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:

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:

• Learn what CAPS players say about commodities.
• Find out how shipping stocks cash in on the commodities boom.
• See what hot commodities are doing for shares of Canadian companies.