The 3 huge hidden risks you need to know about your bauxite investment

Commodity speculation is just that – speculation, and here's why it's not a good idea for beginner investors.

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As I've written before, bauxite has the potential to be a fantastic speculative investment.

Australia has the perfect combination of budding bauxite producers, high quality reserves, and proximity to China available at exactly the same time as prices are soaring.

If that sounds like a great investing opportunity, you're right.

But like any commodity with variable supply and demand, there are major risks.

We saw it just last year with iron ore, when ore prices spiked up to $140 and companies like BC Iron Limited (ASX: BCI) were launched into the stratosphere, trading as high as $5.50 before coming down hard.

BC Iron last traded at $1.585.

Not a pretty outcome.

If you'd bought BC Iron at the right time – say just over $3 – and sold it at the right time, you would have seen profits of 50% in a year.

But if you'd got it wrong, you would have lost 50% of your original investment after two years.

If you and I can spot an opportunity for investing in commodity producers, you can bet your bottom dollar that multi-million dollar companies that employ highly trained analysts with decades of experience in their field can see it coming as well.

So those companies increase production, maybe open new mines, buy up a few competitors and before you know it supply catches up to demand, the market is saturated, prices fall and investors are left holding the bag.

If investors in Australia are jumping on the opportunity to sell bauxite to China, you can again bet your bottom dollar that businesses all through the dozens of nations close to China  are responding the same way.

Australian companies like Bauxite Resources Ltd (ASX: BAU) and Queensland Bauxite Limited (ASX: QBL) have enjoyed phenomenal price rises in the past year, soaring 62% and 171% respectively.

Fellow explorer Cape Alumina Ltd (ASX: CBX) fell 49%, mostly thanks to a frustrated merger with Metrocoal Ltd (ASX: MTE) earlier in the year. This bid has now succeeded and both companies will soon combine, following which I expect to see increased speculation factored into its share price.

But there are several key points investors are missing that desperately beg to be considered before investing in any of these companies:

  1. You might miss the party

Given that none of the above listed companies are close to commencing operations, there's a real risk that increased production at mines in other nations will match supply with demand and decrease prices before Australian companies can get on board.

  1. Costs are high, and competition is stiff

Australia has the highest cost of wages of any nation in Oceania with the possible exception of New Zealand.

We're also the furthest away and thus have the highest transportation costs, although we may have a slight advantage from an infrastructure perspective.

It's going to be very difficult for producers to substantively reduce costs to match any falls in prices – therefore investors will simply have to suffer shrinking margins and profits.

  1. Sovereign risk

Tying in with point two above, the reason bauxite prices have climbed so high is partly thanks to increased export tariffs in India and an export ban in Indonesia, with both nations trying to force increases in domestic manufacturing.

A potential repeal of these policies will re-introduce more competitive supplies of bauxite into the market relatively quickly, increasing supply and making it harder for Aussie miners to compete.

So yes, investors in bauxite have the potential to generate huge returns.

But as you can see there are also huge risks commensurate with those rewards.

You don't need to take on all that extra risk just to earn a comfortable retirement.

A significantly safer bet is The Motley Fool's Top Stock for 2015, and in addition to an awesome business model it has a significant competitive advantage and is trading at a knock-down price.

Click on the link below and enter your email address to read our top analyst's free report and see just why this stock makes a fantastic investment.

Motley Fool contributor Sean O'Neill doesn't own shares in any company mentioned.

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