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