You Don't Need to Buy Commodities

If you want to know what sectors are hot lately, just find out where the action is in exchange-traded funds.

With prices of commodities, from food and energy to metals, climbing through the roof, ETF companies have rushed to offer new funds that track prices of various commodities. If you want to profit when oil rises, for instance, the United States Oil Fund (USO) uses derivatives like futures contracts to track oil prices. Similar funds exist for precious metals. You can even find ETFs that invest in a basket of diverse commodities.

Looking at past performance, you could have made plenty of money using these commodity ETFs. But the real question for investors is this: Do you need these ETFs to profit from the commodities boom?

Sticking with stocks
Instead of investing directly in commodity products, you have an alternative: buying shares of the companies that produce those commodities. For instance, it makes sense that when oil prices rise, large oil producers such as BP (NYSE: BP  ) and Chevron (NYSE: CVX  ) should see their share prices rise in tandem. Similarly, when gold and silver do well, you'd expect companies like Newmont Mining (NYSE: NEM  ) and Pan American Silver (Nasdaq: PAAS  ) to climb.

The important question, however, is whether stocks that produce commodities actually do track the prices of their products. As long as companies have pricing power to pass higher prices on to customers -- which is often the case for commodities producers -- and successfully manage their business operations, then rising product prices should fall through to the bottom line, boosting shares.

Here are a few examples of this phenomenon:


Commodity ETF



Chesapeake Energy

United States Natural Gas ETF (UNG)



Monsanto (NYSE: MON  )

PowerShares Agriculture ETF (DBA)



Source: Yahoo! Finance.

When commodities win
Unfortunately, not all companies that produce commodity products have both pricing power and stable costs. One example is oil refining. Because crude oil and refined products like gasoline are all commodities, refiners like Frontier Oil (NYSE: FTO  ) have very little pricing power -- the energy markets set the prices. Therefore, even when crude oil and gasoline prices both rise, refiners' profits can fall if crude rises more quickly. That's the main reason why Frontier is down more than 40% in the past year, despite the fact that oil and gasoline prices are up sharply.

Another problem that stocks have when matching rises in commodities prices comes from challenges with business operations. For instance, the gold mining industry in South Africa has suffered from a variety of problems, ranging from power shortages that have disrupted production to work site accidents. As a result, despite higher gold prices, South African gold stocks, such as Harmony Gold Mining (HMY) and Gold Fields (GFI), have lost a lot of ground recently.

Avoiding company risk
Those shortcomings show the main benefit of commodity ETFs -- you don't have to worry about whether company shares will actually track rising prices in the related commodity. If you want to focus on the underlying fundamentals of commodities themselves, then commodity ETFs let you filter out the noise of other news that relates to specific companies.

On the other hand, if you're more comfortable analyzing stocks than commodities, then you can reap most of the benefits of higher commodity prices by being smart in picking stocks. If you can find companies that meet operational challenges well, then you're likely to see rising commodities boost your share prices strongly.

For more on commodities and investing:

Chesapeake Energy is a recommendation of the Motley Fool Inside Value newsletter. At Inside Value, we don't just look at fallen angel stocks -- we search for companies that can combine strong growth prospects with reasonable valuations. You can see what else we have to offer with a 30-day, free trial.

Fool contributor Dan Caplinger owns shares of gold and silver commodities ETFs, but he doesn't own shares of the other companies mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy takes all the pressure off you.

Read/Post Comments (3) | Recommend This Article (22)

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 June 24, 2008, at 7:39 PM, stapelbroek wrote:

    One of the advantages to investing in a company is that you're betting on more than just the price movement of the commodity. In the case of CHK, the value of their leaseholds and proven reserves are also increasing. You get the whole package, instead of just the current production.

  • Report this Comment On June 26, 2008, at 3:48 PM, SilverMoney wrote:

    I don't trust ETF's. If you want to get into gold and silver goto the bank, pull out a few thousand dollars and goto your local coin shop and buy as much physical gold and silver as you can. Then go buy and install a secure safe in your home to store your wealth. ETF's are manipulative entities that are part of the on going market manipulation of the gold and silver markets. AVOID the ETF's get physical metal or buy resource stocks...such as Seabridge or even SFMI.PK. [Yes I owned/own shares of those companies]

  • Report this Comment On June 28, 2008, at 2:52 PM, FOOLBEFREE wrote:

    You Don't Need to Buy Commodities ?

    I think you may want to. Historically, when commodity prices go up like right now, non-commodity stock prices go down or stay flat for years.

    Therefore, you have to buy commodity stocks when they pull back.

    We bought CHK over a year ago and it is up over 81%, XTO 38%, PBR 38%. US market indexes have been down about 15% over the last year.

    China, India and other countries will continue demanding energy and commodities for several years.

    To diversify your portfolio and obtain returns that keep up with inflation, I believe you do need to buy commodity stocks and commodity ETFs (MXI, OIH, DBA) when they pull back on light volume. And then sell covered calls to get at least 12% a year.

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