What to Do About Falling Commodity Prices
By Matt Badiali
February 05, 2007
"The price of copper could fall by half, to $1.50 per pound."
Jaws dropped. The audience at the New Orleans Investors Conference in November was ready for another speech about how commodities were going to make them rich, but Paul Van Eeden, a precious metals analyst, told them exactly what they didn't want to hear.
Paul believes a global economic slowdown will act as a drag on China's GDP growth... growth that depends heavily on exports. And if China ships fewer cars, toys, and electronics, that means less demand for copper.
Hyped-up commodity investors should take Paul's point to heart: Prices could easily go down this year.
I've learned the hard way that you can't simply bet on the rising price of a given commodity. That goes for copper, oil, gold, corn, whatever. Instead, our most important job as investors is to buy cheap assets. That way, you reduce your downside risk if a commodity price dips. And if a commodity price rises, well, that's just icing on the cake.
As simple as it sounds, that can be a hard discipline to maintain. It's too easy to excuse high operating costs when a company gets top dollar for its production. But these high-cost operations are heavily leveraged to the assets they produce. While all that leverage may be good in a period of rising prices, it can crush a stock when commodity prices fall.
So I try to think long-term when I buy mining companies. And my strategy is to find the assets selling for way less than they are worth.
That means only buying a copper company for less than $1 per pound of reserves, even when the price of copper soars above $3.
Here's an easy method for sorting the wheat from the chaff among commodity companies: Divide the market cap by the reserves (both figures are readily available in the most recent presentation or quarterly report). This should give you the price to reserves (in dollars per pound or ton or barrel).
Compare that number to the current market price of the commodity. If the price to reserves doesn't give you at least a 20% discount to the commodity price, find a new company. That way, falling prices won't keep you up at night or stop you out of fantastic investments. That's why I don't worry much about the price of copper falling fifty cents.
This simple technique will insulate you from all but the greatest collapses in commodity prices. And if the market heats up, your overlooked company soars along with it. Your cheap producer becomes the next big story... and you reap the reward for getting there early.
Good investing,
Matt Badiali
Editor, S&A Gold Report
