Investing in Commodities For Dummies. Amine Bouchentouf

industrialization

      The first industrial revolution, which took place in the 19th century, was a major transformational event primarily confined to Western Europe and North America. Major industrialization didn’t spread to other corners of the globe until parts of the 20th century – even then, it was only sporadic.

      A new wave of industrialization is taking place in the 21st century, and it may be the most important one in history. This wave is transforming a large number of developing countries into more industrialized countries, and raw materials are fueling this transformation.

      Although many developing countries are on the fast track to industrialization, four countries need to be singled out as the frontrunners in this movement – Brazil, Russia, India, and China. They’re collectively known as the BRIC countries, or just the BRICs.

      The BRIC countries, which are now on a path toward full industrialization, are scouring the globe to secure supplies of key natural resources such as oil, natural gas, copper, and aluminum – the raw materials necessary for a country to industrialize.

      

As demand from the BRIC countries for natural resources increases, expect to see increasing upward price pressures on commodities.

      What Makes Commodities Unique

      As an asset class, commodities have unique characteristics that separate them from other asset classes and make them attractive, whether as independent investments or as part of a broader investment strategy. I go through these unique characteristics in the following sections.

Gaining from inelasticity

      In economics, elasticity seeks to determine the effects of price on supply and demand. The calculation can get pretty technical, but, essentially, elasticity quantifies how much supply and demand will change for every incremental change in price.

      Goods that are elastic tend to have a high correlation between price and demand, which is usually inversely proportional: When prices of a good increase, demand tends to decrease. This relationship makes sense because you’re not going to pay for a good that you don’t need if it becomes too expensive. Capturing and determining that spread is what elasticity is all about.

      Inelastic goods, however, are goods that are so essential to consumers that changes in price tend to have a limited effect on supply and demand. Most commodities fall in the inelastic goods category because they’re essential to human existence.

      For instance, if the price of ice cream increased by 25 percent, chances are, you’d stop buying ice cream. Why? Because it’s not a necessity, but more of a luxury. However, if the price of unleaded gasoline at the pump increased by 25 percent, you definitely wouldn’t be happy about the price increase, but you’d still fill up your tank. The reason? Gas is a necessity – you need to fill up your car to go to work or school, run errands, and so on.

      The demand for gasoline isn’t absolutely inelastic, however – you won’t keep paying for it regardless of the price. A point will come at which you’d decide that it’s simply not worth it to keep paying the amount you’re paying at the pump, so you’d begin looking for alternatives. (Read Chapter 5 for more information on alternative energy sources.) But the truth remains that you’re willing to pay more for gasoline than for other products you don’t need (such as ice cream); that’s the key to understanding price inelasticity.