As the US economy has begun digging out of the massive hole left by the COVID-19 pandemic, ultra-loose monetary policy and several rounds of fiscal stimulus have awoken concerns that inflationary pressures may be just around the corner. In response to these concerns, more investors are considering an allocation to commodities, attracted to the asset class for its inflation-fighting characteristics. While the most common way to get commodity exposure is by investing in a portfolio of commodity futures, many investors believe that owning a portfolio of natural resource stocks is an easier solution. The logic behind this position is often that the largest driver of return for these stocks should be the price of their underlying commodity—for example, a mining company’s share price ought to be driven largely by the price of iron ore.
However, this seemingly commonsense argument couldn’t be further from the truth. For one thing, price movements of natural resource stocks display dramatically different return patterns than their associated commodity. For another, compared with an exposure to commodity futures, natural resource stocks demonstrate higher levels of correlation with the equity asset class while exhibiting significantly greater levels of volatility. Most importantly, they’ve historically been less sensitive to actual inflation. The result is that this intuitively appealing substitution of natural resources stocks for a futures-based commodity exposure leads to a less effective solution for both inflation protection and portfolio diversification.
Why do natural resource stocks behave differently from underlying commodities?
The notion that the shares of a natural resource company behave differently from the underlying commodity may seem puzzling. Why wouldn’t the price of copper, say, be the largest factor in the price movements of a copper producer? Yet there are fundamental differences between these two asset classes that cause their price levels to move independently. First, company-specific factors will influence an organization’s stock price but not the price of the underlying commodity. While stock prices will change to reflect company-specific changes in dividend policy, corporate governance, or earnings potential, there’s no reason to expect that this will have any impact on the associated commodity. For example, the Deepwater Horizon oil spill in the Gulf of Mexico in 2010 had a dramatically negative impact on BP’s share price due to many company-specific risks, including a change in management, fines imposed by the US government, and a revised dividend policy. But the oil spill had only a minor impact on the price of crude oil, which initially rallied following the incident as the market reacted to the negative supply shock.
Second, market-level factors that impact equity prices aren’t mirrored by commodity prices. These factors are categorically referred to as equity beta, which includes such things as the expansion or compression of earnings multiples, a negative regulatory environment for natural resource stocks, and the tendency for equity prices to move together as an asset class. For instance, during the onset of the COVID-19 pandemic in early 2020, general fear in the markets caused the price of the commonly followed NYSE Arca Gold Miners Index to decline over 25% through March 23. While a faintly similar return pattern can be detected in the price of gold, its return over the same period was a gain of 3%, with many investors actually fleeing to gold due to its perceived safe-haven status.
Third, many commodity-related companies are aware of their commodity exposure and may actively hedge away this risk using forward price agreements or other instruments. While this doesn’t completely immunize these companies from the price impacts of the underlying commodity, it diminishes the relationship between a company’s profitability—and, indirectly, its share price—and the price of the underlying commodity.