is the main reason why agro products are less amenable to investment. They are at best useful for short-term trading. Further, government policy can be a challenge as the government does not want the prices of agri products to go too high due to political reasons. These are either good hedging bets for farmers or they are speculative bets.