A popular way of tapping into the commodities market is via the stock market. Millions of investors contribute to the ebb and flow of the commodities industry (consciously or not) by investing in household names such as Exxon Mobil, Shell, Texaco, BP, Glencore, Rio Tinto and many others.
These companies have more in common than being giants of the stock market and Wall Street darlings (except during commodity slumps) for decades. They are all involved in the extraction of precious material from the ground, as well as its refining and processing into high-value goods with essential uses for daily living.
These are commodity companies. They operate across a spectrum: some drill, some supply services to companies that drill and others sell finished products. Many commodity companies share similar market dynamics. This means that they are affected by the same market forces that influence their profitability. The most critical of these is the price of the commodity they deal in.
See the chart below for the relationship between Brent crude oil and the share price for Shell, an oil titan, for the past three years. The decline in oil prices due to oversupply has led to a decrease in the price of Shell stocks.
The trend is also visible in oil giant’s BP second-quarter profits (Q2 2016) – they have almost halved from a year earlier as the company was hit by lower oil prices and weak refining margins.
Hedging And Large Corporations
Weak commodity prices are not the only factor that affects the ‘relative’ performance of commodity companies. Most large commodity companies operating in different markets apply derivatives to hedge against unpredictable commodity prices.
Just like asset managers are using derivatives to seek protection for their portfolios, commodity companies use brokers, and increasingly in-house traders, to hedge their revenues by buying futures, options and CfDs with underlying commodities in the event of prices moving against them. This means that if oil prices slide to all-time lows, an oil company may be able to offset the loss of revenue by selling crude oil derivatives.
The fact that performance may not always match the commodity price is a crucial piece of information to potential investors that aim to gain exposure to the commodities markets indirectly. The performance of the corporations and subsequent share price may not move in line with their primary commodity due to the application of complex derivative strategies.
Smaller oil and mining companies are less prone to applying derivative strategies and are also more likely to see rapid growth if successful with exploration activities. Larger, more mature companies’ profits depend on their ability to maintain healthy margins by driving down costs.
Larger companies also seek to expand by acquiring smaller companies providing services across the entire spectrum.
Of Leverage And Cycles
Most commodity companies make use of an enormous amount of debt to finance operations. This is due to the capital-intensive nature of the industry, where companies require expensive equipment and employ a significant number of people on a permanent and contract basis.
This high cost means there are significant “barriers of entry” to the industry, and this can be advantageous to investors in established market leaders. The energy sector has seen disruptions to the status quo, however, with the fracking revolution and the utilisation of shale gas. These shale gas companies run far fewer expenses and have caused a shift in market dynamics, although they are often met with resistance from locals in areas of extraction due to fears of tremors caused by fracking (a process that derives shale from the ground).
Even these innovative shale gas companies make use of a considerable amount of debt, leaving a leveraged balance sheet that can act as a double-edged sword.
Leverage (debt and its accumulation) is not just a necessity in most cases. It is an opportunity for companies to boost returns in times of prosperity. By borrowing cash from lenders when commodity prices are high, and the potential for churning out profits is also high, these businesses can hire more staff, take on more exploration projects and undertake more research. They are free to take on more risk and with risk there are greater opportunities for returns.
Leverage Has Its Risks
The situation could easily be reversed in downturns. This could play out in the form of a slowing economy, leading to sluggish demand for energy (affecting energy commodities) and jewellery (affecting hard commodities).
Another circumstance could be one where commodity prices slump in a recovering or even booming economy. This has been witnessed starting in 2014, when crude oil prices fell, with a large part of the blame being attributed to the vast oversupply. The shale revolution had been building up for years but started to gain serious momentum in recent years, leading to friction between traditional oil producers in the Middle East and the shale gas innovators in the US.
The result is a running tap of energy from different sources, facing only minor disruptions due to geopolitical tensions in the Middle East and Nigeria.
Companies that were over-leveraged during times of free-falling energy prices suffered, as their profits could not keep up with interest and capital payments to lenders.
As can be seen in the chart above, debt plays a big role in the operations of onshore oil producers and seemed to settle on a steady average for a few years until late 2014 (slump of commodity prices). A debt servicing (making capital and interest payments for loans taken) level at 80% out of operating cash flow leaves very little room for error in exploration and producers stranded if oil prices sink further, depleting cash flows and leading to mass Chapter 11 filings.
Investing in commodity companies can be an excellent way to benefit from an expected rise in commodity prices, while not having to deal with the complex logistics involved in owning actual commodities. However, investors should do a good amount of research (due diligence) before making any decisions since share performance of many large commodity corporations does not always move in tandem with the commodity they deal in.
Also, leverage can and often is the death of many commodity corporations. The problem is, there is no technical definition of “over-leverage” and most analysts will use ratios based on historical trends. As one often rediscovers every day, the past can be a terrible guide for the future.
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