Commodity Stock Underperformance

This story features INCITEC PIVOT LIMITED, and other companies. For more info SHARE ANALYSIS: IPL

By Greg Peel

As we are all now fully aware, global commodity prices have been going through the roof in 2008, prompting comparisons with the high inflation era of the 1970s. This is how soft commodities compare:

Hard commodities are also rampant, with the oil price now above its real 1970s price and coal looking at making a price jump this year of at least 100%.

While there has been value gained in riding the soft commodity boom in some stocks, such as leading global fertiliser producer Incitec Pivot ((IPL))…

…it hasn’t been the same story for the world’s hard commodity producers. As the analysts at GaveKal note, diversified miner/oil producer BHP Billiton ((BHP)) is down 2.8% year to date, while its diversified miner target Rio Tinto is down 0.1%. Among the big oil producers, America’s Exxon is down 6.9%, China’s PetroChina is down 22% (it was recently listed on the NYSE) and France’s Total is down 12.6%.

What does an investor have to do to make money out of this boom?

One of the problems for the traditional share market investor has been the competitive rise of the exchange-traded fund (ETF). Miners and drillers might have significant leverage to commodity prices, but they are also exposed to the problems and costs of actually trying to get the stuff out of the ground/sea and on to market. The rapid growth of ETFs have allowed investors, particularly in the US, to invest directly in the commodities themselves. Trading ETFs is just like trading shares (without the dividends) as the investor owns a financial instrument the price of which is directly tied to a commodity price, or perhaps to a basket of commodities or recognised commodity index. Previously an investor would either have to buy and store an actual commodity, or trade via the volatile and risky futures markets.

ETFs are thus in direct competition to mining stocks as a means of exposure to the commodity boom. There has been a surge in fund manager activity in these instruments in recent years as both an investment and a direct hedge against inflation (and if you’re American, an even more direct counter to the falling US dollar). No more being disappointed by production delays and infrastructure constraints at your average mine. In fact, such impediments become ETF price drivers.

Another reason commodity producers shares have underperformed is as an indirect result of the credit crunch. While this has impacted on highly geared and speculative stocks directly, the big cash flow giants such as your BHPs have been hit by the wave of forced selling along with the rest of the market. Even the gold price can suffer heavy falls in contradiction to increased risk in the equity market, given margin-called stockholders are forced to sell whatever assets they have to raise cash. So if you’re underwater on, say, your financial sector investments, and your broker is at the door, you have no choice but to dump even your prized investments.

Another reason the producers have underperformed goes back to point one – those costs. Shortages of equipment and skilled labour have forced costs through the roof as well, along with price increases in water and electricity.  There is a Catch-22 relationship here, as rising costs of production contribute to higher commodity prices and what we end up with is an upward spiral largely self-driven. But while the direct commodity investor benefits from the commodity price alone the stock investor suffers earnings erosion from those rising costs.

In the case of Australian commodity stock investment, the falling US dollar has helped to push up prices, but the subsequently rising Aussie dollar undermines local earnings and thus share prices.

The other bad news is that there’s a grand total of one commodity ETF listed on the ASX – the GOLD fund. To invest in anything else means going offshore and then having to deal with currency risk.

However, GaveKal makes the point that if ever there was a time in history when free cash flow was a most attractive proposition, it’s right now amidst the credit crunch. So while the resource sector may have still performed a lot better than other sectors in the stock market, a longer term view is making such stocks must-haves, particularly given their absolute underperformance.

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