The price of crude oil has risen close to 20% over the past week. Should I buy it now if I expect geopolitical tensions to persist, or if something more drastic is likely?
Unless you are a geopolitical and macroeconomic expert, it is advisable not to attempt to predict what happens next by buying or selling crude oil directly or indirectly through futures. The best way around this is to invest in an asset class with factors and features that are not solely reliant on random events. This can refer to a company’s financial performance, for example.
Does this mean I should invest only in stocks with exposure to crude oil in this scenario?
The short answer to this question is yes. Different oil and gas companies have varying exposure to crude oil prices, with some more sensitive than others. The great thing about investing in stocks is that, regardless of exposure to a specific commodity, such as crude oil, there are other factors about the company that can be studied to make a more informed decision, such as its financial performance.
See also: What to note when investing in commodities
Is the correct way then, to always invest in commodity stocks and never in commodities?
Not necessarily, but it is advisable for the individual investor. Think about stocks like a supermarket. There is a variety of exposure to the commodity itself, so, depending on the investor’s individual risk profile, they can pick and choose the stocks in which to invest. Also, some stocks pay dividends, so that’s a potential added benefit.
How do you measure sensitivity and how a stock’s price is related to the movement in the commodity’s price?
See also: Base metals slump as Iran war sparks deep selloff across markets
The easiest way to do this is to juxtapose the stock price with the commodity price. Alternatively, if a rare event with a significant impact on the commodity’s price occurs, check how the stock’s share price moves. This must be done over multiple periods, during which stocks can be grouped into low, medium and high sensitivity to the actual commodity price.
But if that is the case, why not invest in commodities directly since the returns are going to be similar?
Aside from dividends, which investing in commodities directly does not pay, stocks generally move during their earnings window, and fundamentally strong stocks tend to appreciate consistently over the long run. Although the price of these stocks may move in tandem with the price of the specific commodity during certain periods, over the long term, other factors, such as the company’s financial performance, significantly impact investor returns; hence, individual investors should consider investing in commodity-based stocks.
What are the different return scenarios for investing in a commodity-based stock, as opposed to investing in commodities directly?
Assuming the individual investor correctly predicts the commodity’s price movement based on macroeconomic factors, they can achieve similar returns by investing in a stock highly sensitive to the commodity (and positively correlated with it). But if they are wrong, they will miss out on the potential returns from investing in a fundamentally sound stock. The idiosyncratic factors of a fundamentally good stock can offset losses from movements in the commodity’s price. And it is much easier to identify a fundamentally good stock than to predict the commodity’s future price.
How, then, do we identify a fundamentally good commodity-based stock?
First, ensure the stock’s primary business is related to the commodity. For example, if the commodity an investor is interested in is crude oil, look at companies whose main business is crude oil. Although it may seem necessary to identify whether a company is upstream or downstream, it is not required; generally, upstream commodity companies are more sensitive to movements in the commodity’s price. The next step is to do a financial analysis of the company, for example, through a scoring table. Then the investor is free to invest in a basket of these commodity stocks to reduce risk through hedging and diversification.
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What should I look at in the scoring table to identify fundamentally good companies?
Many factors determine how fundamentally good a company is. One is the stock’s historical performance. The difference in studying the historical performance of non-commodity-based and commodity-based companies is to see how the financials are affected during periods of crisis or anomalies. It isn’t just about comparing how the share price moves during these periods, but also about how revenue, net income, operating cash flow, and free cash flow are affected. Companies less affected by negative events and that perform better during these periods should score highly in the scoring table.
How about profitability and financial safety? Should they be included in the scoring table?
Yes, and both of these factors are crucial in determining a company’s fundamentals. Profitability can be measured by ratios such as return on assets and return on equity, as well as margins such as operating, profit, and cash flow margins. These collectively reflect how efficiently the commodity-based company utilises its assets and converts movements in commodity prices into profits. Financial safety, on the other hand, reflects the company’s ability to weather losses or tough periods effectively. The company’s liquidity and solvency should be adequate, with ratios such as the current ratio, gearing, and interest cover higher than the benchmark. Companies with strong liquidity and solvency are likely to go under in a commodity market crash and should score well on the scoring table.
Is there anything else to include in the scoring table?
There could be idiosyncratic factors specific to the commodity-based company to consider, but one thing investors should be wary of is sentiment. Although industry experts and analysts may provide valuable insights into the stock and commodity markets, investors should be able to distinguish between fact and opinion. Investors shouldn’t automatically invest or not invest in a commodity-based stock because it has strong positive sentiment, but rather rationalise the reasons behind its positive outlook. Similarly, if too much attention is paid to larger stocks, investors may also look at smaller stocks, which have less coverage and form their own opinions and sentiment.
What is the best strategy to invest in oil now? Or is it too risky given its current price?
For an investor who appreciates financial analysis, buying a couple of fundamentally sound oil and gas stocks may be a good strategy. Also, since nothing is guaranteed, investors familiar with derivatives can purchase put options on crude oil to protect against a correction. It is a small price to pay for the options (relative to the total investment amount), but it’s advisable to be safe rather than sorry. Also, given the spike in crude oil prices, the results of oil and gas companies are likely to be affected, so purchasing these commodity-based stocks may be a good way to capitalise on market fluctuations.
In the next part of this series, an illustration of a scoring table with relevant analysis will be presented.
Disclaimer: This article is strictly for information purposes only and does not constitute a recommendation, solicitation or expression of views to influence readers to buy or sell investment instruments. Any personal investments should be made at the investor’s own discretion, or after consulting licensed investment professionals, at the investor’s own risk. The author of this article does not hold or own any investment instrument featured in this article or have a vested interest in it at the time of writing.
