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A Route to Commodities that Bypasses the Futures Market

Equities of producers offer the benefits of commodity investing while avoiding derivatives and futures curves.

Elizabeth Collins, CFA, 02/26/2013

The love affair with commodities continues unabated. Whether they’re looking for diversification, an inflation hedge, or to speculate on rising prices, investors have plowed hundreds of billions of dollars into commodity-related offerings, including both mutual funds and exchange-traded funds (Exhibit 1). Investments in commodity mutual funds, for example, grew to more than $137.6 billion by the end of 2011 from $9.2 billion at the end of 2002. The growth story for commodity-tracking ETFs is even more impressive. Assets skyrocketed to $150.4 billion from $770 million over the same period.

Suffice it to say that we’ve come a long way since legendary investor and commodity aficionado Jim Rogers lamented, “Commodities get no respect.” This statement would be far from the truth today.

Ways to Invest in Commodities
There are three avenues to gain exposure to commodities:

1. Physically Hold the Commodity
Physically backed exposure offers perfect tracking (net a management fee) to the underlying commodity, because the investor owns the physical commodity. For most investors, however, this is really only practical for commodities that have a high value/weight ratio, such as gold.

2. Buy Commodity Futures
Investors hold futures contracts that obligate the purchase or sale of a set quantity of a commodity, at a set date in the future, and at a set price. There are three main return drivers of futures-based investments: spot return, collateral yield, and roll yield (gains or losses incurred when a contract expires and is rolled into the next one). A good futures-based strategy attempts to optimize these return drivers. But the futures market can be multifarious, requiring investors to have a thorough understanding of how roll yield works.

3. Purchase Equity of the Producer
Choosing the equities of commodity producers has broad appeal for investors. Equity vehicles, such as stocks, are convenient, easy to access, and are less complex than playing the futures market. Using commodity equities also widens the opportunity set to gain exposure to the asset class. Not all commodities have futures associated with them, such as iron ore, timber, water, and coal.

It’s also feasible that commodity equities will outperform the commodities themselves in a rising-price environment. For any given percentage increase in price, a producer’s profits will increase by a greater percentage, all else equal. This leverage to commodity prices is greater for higher-cost producers (those with lower profit margins). Furthermore, higher prices usually mean that more of a company’s resources are economical to produce.

The investment growth performance of AK Steel AKS and Nucor NUE during the runup in steel prices (which occurred between the recovery from the Asian financial crisis and the peak before the global financial crisis) illustrates the greater leverage to commodity prices for higher-cost producers. A $10,000 investment in AK Steel in 2004 returned more than $190,000 by 2009; Nucor returned $70,000 over the same period. AK Steel is one of the highest-cost steel producers in the United States. The company must purchase costly iron ore, and it has significant legacy and financial costs. In contrast, Nucor is one of the country’s most efficient steel producers. The firm has low-cost electric arc furnaces and doesn’t need to purchase iron ore. It has no legacy liabilities and lower financial costs. While AK Steel’s disadvantaged cost position is a serious threat during weak industry conditions, its shareholders benefit from its high degree of leverage during boom times.

Commodity Producers—An Analyst’s View
There are several elements investors must consider that are unique to using a strategy of buying equities of commodity producers.

1. Cost Profiles
As the price of its product changes, a commodity producer’s position on its industry cost curve can have a tremendous effect on its financial performance and, hence, the performance of its shares. Small, marginal producers with extremely unfavorable cost profiles will tend to see very volatile movements in their share prices from movements in the prices of their commodities. This is because relatively small movements in the prices of the commodities (and in the company revenues) can have an outsized effect on these firms’ earnings.

2. Financial Leverage
Highly indebted commodity producers (much like high-cost marginal producers) will tend to see more volatility in their share price performance in response to changing fundamentals.

3. Operational Diversification
There are very few pure-play commodity producers of meaningful size in existence. Most producers have exposure to a number of different commodities or end markets. Take BHP Billiton BHP, for example. The firm produces a wide variety of commodities ranging from coal to diamonds. An investment in a mega-miner such as BHP provides a degree of diversification across commodities and geographies, but still leaves investors exposed to firm-specific risk—such as the potential for ill-timed, overpriced acquisitions, which were numerous during the most recent runup in commodity prices. Other company-specific risk factors, such as business and management risk, don’t exist when investing directly in commodities and warrant consideration.

4. Hedging Policies
Some commodity producers take future price risk off the table by locking in selling prices today. If they do so, they may be either capping future upside in their earnings power or mitigating potential downside should their product prices subsequently fall below these hedged prices.

Upstream vs. Downstream
Not all companies or investment options are equal when it comes to gaining exposure to commodities. In most cases, upstream producers—those directly involved in extracting or harvesting the resources from Mother Nature—are the ones that offer the highest leverage to commodities. Down-stream companies—those that buy raw commodities and then process or refine them for end markets—tend to afford less leverage to commodities.

The most valid way to determine whether a company is an upstream or downstream producer is to understand the business model. Companies typically describe their business—how they make money—within the first item of their 10-K filing.

Exxon Mobil XOM is a company that many investors might turn to for exposure to energy prices. Indeed, Exxon Mobil generates approximately 80% of its profits from upstream activities, or the actual production of oil and natural gas. These activities benefit from higher oil and gas prices. Exxon Mobil’s downstream activities in crude oil refining and chemical manufacturing, however, can suffer from high energy prices, because these commodities are raw materials. In fact, the rise in energy prices has led to lower refined product demand in developed markets. In this way, higher energy prices hurt refining activities on both the cost and demand fronts.

Pure exploration-and-production companies such as Occidental Petroleum OXY, on the other hand, are more leveraged to energy prices than integrated firms such as Exxon Mobil. While the integrated business model affords less leverage to energy prices, this also means less volatility in earnings and equity valuation (Exhibit 2).

The Easier Road
Investors interested in commodities face many investment options. For many investors, however, owning the actual commodity or participating in the futures market is not as practical as investing in a commodity producer. These companies are easy to access on open markets, offer exposure to areas of the commodities market not available through futures, and often outperform the commodity they are producing in a rising price environment.

Easier accessibility doesn’t mean easier returns, however. In addition to the usual research techniques—forecasting a firm’s future earnings stream and cash flows, assigning a valuation, assessing the management team—investors must consider a host of attributes unique to commodity producers, such as heightened operation and geopolitical risk. Only then should investors head upstream for their commodity exposure.

Click to enlarge image.

Elizabeth Collins, CFA, is an associate director of equity research with Morningstar.

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