As confidence in financial paper assets wanes with the recent collapses of the stock market and credit market, investors will increase their exposure to hard assets. Lets look at a few commodities and how investors should examine an investment in them. Commodities represent a real thing, a chunk of gold, a barrel of oil, a silo full of grain, a pile of currency, a bale of cotton. Fortunately, investors can lay claim to such items through the futures markets which control ownership and delivery of these things, allowing investors to claim ownership without having to take delivery. But, why invest in the first place? Here are several reasons for making an investment in commodities:

1. as a store of value
2. as an investment whose price can rise
3. as a hedge against tough times in other markets
4. as a substitute for holding cash
5. as a substitute for holding stocks that benefit from the commodity
6. as a means of diversifying a portfolio of stocks and bonds.
7. as a hedge against dollar depreciation or inflation
8. as a hedge against droughts and natural disasters

Lets take crude oil as an example. Everyone knows that crude oil is the lifeblood of the world. Right now there are not enough substitutes to control the price rises we have seen recently. World demand for oil is growing thanks in part to economic expansion in India and China. The US alone consumes 20 million barrels per day. In the past 10 years the price has gone from a low of $10/bbl to a high of $147/bbl. Currently it sits somewhere around $40/bbl. The experts say it could drop to $20 in a global depression but anything below that is unlikely. On the upside, the predictions vary but go as high as $200-250/bbl.

So, with oil and all commodities there is a fundamental picture that must be evaluated. Ethanol subsidies have caused corn prices and other grains to increase, uncertainty in financial markets have helped gold and other precious metals to rise. As with any investment, the entry point is critical. Those who bought homes in America since 2004 have all lost money on the price declines of between 20-40%.

The same can happen in commodities depending on one’s entry point but in a diversified portfolio, commodity investments can add to overall return without adding significant risk. Since commodities are priced in dollars, and depreciation in the dollar can cause a price to rise, keeping all other factors the same. Thus, an inflation scenario or another lower dollar value scenario can make for a profitable commodity investment. We have now seen the downside of owning paper assets, as sometimes they are not worth the value of the paper they are printed upon. Commodities will always have some intrinsic value for investors providing a reason for investment.