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  • Intro to Investing in Natural Resources

    Posted by Frugal on July 6th, 2006

    Natural resources are commodity, meaning that there is no added value at all, besides its intrinsic value as being the material (such as metals or energy) or the commonly consumed products (such as pork, wheat, coffee).  Because there is often no added values, they are probably the least “fashionable” investment that you can find.  It’s whether you have it (holding companies), or you produce it (producer companies), or you explore for it (exploration companies), or you help to explore/extract/distribute it (service/distribution companies), or not.

    The most direct way of investing in natural resources is to trade futures contracts in the COMEX or any other commodity market.  Commodities are highly seasonal, and didn’t trend up or down until recent years.  Investing in futures can give you a very big leverage power.  Even when you have carefully planned your leveraging strategy, the leverage in futures market can still sometimes hurt you.  At COMEX, they can change the margin requirement on your leveraged positions for the benefit of the big shorting players.  At such time, you will need to come up with additional cash capital to keep your existing positions.  Often, the result is a wholesale of liquidations by many longs, whether you choose to sell or not.  It’s hard to play a game, when the rules of the game can change against you, right in the middle of the rising fun.  Using leverage under such circumstances become even more dangerous and unmanageable.

    Besides futures market, you can invest in the equity market.  If you invest in natural resource producer stocks, you get a little more leverage beyond holding the physical commodity.  The leverage comes in the following form: the natural resource companies have a cost basis of XXX dollars, and the market price for the commodity is at YYY dollars.  The gross profit for the natural resource company will be YYY – XXX dollars.  Assuming that when the market price for this physical commodity doubles to 2*YYY, the gross profit for company will not just double, but definitely more than double.  The only special case is when the cost basis XXX=0 (which is impossible), then the particular natural resource company will not give you any more leverage beyond the physical commodity.  Depending on the actual numbers, the profits can potentially go up very quickly.  When the profits go up, the companies when valuated on the basis of Price to Earning (P/E) ratio, will go up accordingly.

    Understanding the gross profit equation is important to the understanding of investing in the natural resource companies.  The equation cannot be simpler, and yet it has a lot of information.  Here is the expanded examinations on how the price of natural resource interacts with the producer companies.  For the following discussion, I assume that one company produces the natural resource at $100, while the other higher cost basis company produces at $200.

    1. Survival of the fittest: When the price of the natural resource is very low, the profits at the higher cost basis companies will be wiped out rather quickly.  At such time, only the low-cost companies can survive.  Supposed that the price for the natural resource is at $110, the higher cost company will be bleeding cash, while the lowest cost company makes a tiny profit of $10.
    2. Leverage beyond physical commodity: But when the metal price goes from $110 to $220, the natural resource price itself doubled, while the profit at the lower cost company goes from $10 to $120, 12X increase, and the profit at the higher cost company goes from negative to $20.
    3. Higher leverage at higher cost basis company: Let’s assume that price goes up again from $220 to $240, a mere increase of $20, the profit at the lower cost company goes from $120 to $140, a 16.7% increase, while the profit at the higher cost company goes from $20 to $40, a much bigger 100% increase.  At such time, it is actually better to invest in the higher cost company despite all the irony associated with it.

    The second important thing about the gross profit equation is that normally the sale is priced in the international currency, while the cost is priced in the local currency where it is produced.  This trickiness is not apparent at all in the equation.  When the local currency is very strong, it will actually hurt the commodity producers.  Vice versa, it is also true.  A weak local currency is helpful for the commodity producers to compete at the international arena.

    The last extremely important thing about investing in natural resource producing companies is that if the natural resource cannot be easily replenished, the reserve/resource base for the producers become very important.  When the reserve is depleted, the producers must find ways to replenish the reserves, or else the production cannot be sustained.  Natural resources that can be replenished easily are by planting trees (PCL, RYN) at the time of cutting, or any agricultural products.  Natural resources that cannot be replenished easily are oil, gas, any precious metals, or some industrial metals.  There are two different types of measurements for the in-the-ground natural resources: reserves and resources.  Reserves are the recoverable resources at the current market pricing structure.  Definition of Resources is more loose.  Some resource estimates don’t give any consideration to the cost of extracting the natural resources out-of-ground.  That can be very dangerous for investing, because it is possible that those natural resources are as good as nothing, due to the high extraction cost involved.  Amount of reserve to the amount of annual production is an important ratio to consider.  It essentially indicates how long the producer company can operate before running empty.  The consideration in reserves brings out another needed class of natural resource companies: exploration.

    Exploration companies are companies that set out to discover places on Earth that have the particular type of natural resource in interest.  These companies are speculative in nature.  But if they succeed in discovering a natural resource base, it is like hitting a home run.  The return can be splendid.  However, because you cannot know beforehand that who will make the discovery and who will not find it, oftentimes, it is highly advisable to either put very minimum amount of your portfolio in this class of investment, or that if you have more money, you should diversify among many more companies than usual, and in each company, you should place a smaller amount than usual too.  But bottomline is still the collective performance of all of your bets in this class.  Obviously, if you leave it to the law of probability, you won’t do too good.  To get an above average performance in this class of investment, you will need a lot of research which often is not available or financially impractical for retail investors.  Still, the return of 10X to even 50X for a home run is sometimes too good to completely take a pass.

    The last class of companies are service/distribution companies for the natural resources.  This type of companies perform related services in respect to the particular type of natural resources.  The service/distribution companies depend much less on the up & down of the underlying commodity prices, but more on the volume of the commodity being distributed, or the related services performed.  Their performance usually correlate less to the price of commodity.  Some natural resource service industries may actually inversely correlate to the rise of price of commodity, because as the price goes up, the volume goes down, and therefore, service revenues on those volume actually go down.  But more often than not, stocks in service/distribution companies in natural resources often go up in sympathy with the natural resources.  With a rising total revenue of natural resources, there is often more rooms for profits made along the way.

    Here is some holding ETFs that you can consider investing for natural resources: IAU (0.4% expense) & GLD (0.3% expense) for gold, SLV (0.5% expense) for silver, USO (0.85% expense) for crude oil, DBC (1.3% expense) for general commodity, XLB (0.25% expense) for stocks in basic materials.  Here are some mutual funds that I found using Yahoo finance search.  I sorted the list using expense ratio which is very important for the long term performance.  Many top performers in the list probably track more closely to XLE (energy spider, 0.25% expense) and OIH (oil service holder) and are not really natural resources in all kinds but more like a narrowly focused energy mutual fund (VGENX, etc).


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    2 Responses to “Intro to Investing in Natural Resources”

    1. Brian Says:

      Great post!

    2. Jason Says:

      I was just wondering how one directly invests in natural resources such as gold for example. If you believe the value of the dollar will be declining over time wouldn’t you want to buy gold wait and possibly convert it to some other currency later on down the road? I am new to this, so if I’m completely off base let me know.