How to maximise commodity trading returns

With stocks behaving with increasing unpredictability through 2019, commodity trading has come sharply into focus. Gold and silver reached five-year highs in September as precious metals were used as safe havens, while oil has provided a high number of commodity trading opportunities on both the long and short side as politics and conflict heavily influence the price.

Take for instance West Texas Oil, otherwise known as West Texas Intermediate, and Brent Crude Oil. The two are used to benchmark oil prices, with West Texas tending to be slightly cheaper due to innovation in extraction through techniques such as fracking used in the US. Brent is meanwhile used by OPEC to benchmark prices.

In times of relative geopolitical serenity, these two prices often move together as they are essentially the same product – oil perfect for refining into gasoline. But prices can diverge due to political upheaval. During crises, Brent prices, due to it being extracted from the North Sea, can surge while West Texas, being produced in landlocked areas of the US, tend to stay steady. Thus, an important distinction to be mindful of when commodity trading.

However, recent events have shown that this is not always the case as presently, the US trade war has effected West Texas prices. CNBC reported in August that West Texas crude prices dropped 3% as the trade war deepened but reports in October showed prices picking up as talks of trade deals being agreed became clearer.

On the other hand, agriculture is another huge global economic powerhouse that’s often overlooked amongst the hype of tech stocks like Netflix [NFLX] and Amazon [AMZN]. However, the numbers are huge, commodity.com points out the agricultural industry is worth $3tn and continues to employ near 20% of the world’s population – providing ample opportunity for commodity trading with agricultural products.

  

Agriculture commodities include everything from crops such as wheat and corn used for food, animal feed and biofuel, to lumber used for construction and other miscellaneous crops such as rubber, sugar and coffee. Changes in these commodities can have a knock-on effect amongst interrelated types of stocks but also across the wider economy. For instance, in May, Reuters reported farmers feeding their livestock everything from bread rolls to pet food after a surge in corn prices.

Another key asset group for consideration when commodity trading are safe havens, in the form of precious metals. In 2019, for example, precious metals were strong in large part due to investors seeking their stability. Bloomberg pointed to tightening of interest rates and a “demand for a refuge from slowing economic growth” as the main reasons behind golds 19% rise for the year to mid-August.

This has not always been the case. Between 2016 to 2018 both gold and silver prices were struggling. The prices on the two metals also diverged as silver began to underperform gold, mostly due to demand as central banks bought up large stockpiles of gold, peaking in 2015, lending some support to the price. Central bank gold buying peaked again in the third quarter of 2018, when according to the Financial Times these banks collectively bought $5.8bn worth of gold.

Trading commodity indices

While commodities within one market will at times move in the same direction, spreading a trade across a range of individual commodities through an index provides an extra cushion, diversifying a trader’s risk.

Trading an index also offers a cost-effective way of accessing opportunity across a range of individual commodities through a single trade, rather than needing to place a large number of individual trades. For another CMC Markets' custom index, trade FAANG+.

CMC Markets’ custom commodity indices provide the opportunity to trade these commodities through a ready-made diversified portfolio. So, what are the constituents of the CMC Market’s Energy, Agricultural and Precious Metals commodity indices, and what’s the outlook for each?

 

Energy

Nearly 70% of CMC Markets’ energy index is made up of the two types of oil commodity: Crude Oil West Texas has a weighting of 38.42% and Brent a weighting of 28.75%. Oil price is key to trading this index, the price of which has plunged since 2018, but has picked up in recent months. Unrest in the Middle East, global conflict, OPEC and US production, and the on-going trade war are all factors that must be monitored when trading oil.

  

The remainder of the index is made up of a variety of other energy commodities. Gasoline and low-sulphur gasoline, which often follow oil prices with a lag time of around six weeks according to the Balance, constitute a further 18% while and natural gas and heating oil, which are less intimately connected to moves in oil price, constitute almost 15%.

 

Agriculture

The CMC Markets Agriculture index is made up of 12 agricultural products – from soybean to sugar and cotton. This provides effective diversification as Commodity.com explains, the crops have a strong price relationship with each other so in certain circumstances, as the price of one crop falls, the other is likely to rise.

Soybean and corn together make up nearly 50% of the index. These two commodities compete with each other across animal feed, cooking oil production and biofuel. Soybean meal and soybean oil constitute a further 17% of the index. Wheat, another competitor to corn, makes up 10% of the index. The remaining roughly 23% includes a wide mixture of coffee, sugar, cotton, US cocoa and oats.

Climate and production levels of the world’s major agricultural producers (the US and Brazil, for example) are key to influencing agriculture commodity prices, as are energy costs that affect agricultural product prices – higher energy costs mean higher production costs. Then there is demand from China.

  

In May 2019, reports found that soybean futures had dropped to their lowest point in a decade after the US/China trade war caused a slump in demand from China. While soybean prices – along with many agricultural products – have been on the up in the second half of 2019, they’ve not yet recovered from the plunge.

Looking ahead, the prices of agricultural products are expected to remain low. Despite expectations that global demand is set to grow by 15% over the next decade, production is expected to increase at a slightly faster rate due to technological innovation. This, according to an annual report by the Organization for Economic Co-operation and Development and the UN's Food and Agriculture Organization in July, will cause “inflation-adjusted prices of the major agricultural commodities to remain at or below their current levels”.

Precious metals

Gold and silver make up 70% of the CMC Markets precious metals index at 35% a piece, with platinum and palladium splitting the remaining 30%.

Precious metals indices offer a slightly less diversified portfolio due to gold, silver and platinum prices tracking each other much of the time – although as considered above this has not always been the case. However, trading an index that includes gold, silver and platinum, particularly on longer timeframes, provides a great alternative to going all-in on one metal.

  

An index can be further diversified by the presence of palladium, the price of which, due to industrial uses such as car manufacture and hydrogen storage, is not so closely associated with moves in gold prices as silver and platinum.

Currently, with both gold and silver having reached five-year highs in September, many analysts are arguing that due to silver’s relative past underperformance, it now has more room to move than gold; being the smaller market, silver often moves more sharply up or down than gold.

Stocks should be watched carefully by anyone trading the precious metals index over the next 12 months. The 2019 rally was widely down to investors flocking to the likes of gold and silver as the stock market began to underperform and react to geopolitical volatility. However, outcomes such as an end to the US-China trade war, the German economy picking back up, or a positive Brexit resolution could incite a stock market rally, and could trigger investors to exit precious metals to take advantage of equity gains.

It’s also worth noting that cryptocurrencies, particularly Bitcoin, is for some analysts becoming a competitor to precious metals as an alternative safe haven in times when the stock market underperforms.