Are Commodity Stocks Cyclical?

by Robert Shaftoe

    Global central banks are propping up commodity prices by pumping liquidity into global markets.

    Hannelore Foerster/Getty Images News/Getty Images

    Commodities and commodity stocks, such as explorers and producers, are cyclical. There is consensus on this. So this means that to earn excess returns on commodities, all you have to do is recognize the peaks and valleys of the cycle and buy and sell accordingly. Well, not so fast -- there are cycles within the cycles, and you want to make sure you know how long the primary cycle generally lasts. If you are going to invest in cyclical stocks, try to understand the key factors driving commodity prices and related company values.

    Identifying Commodity Companies

    According to valuation guru Aswath Damodaran, there are three types of commodity companies. First are primary producers – companies that explore and extract raw resources from the ground, such as mining companies. Next are companies that purchase commodities and process them into a refined end product, such as many food companies. The third type of commodity company is the service firm that serves both producers and end-users. Integrated oil companies, oil field services and some mining companies qualify as the third kind of commodity companies.

    Normalizing Cash Flow

    A company’s value boils down to cash flow and risk. A cyclical company’s free cash flow follows the broader cycles affecting the markets in which it competes. Be conservative when you model the free cash flow capacity of a company whose performance goes up and down over and over again. Instead of trying to guess at what point of the cycle the company is in, identify the broadest cycle and calculate a simple or time-weighted average of free cash flow throughout the duration of the cycle. To factor in growth, use expected long-term inflation.

    Interest Rates

    The relationship between commodity prices and interest rates is complex. There are conflicting ideas regarding how shifting interest rates influence commodity prices, especially in the case of the prevailing climates in which global central banks continuously pump liquidity into global markets, propping up asset values. In the short term, rising interest rates can benefit commodities and commodity stocks. However, generally speaking, commodity prices rise when interest rates fall. During the 1980s, interest rates were historically very high while commodity prices were low. Rising rates result in lower commodity prices for several reasons. You may find it useful to think of interest rates as the cost of holding money and also as opportunity costs. Rising rates increase producers’ incentives to extract resources from the ground sooner rather than later. Rising interest rates are also reflected in the cost of transportation, so they decrease commodity producers’ desire to hold inventories. Finally, rising rates reduce the relative values of commodities relative to domestic currencies and increase the attractiveness of bond yields relative to commodity holdings.

    China

    The fundamentals surrounding China’s long-term commodity needs are stunning. One result of Chinese demand for industrial and agricultural commodities is that country’s entry into African markets at full speed. China has locked in long-term supply agreements with numerous African countries, guaranteeing them commodities ranging from timber to rare earth minerals at below-market rates. In exchange, China has paid kickbacks to African dictators and sent thousands of Chinese laborers into Africa to work on massive infrastructure projects. Chinese demand is so voracious that holding global demand constant, by 2020, annual copper production in Chile, which is the world’s largest copper producer by a factor of four, will need to triple. Meanwhile, additional crude demand will equal current annual production in Saudi Arabia.

    Photo Credits

    • Hannelore Foerster/Getty Images News/Getty Images

    About the Author

    Robert Shaftoe started his career in asset management before moving to consulting, where he has spent the past 10 years. His specialties include securities valuation and complex financial analysis. He has substantial experience in working on large commercial litigation matters, and in consulting for private and publicly traded firms primarily with respect to valuation-related issues. Shaftoe earned his undergraduate business degree from one of the largest public universities in the country.

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