The Secret to Commodities Investing

Investing is prone to manias and panics. Investors get excited as prices rise and become convinced they will continue to rise. People end up buying today what they should have bought years ago. The recent commodities sell-off reminded me of the rule I follow for commodities investing. Had you followed this one rule, you would have saved loads of money in 2008 and 2009 and made tons recently.

The rule
The time to own commodities is when they are down, when everybody has lost money in them, and when they trade below the cost of production.
 
-- Bill Miller

When a commodity is unprofitable for the companies that make it, high-cost producers die off or halt operations. The industry shrinks, leaving only the most efficient firms as high-cost producers gradually halt operations. This time is noted by large amounts of turmoil, falling stock prices, and occasionally bankruptcies before supplies decline and prices rise again.

Most importantly, it's the time to buy
That's easier said than done. It's gut-wrenchingly hard to buy when every day, anchors are ranting about how your stock is losing money, your friends are getting out of the market, and you feel nervous to invest. But that's how fortunes are made.

Consider Resource Capital Funds, the private equity firm that bought Molycorp (NYSE: MCP  ) from Chevron in September 2008 when rare earths had fallen off the highs of 2007 and early '08, making out like bandits.

Wilbur Ross bought the non-union assets of bankrupt Horizon Natural Resources to form International Coal Group (NYSE: ICO  ) in 2004 after the low prices of 2002 and 2003 caused many coal companies to struggle.

Where's the opportunity now?
Natural gas.

The commodity is currently trading at $4.25/mcf, below many companies' cost of production. Producers are slowly moving away from natural gas to other resources such as oil. For instance, SandRidge (NYSE: SD  ) bought Arena Resources last year for its oil reserves. Even natural gas heavyweight Chesapeake Energy (NYSE: CHK  ) is moving away from natural gas, aiming to drill for more oil and natural gas liquids, or NGLs, as opposed to straight natural gas. The reason is oil and NGLs can be drilled using the same technologies used to drill for natural gas; however, the profits realized by drilling for the former are much higher currently than can be realized for $4/mcf gas. This profit differential will continue to lead companies to shift production away from natural gas and toward oil. At current oil prices, the profit advantage of drilling for oil would still be there even if natural gas were at $6/mcf, leaving ample room for prices to rise above $6/mcf after enough companies have stopped producing it.

There will be more pain before there are large gains. Companies are still sitting on plenty of leases with obligations to drill or lose it, pushing down prices. The ones to own are the lowest cost producers, as they are best positioned to ride out the storm.

Below is a chart of some popular natural gas producers (and the industry average) ranked from highest to lowest production cost for the most recent quarter.

Company

Production Cost

Chesapeake Energy $6.78/mcfe
Range Resources (NYSE: RRC  ) $6.15/mcfe
Industry Average $5.41/mcfe
Southwestern Energy (NYSE: SWN  ) $3.85/mcfe
Ultra Petroleum (NYSE: UPL  ) $2.61/mcfe

Source: Company filings.

Both Southwestern Energy and Ultra Petroleum's production costs are below the current price of natural gas ($4.25/mcf). As you can see, though, Ultra Petroleum's costs are significantly below the rest of the pack.

What's to like about Ultra?
Despite having petroleum in its name, 90% of Ultra's revenue comes from natural gas. The first half of the company's name provides a fitting description of its management. The company has a returns-obsessed management team with CEO Michael Watford saying Ultra wants to "make money first and .... grow second." The team's incentives back up that statement; cash bonuses are based on cash flow, net income, and three-year production growth, while stock awards are based on return on equity, reserve replacement, and production growth.

As you would expect, the company has been doing well even with low natural gas prices. In its most recent quarter, the company had a net income of $70 million -- at a time when other natural gas producers have been reporting losses.

Foolish bottom line
When looking to invest in a commodity, you are best off investing in the lowest cost producer. Focus on commodities trading below the cost of production, and over time you should be duly rewarded. Looking for more ideas? Check out The Motley Fool's free report "The Only Energy Stock You'll Ever Need." Just click here to grab a copy.

Dan Dzombak's musings and articles he finds interesting can be found on his Twitter account: @DanDzombak.

Range Resources is a Motley Fool Inside Value recommendation. Alpha Newsletter Account, LLC has written puts on Southwestern Energy. The Fool owns shares of Range Resources, and Ultra Petroleum. Alpha Newsletter Account, LLC owns shares of Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (27) | Recommend This Article (74)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 10, 2011, at 7:16 PM, MegaEurope wrote:

    Contango (MCF) and Apache (APA) are two other examples of low-cost producers. And they appear somewhat cheaper than SWN and UPL.

  • Report this Comment On May 10, 2011, at 7:30 PM, AjarnMichael wrote:

    I just took a look at UPL and noticed it has negative cash flow and has for awhile. Anyone know why this would be if it is producing natural gas at roughly 60% of the current trading price?

  • Report this Comment On May 10, 2011, at 8:06 PM, StockSymbol wrote:

    I would like to see TMF come out with a premium commodity service newsletter just as they do for stocks. Complete with analysis, entries, exits, etc.

  • Report this Comment On May 10, 2011, at 10:05 PM, marcjones281 wrote:

    Great Article!

    also love Contango!

  • Report this Comment On May 11, 2011, at 8:54 AM, TMFDanDzombak wrote:

    @MegaEurope Contango gets most of its revenue though from NGLs however

  • Report this Comment On May 11, 2011, at 8:59 AM, TMFDanDzombak wrote:

    @AjarnMichael the company has positive operating cash flow which it is using to invest in more properties and equipment.

  • Report this Comment On May 11, 2011, at 9:00 AM, TMFDanDzombak wrote:

    @StockSymbol This has come up before but people internally are hesitant to focus a newsletter on just one sector.

  • Report this Comment On May 11, 2011, at 9:00 AM, TMFDanDzombak wrote:

    @marcjones281 thanks

  • Report this Comment On May 11, 2011, at 10:08 AM, Darwood11 wrote:

    Good article. I agree 100%. Bought CVX, XOM, NOV, HACMX and some others in 2008-9. Got both good stocks and dividends. Thanks for the "heads up" on natural gas.

    My "total" commodities exposure is about 10% of my stock/mutual fund portfolio, and that includes the companies in the mutual funds. It includes about 0.5% of GLD. These are intended to be long term (10 year) holdings, with the possible exception of GLD.

    I can see the issue with a newsletter on a single sector. Since I've decided to keep only a small percentage of my "wealth" in commodities, I would not subscribe to such a letter.

  • Report this Comment On May 11, 2011, at 12:54 PM, Borbality wrote:

    anyone know a good natural gas ETF?

  • Report this Comment On May 11, 2011, at 1:06 PM, isacsimon wrote:

    Excellent article Dan!

    One really need guts to recommend a buy when everyone cries sell!

    However, I am a bit skeptical about Ultra Petroleum's business model, though there is nothing really wrong about it.

    But great stuff!

    -Isac

  • Report this Comment On May 11, 2011, at 1:08 PM, jargonific wrote:

    You are saying just buckle down and buy the world's criminal polluters and all will be well. Hey, I disagree vehemently.

    There is roughly 4 years left to save thousands of species. The water is being polluted to the point of global disaster... and what ... you want to invest in water instead of working to stop polluters? It's not contrarian, it's nuts.

    Buy green energy stocks and do all you can to work for those in your community that need help with govt. agencies and so on. Tell them you will invest in them up until they are bought out by Total... or Chevron, or whatever co.

    I'm speaking as someone who has studied this for three decades. We're at the end of our ability to stop these global predator companies. And we must stop them, lest we face global fascism, and loss of all rights to the resources in our lands.

    In Peace, Jargonific

  • Report this Comment On May 11, 2011, at 2:11 PM, pastreet wrote:

    Commodities investing is likely a losing game. Buying something and waiting for someone else to pay more for it... it's pure unadulterated speculation. I'd rather buy something that creates wealth than something which represents wealth.

    Pat

    www.compoundingreturns.com

  • Report this Comment On May 11, 2011, at 2:36 PM, TMFDanDzombak wrote:

    @Darwood1 Thanks

  • Report this Comment On May 11, 2011, at 2:37 PM, TMFDanDzombak wrote:

    @Borbality Not sure.

    @IsacSimon Thanks

  • Report this Comment On May 11, 2011, at 2:42 PM, hheiserman wrote:

    pastreet -

    compoundingreturns looks like a good site. But Mr. Buffett has two t's in his last name.

    Also, when you say "commodities investing is likely a losing game," this is broad statement on your part. Please be more specific with your claim. Also, can you give us an example of what "creates wealth?"

    Dan -

    Good column.

  • Report this Comment On May 11, 2011, at 2:43 PM, TMFDanDzombak wrote:

    @Borbality Where do you get 4 years from?

    I'm from Western PA and am keenly aware of the environmental impacts of shale fracturing and am watching the situation closely.

    Another comment, buying green stocks does not help the environment, just as boycotting Altria's stock does not hurt the cigarette companies. Helping the environment takes real effort and their are multitudes of ways to do your own part.

    If you are looking to put money towards doing your part for the environment their are plenty of startups, scientists, and projects all looking for money.

  • Report this Comment On May 11, 2011, at 2:45 PM, TMFDanDzombak wrote:

    @hheiserman Thanks! I enjoyed your book

  • Report this Comment On May 11, 2011, at 2:50 PM, hheiserman wrote:

    paststreet - also, per your criticism of commodities (see above), you'll forgive me for a chuckle over the first two commercial ads on your blog, which are for gold and oil.

  • Report this Comment On May 11, 2011, at 8:54 PM, FlorisHJ wrote:

    Take a look at BHP. Large multinational mining company. Price ran up a bit too fast in the last few month, having a bit of a pullback that may create an entry (or add) point. Nice dividend, broad exposure to "natural resources". Not just gold, but the stuff people need to create more wealth.

  • Report this Comment On May 11, 2011, at 9:37 PM, TMFDanDzombak wrote:

    @FlorisHJ David Lee Smith wrote about BHP today

    "A Solid Commodities Bet"

    http://www.fool.com/investing/general/2011/05/11/a-solid-com...

  • Report this Comment On May 12, 2011, at 12:31 PM, FlorisHJ wrote:

    @TMFDanDzombak: thanks. I had not seen the article. Makes my point for me, but much more eloquently.

  • Report this Comment On May 12, 2011, at 10:04 PM, idlebminor wrote:

    Some good insight on commodities. I agree with "Stocksymbol", would love to see a commodities newsletter from TMF.

  • Report this Comment On May 13, 2011, at 7:29 AM, silverminer wrote:

    Though I maintain there is still plenty of wealth-creation potential locked inside quality resource stocks across a broad swath of commodities, I certainly can not fault the logical conclusion that effectively every point of entry into longstanding producers from here forward is likely less ideal than an entry point nearer the beginning of the particular secular bull market in question.

    Great article!

  • Report this Comment On May 13, 2011, at 9:25 AM, TMFDanDzombak wrote:

    @idlebminor Thanks.

    You never know, maybe someday the Fool will do one.

  • Report this Comment On May 14, 2011, at 8:25 AM, skypilot2005 wrote:

    Dan,

    Great article. I’ve been struggling unsuccessfully with how to invest profitably in Natural Gas over the last year.

    We have abundant quantities of it at a relatively low cost.

    I am not a “Tree Hugger” but would like to see all semi tractors run by N. G. engines as a start. It would reduce pollution, fuel costs and provide thousands of jobs. The newly created infrastructure could then be used for autos.

    I wish the Environmentalists and Energy Companies would put their differences aside and make it happen.

    Thanks again, for the piece.

    Sky Pilot

  • Report this Comment On May 15, 2011, at 3:52 PM, owlbert wrote:

    As Iran is gradually becoming the dominate Middle Eastern power, at some point we can expect them to slow or shut off the oil supply. The Saudis, even if the royal family hasn’t fallen, won't be able to make up the difference. At that point, the US will finally be forced to look at other sources of energy, such as natural gas to power our cars, trucks and tractors. I don't know how soon it will happen, but it wouldn't surprise me if it is before 2020.

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