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When Commodities Attack!

Jacob Roche
December 29, 2010

You know about stocks and bonds, but there are a few other investment classes out there that most individuals don't think much about, especially as they relate to individual companies. One is foreign exchange, which I've already talked about. Another is commodities, probably the world's oldest investments. Almost every type of business relies on commodities in some way, making it important for every investor to think about the broad implications of how their companies operate.

In a nutshell, commodities are raw materials like steel, cotton, sugar, or coffee beans. They are "fungible," which means they are the same no matter who produces them. Thus, extrinsic things like brand don't factor into the price of a commodity, only supply and demand. Unfortunately, supply and demand have their own problems.

For many important commodities like cotton or coffee beans, production is done mostly in a few areas of the world, so supply can be affected by currency risk, or even weather. Political risk is also a factor when a commodity is concentrated in one region, as we've seen with Middle East oil. Recent Chinese actions involving rare earths exports are also causing some worry about limited geographic scope of commodities production.

All the beans are in one basket
Take coffee, for example. Java companies like Starbucks (Nasdaq: SBUX  ) , or even Maxwell House and Yuban owner Kraft (NYSE: KFT  ) , have had to raise prices this year because of a double whammy of (1) poor weather in Brazil hurting coffee crops and lowering supply, and (2) the Brazilian real rising against the dollar. Brazil is by far the world's largest producer of coffee beans, so any large purchaser of beans has few other options if Brazilian coffee is too expensive, and one year of bad Brazilian weather could wreak havoc on a coffee company's margins.

Meanwhile, bad weather in China already damaged cotton crops, which, coupled with the flooding in Pakistan this summer, has caused cotton prices to nearly double in the past six months, putting a damper on third-quarter margins at clothing manufacturers like Hanesbrands (NYSE: HBI  ) and Abercrombie & Fitch (NYSE: ANF  ) .

Hedge maze
Fortunately for producers and buyers alike, the futures market exists. A large amount of commodities are bought and sold at the "spot" price, which is the current market price. But futures allow a buyer or a seller to lock in a certain price for a certain date in the future, hedging the risk. It's similar to filling up a tank of gas at today's price (the spot price), versus filling up a bunch of spare gas canisters when gas is cheap, anticipating that it will go up soon.