How does commodity investing work?

Manufacturers, farmers, and miners buy or sell goods in such large quantities that price fluctuations can prevent them from planning for the future.

So traders invented futures contracts. You can get the full lowdown on how these work in a separate guide about futures and options, but for a quick refresher: a futures contract is a commitment to buy or sell something in the future at a certain date and price. A contract could specify that on November 20th you’re going to buy 1,000 barrels of oil for $70 per barrel – come November 20th, the contract settles and you’re handed a bunch of oil. ⛽

These futures contracts guarantee the price way in advance of the actual transaction date, offering stability to industry.

Commodities can be bought and sold in their physical form, but the industrial scales involved can make it hard for small investors to get a look in. So the side benefit of futures is they allow people like you to invest in things like copper or wheat without needing to store them in a warehouse.

How? Futures are available to buy and sell, so you can speculate on the price. Say the price of coffee is $1 per pound, and you think it’ll soar to $2 by year’s end – you could buy a futures contract for coffee that settles in December at $1.50. Come November, if coffee’s trading at $1.75 per pound, your futures contract becomes rather valuable. Starbucks will collect that coffee contract for their next brew, and serve you a tidy profit (though they might still get your name wrong on the cup). ☕

The jargon of futures pricing

What does futures pricing look like?

Brace for jargon. Commodities investors talk about the “futures curve” mapping out the prices today for contracts that settle on different dates in the future. Normally, the curve slopes upwards: the price of oil two months from now would be greater than its “spot price” today. That’s because the seller of the contract has to be paid for the storage of the commodity for those two months, and compensated for having to wait two months for their cash. In these situations, traders say the curve is… normal (they’re an imaginative bunch).

But when it’s cheaper to have the commodity delivered two months from now than to get it today, we have the opposite inverted curve sloping downwards. A temporary shortage of beef, for instance, would drive up the price for today’s cows while leaving the price of future cows the same.

And how do these prices change over time? Futures contracts let you buy something for a set price in the future – but that doesn’t mean that the price you’re paying today for a January 21st delivery is the actual price you would pay on January 21st. If the curve is normal, the futures price might be higher than the expected “buy-it-now” price for January 21st. If that’s the case, we say the market is in contango – people expect the price of the futures contracts to fall over time to meet the expected “buy-it-now” price.

The opposite is when the market’s in backwardation. That’s where the futures price is below the expected “buy-it-now” price for January 21st, signifying that people think the price of the futures contracts will rise over time. Markets that are in backwardation are perfect for long-term investors, because they’re holding onto an asset that’s increasing in value. 🚀

Be warned: traders sometimes use these terms interchangeably. The two concepts are subtly different: normal and inverted refer to today’s snapshot expectation of the future, whereas contango and backwardation are analyses of how prices of the underlying commodity will actually move over time.

Now you know the jargon, let’s get to the fun – how to actually trade commodities.