Sunday, August 30, 2009

Commodity companies and commodity dependent markets

My trip to Peru started me thinking about commodity based companies and markets and how best to value them. It is fairly obvious that the value of a commodity company will be a function of the price of the commodity. As oil prices go up and down, the prices of oil companies will vary. Embedded in this obvious relationship, though, are several interesting valuation issues:

a. What is the best way to forecast future commodity prices?
There are two basic approaches. One is to trust price cycles and look at average prices across time. Implicitly, we assume that commodity price cycles are pre-determined and that they will go through the same up and down cycles that they have historically (perhaps adjusted for inflation). The second is to look at the demand and supply of the commodity: arguing that higher demand from the growing Indian and Chinese economies will push up the price of oil is an example. I think there is some value in both approaches and perhaps a melding of the two will yield the most reasonable forecasts.

b. Should you bring commodity price views into the valuation of commodity companies?
Even if you have a view on commodity prices for the future, should you bring those views into the valuation of commodity companies? Put another way, if you believe that oil prices will double over the next 3 years, should you use those predicted prices in valuing oil companies. In my view, you should not. By bringing in macro views into micro valuations, you create composite estimates of value that reflect not only your views of the company being valued but also of the underlying commodity. (If you believe that oil prices will double over the next 2 years, almost every oil company you value will look cheap) As the user of your valuations, I would prefer that you be commodity price neutral when you value companies and offer your commodity views separately. That way I can decide which aspect of your forecasting - the macro or micro part - I think is of higher quality and worth following. What exactly does being price neutral mean? You do not have to assume that oil or gold prices will remain at today's level forever. You can use forward market rates but you cannot super impose your views on top of these.

c. How do you differentiate between commodity companies that hedge against commodity prices from companies that do not?
Some commodity companies hedge against commodity price volatility, and in the process, under cut investors who buy their shares to make a bet on the commodity. In general, I do not favor this type of hedging, with two caveats. If a commodity company is either highly levered or feels that is competitive advantages are at the operating level (finding the right place to explore for a resource... mining efficiencies), it may want to reduce it risk of default and increase the focus on its competitive advantages by hedging against commodity price risk.

In my latest edition of the Dark Side of Valuation, I have a chapter on valuing commodity and cyclical companies. I have modified the chapter to make it a down-loadable paper. If you are interested, you can get the paper by clicking on this link.
Paper on commodity and cyclical companies

Hope you find it useful!


Pit said...

Dear prof this paper is very useful and interesting and thank for giving us the opportunity to share it with you. Just a question: is the case to use this paper for valuating a company which core business is the commodity trading (steel,coal) and the last 15 years has diversificated in distribution services,energy,shipping and most of all industrial production ( steel products ) in all over the world? I looked in your book( Applied corporate finance,big 'friend' during my MBA course) and in your site but i am not sure which paper could be helpfull to my valuation, due to the complexity of the company.Thank you very much, Pit

Rahul said...

Dear Sir, This comment is not related to the blog item for which it is meant to be but I am using this space to communicate on an issue which in has been "a pain in my neck" (as you would have termed it) since this morning of 3rd Sep,2009. For over the last three weeks, I have been studying while watching the webcasts of your spring 2009 lectures of Corporate Finance and Valuation courses (in echo 360 system). But the access to them has been withdrawn this morning and they have been made password protected. Is this how things are going to be this point forward? Or being a purveyor of "information must be free" thinking would you do some arrangement where people like me can regain the access to the quality resource? Btw whatever is the outcome please accept my thanks and regards for everything I have learned and unlearned through the engagement with your webcasts and unfathomable study material on your webpage. ( I tried earlier webcasts of corporate finance but none of them are working, although one valuation webcast of fall 2008 is working fine. Thanks, Rahul Kumar.

Vesna said...

Rahul, I was able to download mp3 lectures from Spring 2009 valuation class

Rahul said...

Hello Vesna, very nice and generous of you to share that piece of information with me. Please write to me on my email address or may I reach you on your email address? Would have been great if someone like Vesna turns up with a similar offer for Spring 2009 Corporate Finance course? or the best would be if the free access to the lectures be given for 3-4 more days and so that I can download right from the source.