A Soft Sell on Hard Commodity Assets

The lack of distinction between commodity producers and processors is more than quibbling on my part. The alpha, or expected outperformance relative to the broad market, of a commodity producer such as Newmont Mining(NEM Quote) tends to describe a call option's profit profile as a function of gold prices. The stock tends to rise in price earlier and faster than gold and tends to fall in price more slowly as higher-cost incremental production capacity is closed first.

This is not a universal relationship for commodity producers, however. The alpha of Phelps Dodge(PD Quote), for example, tends to describe the profit profile of a short put option on copper. As copper prices rise, the premium of the cash market to the futures market, or backwardation, tends to rise, signaling an impending drop in the metal. Once this backwardation forms -- which it has not yet done, meaning the metal's rally has further to go -- the stock will underperform.

The alpha of commodity consumers in natural gas, such as DuPont(DD Quote) or Dow Chemical(DOW Quote), tends to have a complementary profit profile, that of a put option on the commodity. Higher feedstock prices squeeze operating margins, and the stocks' alpha tends to lead natural gas price changes of an opposite sign by as much as three months.

Blending various classes of commodity-linked equities into a single index produces a measure not at all parallel to an underlying commodity index. The GSR and the Goldman Sachs Commodity Index (GSCI), the most heavily energy-weighted of the commodity indices, paralleled each other roughly between the onset of the Asian crisis in 1997 and the July 2002 market low, but diverged both before and after. By the onset of the Iraq war (and beginning of the present market rally), the divergence had grown to such an extent that a casual observer might have inferred an inverse relationship between the two. The GSR has rallied strongly since, as oil prices have remained stubbornly high and as metal miners' stocks have firmed.

Commodities and Commodity-Linked Equities

Source: Bloomberg