Understanding the Investment Risks in Commodities

Investment Risks in Commodities - Complete Controller

Investing is all about risks involved in generating returns. Take a look at some common risks you face when investing in commodities and some steps you can take to minimize these risks.

The Geopolitical Risk

One of the risks inherent to commodities is that the world’s natural resources are located on different continents. The jurisdiction over these products is from sovereign governments, international companies, and many other entities. For example, to access the large oil fields located in the Persian Gulf region, the oil companies have to deal with the Middle East’s sovereign countries with jurisdiction over this oil. Check out America's Best Bookkeepers

Negotiations for natural resource extraction can be quite tense fairly quickly, and disagreements arise over license agreements, fiscal structures, environmental concerns, employment of indigenous workers, access to technology, and many other complex issues.

International disagreements over the control of natural resources are quite common. Sometimes, a host country will kick out foreign companies that produce and distribute the country’s natural resources. In 2006, Bolivia, which contains the second-largest natural gas field in South America, nationalized the natural gas industry and disposed of the foreign companies involved. In a day, several companies such as Petrobras of Brazil and Repsol of Spain were left without a mandate in a country where they had spent billions of dollars on developing the natural gas industry. The investors of Petrobras and Repsol paid the price.

So, how to protect yourself from this geopolitical uncertainty? Unfortunately, there is no magic wand that you can shake to eliminate this type of risk. However, one way to minimize that is to invest in companies with experience and economies of scale. For example, if you are interested in investing in an international oil company, go with an established international track record. A company like ExxonMobil, for example, has the scale, scope, and experience in international markets to manage the geopolitical risk they face. A smaller company without this kind of experience is going to be more risk than a bigger one. In the raw materials, the size does matter. Check out America's Best Bookkeepers

The Speculative Risk

Like the bond or stock markets, the commodity markets are populated by traders whose main interest is in obtaining short-term profits by speculating whether the price of a security will go up or down.

Because speculators, unlike commercial users who use markets for hedging purposes, are interested in making profits, they tend to move markets differently. Although speculators provide much-needed liquidity to markets (especially in commodity futures markets), they can also increase market volatility. Because speculators can get out of control, as they did during the dot.com bubble, always be aware of the markets’ speculative activity. The amount of speculative money involved in the product markets is constantly fluctuating but as a general rule,

Too much speculative money entering the commodity markets can have detrimental effects. There may be times when speculators drive commodity prices above the basics. If you see too much speculative activity, it’s probably a good idea to get out of the markets. Check out America's Best Bookkeepers

If the merchandise trade constantly checks the pulse of the markets, find out as much as possible about who the market participants are so that you can distinguish between commercial users and speculators. One source is the Merchants Report Commitment extended by the Commodity Futures Trading Commission (CFTC). This online report gives a detailed look at market participants.

Corporate Governance Risk

As if there were not enough things to worry about, you always have to look out for simple fraud. Although the Commodity Futures Commission (CFTC) and other regulatory bodies do a decent job of protecting investors from market fraud, there is always the possibility that you will become a victim of fraud.

One way to prevent someone from taking advantage of you is to be extremely vigilant about where you are putting your money. Make sure you thoroughly research a company before handing over your money. Unfortunately, there are times when no amount of investigation or due diligence can protect you against fraud. It is just a fact of the investment game.

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