Understanding how most types of companies make a profit usually isn’t that complicated. An ice cream vendor, for example, is a business with expenses and profits easily calculated and can be modeled to show future growth or earnings. But commodity-based companies don’t operate the same way.
Industries like mining and oil drilling are capital intensive, requiring large sums of money to build drilling rigs and construct mines. There’s a high barrier to entry in the field and makes long-term financing the only realistic way to keep the business running on a day-to-day basis.
Like most businesses, supply and demand plays a large role in the success of a commodity-based company. However, there are many more factors that influence these types of companies, and keeping costs as low as possible is one of the best tools to stay competitive in the marketplace.
Types of Commodity-Based Companies
Mining companies and oil and gas companies are generally broken down into two main sub-categories.
- Exploration – These types of companies are focused only on finding metals and minerals, and carry few assets.
- Production – These companies are full mining operations designed to extract and produce whatever metal or metals they are mining for.
Oil and gas sub-types:
- Upstream – This is the core of the industry that revolves around the exploration and production of oil and gas.
- Downstream – This type of company focuses on the point of sale following the production process. They typically engage in the selling of fuel for vehicles or for heating homes.
The Primary Statistic for a Commodity-Based Company
The cost of production is the single most important piece of information investors need to rate the quality of a commodity-based company. Lower costs mean higher operating margins and greater breathing room from volatile price swings for the underlying commodity.
For example, many offshore drillers were unable to continue normal operations once oil dropped below $50 per barrel. The cost to maintain an offshore drilling rig means oil needs to be high enough to justify the cost of extracting it. Mining companies are similar. If a gold miner’s all-in cost of production remains lower than the spot price for gold, the company will stay profitable.
Supply and demand play a large part in the value of commodities, but other factors like the value of the U.S. dollar, level of inflation and interest rates also affect commodities.
One thing investors need to understand about commodity-based companies is that there are different methods used to determine value. In the mining industry for example, price-to-earnings ratios are essentially worthless – although very valuable when determining value in most other industries.
Commodity values can fluctuate rapidly, so companies that have the lowest cost of production have the greatest flexibility. Companies often hedge against commodity prices with futures contracts, but long-term weakness like what we’ve seen in the oil industry can be problematic for commodity-based businesses. Only those with the lowest cost of production and highest margins are able to weather the downturns and stay in operation.