Commodity is a broad term that can encompass everything from corn to gold. In general, commodities and the companies that produce them are prone to dramatic, and often swift, price swings -- so you need to dig a little deeper into stocks you are considering in the broad commodity sector. Here's why you should look at Franco-Nevada Corp. (FNV +0.47%), Teck Resources (TECK 0.38%), and, for more aggressive investors, Cameco Corp. (CCJ +1.01%).
A lot of moving parts
Commodities are largely interchangeable. One ounce of gold is, basically, the same as every other ounce of gold. Thus commodity producers generally lack pricing power, leaving them largely subject to the prices dictated by supply and demand. This is good when prices are moving higher, but horrible when prices are falling. Contracts and hedging can help reduce the impact of volatile commodity prices, but can't eliminate the problem.
You need to look beyond just commodity prices when you buy a commodity stock, or you could end up selling at the worst possible time. Image source: Getty Images.
The cause here is human nature. When commodities like iron ore, gold, copper, and oil are fetching high prices, producers want to take advantage to the best of their ability. That usually means increasing the supply of the commodity by building new mines and wells or, in the case of agricultural commodities, planting additional crops. When the additional supply hits the market, it pushes supply and demand out of balance, and prices start to drop.
If prices go low enough, companies that increased production when prices were high will start to trim production. That often causes a painful string of bankruptcies that help clear the playing field. Once enough supply is out of the market, however, prices will start to head higher again. That, in turn, starts the cycle all over. Everyone wants rational minds to prevail, but human beings just aren't built that way, so we get cycles.
This is why it's important to take a deeper look at the companies in which you are investing. What are the important facts beyond the prices of commodities, which no company can control?
Avoiding the mines
A great example that shows how a differentiated business model can lead to strong performance is streaming and royalty company Franco-Nevada. The company's results are tied to gold and silver, which together make up around 85% of its revenues. However, it has a very different business model than a miner. In fact, Franco-Nevada doesn't own or operate a single precious-metals mine. What it does is provide cash up front to miners for the right to buy silver and gold at reduced rates in the future, which is known as streaming.
This provides Franco-Nevada with wide margins in both good years and bad, because of its locked-in low costs. Commodity downturns, for reference, usually push miners' margins into negative territory, because it takes time to adjust operating costs to falling commodity prices.
Downturns are actually a good time for Franco-Nevada to expand its business. Banks and capital markets tend to be stingy when commodity prices are weak, so downturns are when miners are most likely to need the cash that streaming companies provide. They use that cash for things like shoring up their balance sheets and funding expansion projects.
Franco-Nevada's commodity exposure. Image source: Franco-Nevada Nov. 2017 investor presentation.
Franco-Nevada, however, is unique among its peers, which include Wheaton Precious Metals and Royal Gold, in that it is has been taking advantage of the oil downturn that started in mid-2014 to put its streaming model to work in the energy patch. It gets around 7% of its revenues from oil and natural gas, but expects that to increase over the next few years. This move opportunistically increases Franco-Nevada's diversification, but keeps it well within its business-model comfort zone of providing capital but not operating any assets.
If you are looking for a commodity company that takes a different approach to the space, consider any of the major streamers. Franco-Nevada, however, offers a level of diversification that its peers can't. It can't avoid the ups and downs of the commodities it's involved in, but the wide margins built into the model help soften the hit of declines in commodity prices. If you want evidence, look no further than the company's dividend, which has been increased every year for a decade.
Adding something new
Speaking of oil, another miner you might want to look at today is Teck Resources. Teck's primary businesses are now metallurgical coal (used to make steel), copper, and zinc. When commodity prices fell sharply during the downturn that started in 2011, investors were concerned that Teck wouldn't be able to pay its bills because of its hefty debt load. This fear was exacerbated by Teck's agreement to be a 20% partner in a new multibillion-dollar project that got final approval in late 2013.
It was tough for a little while, with Teck's debt levels increasing every year through 2015. However, 2016 proved an important turning point, as commodity prices started their recovery. The miner's long-term debt has fallen every quarter since the start of that year, dropping by more than a third in just seven quarters. There's no longer any concern about Teck's long-term viability. But what about its future?
Teck has reduced debt materially even as it continues to fund the development of the Fort Hills oil sands project. Image source: Teck Resources conference presentation, May 2017.
Commodity prices will continue to drive the top and bottom lines. But Teck's new mine is set to come online at the end of 2017, with a ramp-up to full production throughout 2018. The best part, however, is that the project, known as Fort Hills, is an oil-sands mine. That will add a fourth major commodity to Teck's portfolio, materially increasing the diversification of its revenues. And the capital spending associated with the project will end as it builds up to full production, so not only will Teck be adding another revenue stream, but its expenses will be getting a helping hand, too.
If you are looking for a diversified miner, Teck is on the cusp of a material change to its business model. It's worth a deep dive today, before the oil really starts flowing.
Couldn't get much worse
Uranium miner Cameco isn't for the faint of heart: The company just cut its dividend and announced that it was closing more of its operations. A deep downturn in uranium prices is the main reason. In fact, at this point, it appears to be more cost-effective for Cameco to buy uranium on the spot market than to mine for it.
Why on earth would you want to get involved in that? The answer is twofold. First, Cameco has a rock-solid balance sheet, with long-term debt at roughly 25% of the capital structure and a current ratio of an impressive 5.4, as of the third quarter of 2017. The uranium market may be tough today, but Cameco is conservatively financed and built to survive.
Second, the company, along with some of its largest competitors, is working to reduce the supply of uranium. That, along with the new nuclear power plant construction that is happening today, should help to alleviate the supply-demand imbalance that has kept uranium prices in a downturn since 2011. When that happens, uranium prices should head higher again.
Nuclear power plants are still being built today, despite the industry's bad image. Image source: Cameco Corp. investor presentation, Oct. 2017.
To put it simply, there remains a lot of risk with Cameco; the company's stock is only appropriate for aggressive investors. And there's no way to tell when uranium prices will start to rebound, so go in expecting continued red ink over the near term. But Cameco's stock is trading near 10-year lows. It's the largest pure-play uranium miner, it has a solid financial foundation, and it can bring production back online relatively quickly when uranium prices pick up. When that happens, investors are likely to reward the shares fairly quickly. If you have a strong stomach, Cameco is a turnaround play in which you might be interested, since it's hard to envision things getting too much worse.
More than commodity prices
There's nothing a commodity producer can do about the ups and downs of commodity prices, and those price swings will have a material impact on top and bottom lines throughout the space. However, if you step back and take a closer look at what is happening at each company, you can start to get a feel for where you might want to put some money.
For those looking for a low-risk approach to commodity markets, precious-metals streaming company Franco-Nevada is a solid option. Teck is on the cusp of a big business change that could materially alter its future. And Cameco, while still suffering, is taking the steps necessary to survive the uranium downturn so it can thrive when prices pick up again. All three are worth a deep dive in the commodity space.
