Commodities

Oil is one of the most important, and often volatile, commodities. Crude oil, which is priced per 'barrel' (42 US gallons) is primarily refined into the fuel that powers our cars, trains and planes etc. but is also used in the manufacture of other products such as plastics, asphalt and lubricants.

The world's capacity to produce oil is relatively fixed in the short term and even the discovery of new oil fields may not be enough to satisfy eventual demand if emerging countries such as China and India one day consume the same amount of oil per person as the US. However, while very long term supply could be scarce, supply currently more or less matches global demand at 85 million barrels a day.

If current supply pretty much matches demand, why does the price vary so much?

• Events such as wars, political unrest and natural disasters can temporarily hit production, reducing supply.
• A group ('cartel') of oil producers (mostly Middle Eastern) called OPEC sometimes reduces supply to try and prop up (or increase) oil prices for the benefit of its members.
• Some believe that a flood of financial speculators buying futures in the expectation of oil price rises can actually result in oil price rises.

It's also widely held that the cost to extract oil from the ground is increasing, which naturally results in a rising oil price over time.

Natural gas is extracted from the ground and refined into a fuel. For many of its uses gas competes with oil, which means the gas price tends to be affected by the oil price. If the cost of oil rises then demand for gas normally increases (as it's a cheaper alternative) and vice versa.

Gas is measured in cubic feet or metres and normally priced per 1,000 cubic metres (Mcm) or 1,000 cubic feet (Mcf). One barrel of crude oil is the equivalent of about 170 cubic metres of natural gas.

The factors affecting gas prices are very much the same as those affecting oil prices.

Industrial metals are used extensively in construction and manufacturing. The most common examples are iron (accounts for 95% of all metal production), aluminium, nickel, copper, tin, zinc and lead.

Popular uses (hence influences on demand) for industrial metals include:

• Copper - piping (e.g. water), electronics and coins.
• Iron - most commonly used in the form of steel for construction and the manufacture of machinery, vehicles, ships and household goods.
• Aluminium - vehicles/planes/ships, packaging (e.g. foil and cans), construction.
• Nickel - manufacture of stainless steel and combined with other metals to produce alloys used in manufacturing.
• Tin - solder (used when making electronics), plating other metals to prevent corrosion
• Zinc - coating iron/steel to prevent corrosion chemicals and pharmaceuticals.
• Lead - batteries and plastics (PVC).

As developing economies (notably China) continue to grow, so the demand for (hence price of) industrial metals has soared. The global downturn has since seen prices fall back, but many predict that the long term trend for industrial metal prices remains upwards.

Precious metals are rare, hence they command higher prices than industrial metals. The most common examples are gold, silver, platinum and palladium.

Popular uses (hence influences on demand) for precious metals include:

• Gold - jewellery (about two thirds of gold demand), investment and industrial.
• Silver - industrial, photography, jewellery and silverware.
• Platinum - industrial (including vehicle catalytic converters), jewellery and investment.
• Palladium - industrial (including vehicle catalytic converters), electronics and dentistry.

Gold is by far the best known precious metal. Although mine production is fairly consistent, gold supply is boosted by 'old' gold being melted down and re-used (typically one third of total supply) and governments selling off their gold reserves. Jewellery represents the largest demand, with India, China and the Middle East topping the list. If consumer prosperity increases in these countries you'd expect them to spend more on gold and vice versa.

Gold is also favoured by many investors as a hedge against inflation and as a safe haven during troubled times.

Precious metals are priced by the Troy ounce (about 10% heavier than a conventional ounce). The gold bars that are internationally traded (and the type you usually see in films) are called London Good Delivery bars and weigh 400 Troy oz.

Grains are primarily needed to feed humans, livestock and poultry. They're one of the most important foodstuffs in the world.

Popular grains include:

• Corn - as well as a foodstuff, it's also used to produce ethanol, an alternative to fossil fuel.
• Wheat - primarily used to make flour.
• Rice - the staple diet for billions of people around the world.
• Soybeans - very versatile, can be used to produce many food types and oil.

Factors influencing the demand and supply (hence price) of grains include climate, demand for alternative fuels and the attractiveness for farmers to grow grains in preference to other crops (i.e. relative prices).

Other crops include coffee, cocoa, sugar, cotton and fruits, such as oranges. Demand is largely determined by consumer taste. For example, the continued growth of 'coffee culture' in Western countries coupled with increasing popularity in developing countries has led to steady annual increases in coffee bean demand.

Developing countries such as China and India could have a big impact on demand for crops such as wheat and sugar if they develop a Western palate.

Sugar can be used to produce an alternative fuel called ethanol, which tends to push up sugar prices when the price of oil is high.

Livestock are primarily used for food and fibre (e.g. wool and leather). The most common examples of livestock are cows ('cattle'), pigs ('hogs') and sheep. Some also call poultry and fish livestock too.

High grain prices increase the cost of raising livestock (as feed is more expensive) and it may also encourage more farmers to grow grain rather than raise livestock, further pushing up the price of livestock.

Once again, rising demand from developing countries such as China is responsible for a steady growth in global demand, which has generally kept livestock prices buoyant.

There are several unit trusts investing in hard commodities. Some may have a strong bias towards certain hard commodities over others, so it's important to check.

Commodity unit trusts buy shares in commodity companies, not futures, so expect volatility to be higher than the commodity prices themselves.

There are a handful of investment trusts that invest in hard commodities. Possible attractions for investors include lower charges than similar unit trusts and the potential for 'gearing', i.e. the investment trust borrows money to increase your investment exposure (although gearing on commodities trusts tends to be modest).

Because investment trusts are companies listed on stock markets, their performance tends to be more correlated to stock markets than is the case with commodities. The value of an investment trust is based on the price of its shares ('market capitalisation'), which may be different from the value of the property it owns ('net asset value'). If so, you could pay more than the value of the net assets (a 'premium') or less (a 'discount'). This adds to volatility.

Exchange Traded Funds (ETFs) are index tracking shares traded on stock markets. They have the advantage of low charges and a wide choice of investment. The options available for both hard and soft commodity investors are plentiful, you can even buy ETFs that 'short' a commodity (i.e. the ETF price rises when the commodity price falls).

If you buy an ETF it's important to understand which index it tracks and how that index is constructed. This will ensure you're getting exposure to the commodities you wish to invest in. You could also suffer from 'contango', reducing your annual return versus the actual commodity price (for more details read the above commodity futures section).

While pension funds specialising in commodities are rare, you should be able to buy all the other commodity fund options mentioned if you have a self invested personal pension (SIPP).