Corporate governance risk of commodity trading

As if there weren’t enough things to worry about, you should always watch out for plain and simple fraud. Although the Commodity Futures Trading 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. For example, your broker may hide debts or losses in offshore accounts, as was the case with Refco. One way to prevent being taken advantage of is to be extremely vigilant about where you’re putting your money. Make sure that you thoroughly research a firm before you hand over your money. Unfortunately, there are times when no amount of research or due diligence is able to protect you from fraud — it’s just a fact of the investment game.

Speculative risk of commodity trading

The commodities markets, just like the bond or stock markets, are populated by traders whose primary interest is in making short-term profits by speculating whether the price of a security will go up or go down. Because speculators, unlike commercial users who are using the markets for hedging purposes, are simply interested in making profits, they will tend to move the markets in different ways. Although speculators provide muchneeded liquidity to the markets (particularly in commodity futures markets), they can also tend to increase market volatility, especially when they begin exhibiting what one Alan Greenspan termed “irrational exuberance.” Because speculators can get out of control, as they did during the dot.com bubble, always be aware of the amount of speculative activity going on in the markets. The amount of speculative money involved in commodity markets is in constant fluctuation, but as a general rule, most commodity futures markets contain about 75 percent commercial users and 25 percent speculators.
Although I’m bullish on commodities because of the fundamental supply and demand story, too much speculative money coming into the commodities markets can have detrimental effects. I anticipate that there will be times when speculators drive the prices of commodities in excess of the fundamentals. If you see too much speculative activity, it’s probably a good idea to simply get out of the markets. If you trade commodities, constantly check the pulse of the markets, finding out as much as possible about who the market participants are so that you can distinguish between the commercial users and the speculators. One source I recommend you check out is the Commitment of Traders report which is put out by the Commodity Futures Trading Commission (CFTC). This report is available online at www.cftc.gov/cftc/cftccotreports.htm and gives you a detailed look at the market participants.

Geopolitical risk for commodity trading

One of the inherent risks of commodities is that the world’s natural resources are located in various continents and the jurisdiction over these commodities lies with sovereign governments, international companies, and many other entities. For example, to access the large deposits of oil located in the Persian Gulf region, oil companies have to deal with the sovereign countries of the Middle East that have jurisdiction over this oil.
Negotiations for natural resource extractions can get pretty tense pretty quickly, with disagreements rising over licensing agreements, tax 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 commonplace. Sometimes a host country will simply kick out foreign companies involved in the production and distribution of the country’s natural resources. In 2006, Bolivia, which contains South America’s second largest deposits of natural gas, nationalized its natural gas industry and kicked out the foreign companies involved. In a day, a number of companies such as Brazil’s Petrobras and Spain’s Repsol were left without a mandate in a country where they had spent billions of dollars in developing the natural gas industry.
Investors in Petrobras and Repsol paid the price. So how do you protect yourself from this geopolitical uncertainty?Unfortunately, there is no magic wand you can wave to eliminate this type of risk. However, one way to minimize it is to invest in companies with experience and economies of scale. For example, if you’re interested in investing in an international oil company, go with one with an established international track record. A company like ExxonMobil, for instance, has the scale, breadth, and experience in international markets to manage the geopolitical risk they face. A smaller company without this sort of experience is going to be more at risk than a bigger one. In commodities, size does matter.

The Pitfalls of Using Leverage

In finance, leverage refers to the act of magnifying returns through the use of borrowed capital. Leverage is a powerful tool that gives you the opportunity to control large market positions with relatively little upfront capital. However, leverage is the ultimate double-edged sword because both your profits and losses are magnified to outrageous proportions. If you invest in stocks, you know that you are able to trade on margin. You have to qualify for a margin account but, once you do, you are able to use leverage (margin) to get into stock positions. You can also trade commodities on margin. However, the biggest difference between using margin with stocks and with commodities is that margin requirement for commodities is much lower than margins for stocks, which means the potential for losses (and profits) is much greater in commodities.
If you qualify for trading stocks on margin, you have to have at least 50 percent of the capital in your account before you can enter into a stock position on margin.
The minimum margin requirements for commodity futures vary but are, on average, lower than that for stocks. For example, the margin requirement for soybeans in the Chicago Board of Trade is 4 percent. This means that with only $400 in your account, you can buy $10,000 worth of soybeans futures contracts! If the trade goes your way, you’re a happy camper. But if you’re on the losing side of a trade on margin, you can lose much more than your principal. Another big difference between stock and commodity futures accounts is that the balance on futures accounts is calculated at the end of the trading session. This means that if you get a margin call, you need to take care of it immediately.
When you’re trading on margin, essentially on borrowed capital, you may get a margin call from your broker requiring you to deposit additional capital in your account to cover the borrowed amount.
Because of the use of margin and the extraordinary amounts of leverage you have at your disposal in the futures markets, you should be extremely careful when trading commodity futures contracts. In order to be a responsible investor, I recommend using margin only if you have the necessary capital reserves to cover any subsequent margin calls you may receive if the market moves adversely

Is Investing in Commodities Only for the Brave?

Commodities have a reputation for being a risky asset. Many investors are simply scared of investing in this asset class. This fear is largely unfounded because, statistically speaking, there is no greater risk in investing in commodities than there is in investing in stocks.
For whatever reason, investors have shunned this asset class in favor of what they think are more “prudent” investments such as stocks. This is quite baffling because the performance of commodities in recent years has been superior to that of stocks. For example, between 2002 and 2005, the Dow Jones Industrial Average returned a respectable 7 percent. However, the Dow Jones-AIG Commodity Index, which tracks a basket of commodities, was up over 21 percent! In fact in 2002 alone, while the Dow Jones Industrial Average had negative returns (–7 percent), the Dow Jones-AIG Commodity Index had returns of 26 percent.
I once attended a lecture with a world-renowned market psychologist who made this simple argument: Investors are afraid of what they don’t know. Many investors will prefer to stick with an investment they know even if that investment doesn’t perform well for them. For example, during 2000 and 2001, the investing public lost a total of $5 Trillion in stocks (remember the bursting of the dot.com bubble?). And yet you never hear the kinds of warnings about stocks that you hear about commodities. Is this a double standard? You can judge for yourself.
I believe that many investors are afraid of commodities because they don’t know too much about them. However, I’m not denying that commodities present some risk — all investments do. So I give you some tools in the following sections to minimize and manage those risks.