Commodity equities - they are not all the same

There is a strong distinction between commodity futures investing and investing in equities associated with commodities. Specifically, there are differences in the type of firms that are associated with commodities. We classify four types of commodity equities firms. Classifying firms into different types of commodity equities helps provide context to the sensitivity of equities with the underlying commodity.

Producer equities - mining or exploration and pure production or extraction companies. These are the firms that mine, explore, produce or extract a commodity. There will be a close link between the price of the commodity and value of the equity. Value is determined by the difference between price and marginal cost times the production and level of reserves at the company. Price increases will lead to higher value. The difference in value increase across firms will be related to the marginal cost of production. Low cost producers will see a larger gain than high cost producers. The value will also be determined by the distance between the price and marginal costs. If there p[rice increase will lead a company from a loss to a gain because the price is now above the cost of production, there may be a greater change in value. This can be called the optionality of producer firms.

The simple fair value will be the discounted present value of future earnings. Producers in mining and energy E&P are, however, not infinite lived companies. The resource or production is exhausted over time, so the value is a combination of price minus marginal cost times the amount that will be extracted each year.

Nevertheless, the life of the equity producer is greater than that of a commodity futures. The value will have to discount future production not by the current price but by the stream of expected future prices. If the futures is an unbiased estimate of future prices, there value of the firm will be affected by distant futures prices more so than nearby futures prices.

The producer company will have characteristics of a bond because the cash flows are limited so the discounting has a finite life. There is also the potential for more leverage based on operating margins versus a futures contract. Like all equities, the company value is an option. Hence the value of the firm will be affected by volatility.

There is no reason to believe that a one percent change in the nearby futures price of oil will lead to a one percent change in the price of oil exploration company; consequently, the link between equities and futures should not be expected to be strong.

Intermediary or (refiner/processor) equities - firms like Bunge or ADM which are involved in a form of arbitrage  would fall into this category.  Let's take the simple example of ADM which is in the soybean processing business and ethanol business. In the case of soybean processing, an increase in the price of soybeans may not lead to an increase in margins associated with the soybean crush. The crush arbitrage may show a better link with ADM than soybean prices. The demand for meal and oil, while tied with the price of soybeans, will not move in lockstep with the underlying commodity; consequently, there could easily be a decrease in the price of ADM when there is an increase in the price of soybeans.

The same could be said for corn and ethanol production. The price of corn my change, but that does not mean there will a similar change in the margin from processing ethanol. Ethanol prices will be associated with gasoline demand as well as corn prices.

Now the profitability will be associated with the margins for certain arbitrage, but the link between commodity prices and stocks prices for these types of firms may be weak or contrary to the general direction of futures prices.

Commodity retail equities - firms that engage in the selling of commodities to end users. This type could include food companies which use agricultural inputs in their production process or gasoline retailers. An increase in the price of inputs like corn or sugar or cotton may have a negative impact on profits since the value of the firm will decrease if there is an increase in the cost of  production. However, the cost of the input may actually be a small relative to the cost of marketing, so the link between commodity prices and commodity equities on the retail level may be weak.

Accessory equities - firms that sell to commodity companies. This would include firms like Monsanto, the seed company or Caterpillar which sells farm equipment. Another example may be oil services companies which provide services to the producer. In these cases, the price of the equity will be associated with the level of wealth or earnings of the firms that would buy the services of the accessory companies. These firms will not be sensitive to short-term prices which do not change the level of wealth of a farmer of service buyer. If there is longer-term change in prices, there will be a boost in the commodity equity, but the link will only exist if there is a longer-term sustained gain in price.

Of course, firms that hedge will mitigate any of the change in price associated with a commodity. For example, airlines could be thought of in the retail space. they convert energy to transport and use oil as in input. If there is a hedging program, there will be less sensitivity to oil in the short-run.