Commodity businesses

In simple terms

A commodity is a product that is essentially the same whoever makes it: steel, aluminium, copper, crude oil, natural gas, cement, many chemicals, sugar. Customers buy on price, so no single producer can charge more than the market. Commodity producers are price takers.

Their profit therefore depends on two things: the market price, which they do not control, and their own costs, which they do. Analysing them means understanding where prices are in the cycle and where the company sits among its competitors on cost.

What drives prices

Commodity prices swing with supply and demand:

• Demand follows the economy, construction, manufacturing and, for some commodities, global trade.
• Supply follows capacity. New mines, plants and wells take years to build, so supply responds slowly. When it arrives, it often arrives all at once.
• Inventories, currency moves and government policy, such as export duties or import restrictions, also move prices.

The result is the cycle described in the cyclical businesses lesson: high prices encourage investment, new supply pushes prices down, losses force closures, and prices recover.

The cost curve

A cost curve ranks all producers in an industry from lowest cost to highest, with the width of each bar showing its output. The market price tends to settle where the most expensive producers needed to meet demand can just survive.

Sources of low cost include better ore or reserves, cheap energy, proximity to raw materials and customers, scale, and efficient technology.

Valuing commodity producers

Because profits swing so widely, valuing a commodity producer on one year's earnings is misleading, as the valuation pitfalls lesson explains.

Normalised earnings. Estimate profit at a mid-cycle price, using average volumes and margins across a full cycle, and value the company on that.

Value per unit of capacity. Compare enterprise value per tonne of capacity with peers and with the cost of building new capacity. If a company can be bought on the stock market for much less than it would cost to build its plants, that may signal value, if the capacity is competitive.

Reserves. For mining and oil companies, the size, quality and life of reserves matter.

Cash flow at different prices. Model free cash flow at low, mid and high prices to see how the company fares in each.

Balance sheet and capital spending

Debt is dangerous. Prices can stay low for years, and a producer with heavy debt may be forced to sell assets or issue shares at the bottom. Check interest coverage at low-cycle prices.

Capital discipline matters. Producers that expand aggressively when prices are high often add capacity just as the cycle turns. Those that invest steadily, or buy assets cheaply in downturns, tend to create more value. Read management's capital spending plans against the cycle.

Why it matters

Commodity producers can be among the best and worst investments in the market, depending on when they are bought and how good they are. Understanding the cycle and the cost curve helps you avoid buying at the peak, when they look cheapest, and identify the low-cost producers most likely to survive and prosper across cycles.

Limitations

Commodity prices are notoriously hard to forecast, and normalised earnings depend on what you assume a mid-cycle price is. Cost curves change as new capacity arrives and technologies change. Government policies can change prices and costs suddenly. Treat valuations as ranges across price scenarios.

Common mistakes

• Valuing on peak or trough profits.
• Ignoring cost position and focusing only on size.
• Ignoring debt because profits are high today.
• Applauding big expansions announced at the top of the cycle.

Try it yourself

1. Choose a listed metals, cement or oil company.
2. Collect ten years of its revenue, operating profit and output, and calculate profit per unit of output each year.
3. Calculate average profit across the period and value the company on it.
4. Find how its costs compare with peers', using results presentations, and decide where it sits on the cost curve.