When Investors Purchase a Commodity, They Believe Prices Will Rise

Investors buy commodities expecting prices to rise, allowing them to sell at a profit. These assets include raw materials like oil, gold, and agricultural products, which are influenced by global supply, demand, and economic conditions. Unlike stocks or bonds, commodity investments often involve contracts rather than direct ownership.

Commodity Ownership

Investors can gain exposure to commodities in different ways, each with varying levels of risk, liquidity, and potential returns. Some purchase physical assets, such as gold bars or barrels of oil, which provide direct ownership but come with storage and insurance costs. Others prefer financial instruments that track commodity prices without requiring possession of the underlying asset.

Exchange-traded funds (ETFs) allow investors to participate in commodity price movements without handling physical goods. Funds like SPDR Gold Shares (GLD) or the United States Oil Fund (USO) hold assets or derivatives that mirror price fluctuations. These funds trade on stock exchanges, making them accessible to retail investors. Mutual funds and hedge funds also provide exposure, often using a mix of futures, options, and equities tied to commodity markets.

Another approach is investing in companies engaged in commodity production. Mining firms, oil drillers, and agricultural producers benefit from rising commodity prices, making their stocks a proxy for direct ownership. For example, an investor expecting copper prices to rise might buy shares of Freeport-McMoRan (FCX) instead of purchasing copper itself. While this strategy introduces company-specific risks, such as management decisions and operational costs, it allows participation in commodity price movements without handling physical goods.

Types of Contracts

Investors who do not take physical possession of commodities typically use contracts to gain exposure to price movements. These agreements specify the terms of a transaction, including the quantity, price, and delivery date of the commodity. The three primary types of contracts are spot, forward, and futures, each serving different purposes and carrying distinct risks.

Spot

A spot contract involves the immediate purchase or sale of a commodity at the current market price, with delivery occurring shortly after the transaction. These agreements are common in markets where physical goods change hands quickly, such as crude oil, natural gas, and agricultural products. The price in a spot contract, known as the spot price, reflects real-time supply and demand conditions.

For example, if the spot price of gold is $2,000 per ounce, an investor purchasing 10 ounces would pay $20,000 for immediate delivery. Spot contracts are often used by businesses that require raw materials for production, such as a bakery buying wheat or an airline purchasing jet fuel. While they provide direct exposure to commodity prices, they also require buyers to arrange for storage and transportation, which can add costs.

Forwards

A forward contract is a private agreement between two parties to buy or sell a commodity at a predetermined price on a future date. Unlike futures contracts, forwards are not standardized or traded on exchanges, making them customizable but also less liquid. Producers and consumers use these contracts to hedge against price fluctuations.

For instance, a coffee producer expecting to harvest beans in six months might enter into a forward contract to sell them at a fixed price of $1.50 per pound. If market prices drop to $1.30 per pound at the time of delivery, the producer still receives the agreed-upon $1.50, protecting against losses. However, if prices rise to $1.70, the seller misses out on potential gains. Since forwards are privately negotiated, they carry counterparty risk—the possibility that one party may default on the agreement.

Futures

Futures contracts are standardized agreements traded on regulated exchanges, such as the Chicago Mercantile Exchange (CME) or Intercontinental Exchange (ICE). These contracts obligate the buyer to purchase, and the seller to deliver, a specific quantity of a commodity at a set price on a future date. Unlike forwards, futures are marked to market daily, meaning gains and losses are settled regularly rather than at the contract’s expiration.

For example, an investor expecting oil prices to rise might buy a crude oil futures contract at $75 per barrel for delivery in three months. If prices increase to $80, the contract gains value, and the investor can sell it for a profit before expiration. Futures are widely used for speculation and hedging, with traders often closing positions before delivery to avoid handling physical commodities. These contracts also require margin deposits, which act as collateral to ensure both parties fulfill their obligations.

Margin Requirements and Settlement

Trading commodity contracts involves margin requirements, which dictate the amount of capital an investor must maintain in their account to initiate and hold positions. Unlike traditional stock purchases, where buyers typically pay the full price upfront, commodity traders use leverage, meaning they control a larger contract value with a smaller initial investment. Exchanges set minimum margin levels, but brokers may impose higher requirements based on factors like volatility and the trader’s experience.

Initial margin is the upfront deposit required to enter a position, typically ranging from 3% to 12% of the contract’s value. For example, if a crude oil futures contract represents 1,000 barrels and is priced at $75 per barrel, the total contract value is $75,000. If the initial margin is 10%, the trader must deposit $7,500 to open the position. Maintenance margin, usually lower than the initial margin, is the minimum amount that must be kept in the account to avoid a margin call. If market fluctuations cause losses that reduce the account balance below this threshold, the broker will require additional funds to restore the margin level.

Settlement of commodity contracts can occur in two ways: physical delivery or cash settlement. Physical delivery requires the contract holder to provide or receive the actual commodity, but most traders avoid this by closing positions before expiration. Cash settlement, used in contracts like the CME’s E-mini crude oil futures, involves a financial adjustment based on the difference between the contract price and the market price at expiration. This simplifies transactions and eliminates logistical concerns like transportation and storage.

Global Supply and Demand Factors

Commodity prices fluctuate based on production levels, geopolitical events, currency movements, and macroeconomic trends. Supply disruptions, whether from natural disasters, trade restrictions, or geopolitical conflicts, can sharply impact availability and drive prices higher. For instance, when the Russo-Ukrainian war disrupted grain exports from Ukraine, wheat prices surged due to reduced global supply. Similarly, OPEC+ decisions to adjust oil production directly affect energy markets, influencing costs for businesses and consumers.

On the demand side, industrial activity, population growth, and changing consumer preferences shape commodity consumption. Rapid urbanization in emerging markets, such as China and India, has led to increased demand for metals like copper and aluminum, essential for infrastructure and technology development. Conversely, slowing economic growth or recessions often reduce demand, exerting downward pressure on prices. During the 2008 financial crisis, crude oil prices collapsed from over $140 per barrel to below $40 as global demand plummeted.

Currency fluctuations also play a role, particularly for commodities priced in U.S. dollars. A stronger dollar makes imports more expensive for foreign buyers, potentially reducing demand. Additionally, government policies, such as subsidies, tariffs, and environmental regulations, can influence both production costs and market dynamics.

Mark-to-Market Accounting

Commodity contracts, particularly futures, are subject to mark-to-market accounting, a process where positions are adjusted daily to reflect current market prices. This ensures that unrealized gains and losses are accounted for in real time, preventing large discrepancies between contract values and actual market conditions. Exchanges enforce this system to maintain financial stability and reduce counterparty risk, as traders must settle profits and losses regularly rather than waiting until contract expiration.

For example, if an investor holds a wheat futures contract at $7.50 per bushel and the market price rises to $7.75, their account is credited with the unrealized gain. Conversely, if prices fall to $7.25, the account is debited accordingly. This daily adjustment impacts margin requirements, as traders experiencing losses may need to deposit additional funds to maintain their positions.

Tax Categorization of Commodity Gains

Tax treatment of commodity investments varies based on the type of contract and the investor’s holding period. The IRS classifies gains from futures contracts differently from those on physical commodities or stocks, affecting how profits are reported and taxed.

Futures contracts traded on regulated exchanges fall under Section 1256 of the U.S. tax code, which applies a 60/40 rule to capital gains. This means that 60% of gains are taxed at the long-term capital gains rate (maximum 20%), while 40% are taxed as short-term gains (ordinary income rates up to 37%). Additionally, Section 1256 contracts are marked to market at year-end, meaning unrealized gains and losses must be reported annually.

Investors holding physical commodities or commodity ETFs are subject to different tax rules. Gains from selling physical assets, such as gold bars, are taxed as collectibles, with a maximum rate of 28%. Certain ETFs structured as partnerships may generate K-1 tax forms, requiring investors to report income even if they did not sell shares.