Today another post, which is not strictly company-specific so doesn’t brings investment ideas, nevertheless I hope you will find it interesting. Before I started building my portfolio (well it is so expensive that it will take more time than I expected) I was investing in different asset classes (some investments are not closed yet). There were also commodities.

First months were quite good for commodity investors – not only price of popular oil/gold rebounded, but also soft commodities are well performing. This directly affects some commodity related companies, but before I come to this let’s think is it better to invest in commodity related companies or commodities directly?

Well, the answer is not so easy. First look at potential risk/return perspective. When investing in commodities there is practically 0% probability that you will lose everything (price of commodity can’t fall to zero), while when investing in company it can go bankrupt. So risk is higher when investing in commodities. Second is operating and financial leverage. Many commodity producers are highly leveraged – see Glencore, oil companies etc. Then change in price of raw material brings significantly higher change in share price. Companies like Nucor, Chevron or ADM are well performing from the beginning of the year. I pointed big companies, but we should remember that smaller players are more susceptible to commodity prices. Moreover big players like Chevron looks also on refining margins, not only on oil prices. Anyway, the key point is, that companies are more risky and this is why they should also be more volatile.

On the other hand when investing in commodities investors are loosing money on rolling position (especially in case of contango), while in case of equity investments there is a chance for dividends – this part I like the most. When we think then about significant producers of commodities I think that weak prices might be an opportunity to make cheap acquisitions (if only there is cash/availability of debt). Moreover imagine a situation that e.g. Glencore is in troubles – how should commodity prices react? I think they should go up as potential supply might be decreased. But it can be argued that there might be hedge funds who speculatively will push prices even lower…

Also the case is whether companies hedge their exposition. Let’s imagine that commodity prices are going up, but company hedged exposition for next year – then higher profits will not be visible in mid term. As policy of hedging might change it is difficult to estimate potential impact on quarterly results.

At the end some thoughts about refiners. Think about ADM, which (as a part of business) is long Soybean Meal and Soybean Oil and short Soybean (as an input to be refined). Obviously quotes of all these products are correlated, but the case is that when prices are going up then spread should increase, while when going down the opposite is true. This means that in last months not only revenues for ADM increased, but also margin should expand. And here comes the question – why commodity prices started a strong rally in April and share price of ADM was strong much earlier (from the mid-January, partially due to rebound in overall market, but anyway the strength in this period is visible)?

And the second question is why having oil prices around $30 I didn’t close my eyes and bought some high quality oil producers (preferably XOM)?

Disclosure: long ADM