Commodity and Producer Buying Cycles

Global MarketsHaving looked at the way in which commodity producers create value in the down cycles of the economy, we are able to come up with a basic investment thesis for tracking when and how it is that we’d want to take advantage of these trends. Specifically, by oscillating our position with the market, we are able to ensure that we are most efficiently allocating our capital, while maintaining reasonable protection against macroeconomic risks.

When managing a position that trades between commodity producing companies and the commodity itself, we need to keep in mind the investment objective of the current economic cycle. If we are in the midst of an economic down-turn, a commodity itself will not offer any kind of cushion against the declining demand for the product itself, whereas a producer can at least increase its asset base, and position itself in a way that allows it to better scale its operations, and capture a greater share of the shrinking market space. Be it through acquisition or expansion, a production company will provide tangible value to its investors in a down-turn by ensuring that funds are tied into assets that are either already income producing, or in a position to become income producing.

On the other side of the economic cycle, a booming commodity market creates a bit of a conundrum for the personal investor. While a production company will be generating great deals of new cash flows from the investments they made in the asset bases of the lower end of the pricing spectrum, it is important to remember that they will not immediately benefit from the upswing due to hedging contracts.

What’s more, the companies must also begin taking efforts to improve their balance sheets in a way that improves the amount of control that they have over their portfolio of producing assets. This means that the companies must begin spending amounts of their earned incomes into paying down their debts, and ensuring that their asset base is maintained in a way that will sustain their production. While all of this income will remain as tangible value for the investor, and does still represent a period of prosperity, it is important to remember that a commodity price that is sling-shotting upwards does not necessarily mean that the producers will follow suit right away.

In understanding how it is that a commodity producing company effectively mediates the value of a commodity price through tangible asset value and cash flow from extraction, we can begin to see how it is that the producing company becomes a longer term investment into the usability of the commodity itself, whereas an investment into the tangible commodity itself represents more of a long term investment into the usability of the product itself.

This is as opposed to tangible value that the commodity itself will produce, which will only provide returns as a hedge against inflation during the growth period. The end result is that we are better off shifting our position into the producing company during the down-swing, and then moving a portion of those holdings into the commodity itself, so as to have exposure to the rising price, and hedge our portfolio against the ensuing inflation as well.

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