Trade in Groups

In the previous article introducing commodities, one strategy that was mentioned was relative value trading using long positions paired with short positions. A benefit of this strategy is that having both long and short positions can help offset broader market moves; for a more detailed explanation see “Absolute Returns for Individual Investors: Long/Short”.

When the topic of investing in commodities comes up, there are two natural approaches that tend to arise – either owning the physical commodity, such as gold or oil, or owning stocks of companies that produce commodities, like Barrick Gold (ticker: ABX) or Goldcorp (GG), or Exxon Mobil (XOM) or Chevron (CVX). While the long/short strategy can be applied to play commodities against each other, as with gold and silver or oil and natural gas, a more direct way is to value the stock of the company on a relative basis compared to the price of the commodity they produce.

The first chart here compares the price of the Amex Goldbugs (an index of gold producers) relative to the price of gold. After holding fairly steady for over two years, the relationship – like many others – fell apart in the second half of 2008.

An easier way to visualize this might be to break down the above chart into its component parts. HUI represents the value of the gold producers index, and GLD is a gold-tracking ETF. The price of gold is essentially flat in the last year, while gold stocks are down 40%.

This should raise questions about whether gold stocks are undervalued relative to the present price of the good they produce, especially because plummeting energy prices will translate to lower costs and higher profits. In a simple long-only portfolio, buying gold stocks might be risky because of the uncertain future price of the metal, but putting on a trade being long gold stocks and short the price of gold (via the GLD ETF) could be a better way to hedge out uncertainty and manage risks. The theory behind this trade is simply a classic hedge play: if the price of gold goes down, gold stocks might fall, but being short the price of gold will ideally offset (and then some) any losses on the long position. If gold prices soar, the gold producers will generate enormous profits and their stock prices will soar – ideally, in excess of the losses on a position being short the price of gold.

One thing to be aware of is that oftentimes large commodity companies, while known for one particular product, actually have multiple lines of business. ConocoPhillips (ticker: COP) is known as an oil company, but they also have large natural gas holdings, so trying to use that for a long/short trade might result in an imperfect hedge. Likewise, a company such as Freeport McMoRan (ticker: FCX) is primarily a copper producer, but they also have revenue from gold mining as well as molybdenum production. Not everything can be hedged.

Here is a chart of FCX relative to the price of copper; note the potential double bottom that was recently put in.

A final thought for now: ETFs are a great tool for investors, but make sure your ETF is accurately tracking the index it is supposed to follow. For example, the copper ETF (ticker: JJC) is shown below, relative to the price of copper futures. Although there has been volatility of late, this ETF has followed its benchmark closely.

This is part of a series. Prior parts:

Long/Short

Capital Structure

Convertible Securities

Volatility, Part I

Volatility, Part II

Commodities, Part I