Stock up on commodities

Stock prices of commodity producers are closely linked to underlying commodity prices. An analysis of the linkage and what it means to you

Commodities have taken investors on a double-digit price ride since 2016. In India, however, investors who are drawn to commodities have only one option — the futures market.

The issue with a futures contract is the high leverage — you pay a small margin money but get exposed to price volatility. You also have to keep coughing up extra margin money based on market price and if you fail to roll-over your contract on expiry, you may end up with tonnes of the commodity in your hands.

Buying in the physical market is an option, but there is the hassle of storage. You may also not be able to find a buyer when you want to exit and if it’s an agri commodity with a limited shelf life, you may end up in loss.

In India, the best route to play commodities is through commodity stocks, i.e., companies that produce commodities and benefit from the rally in the price of the commodity. Say, you want to invest in oil; oil exploration companies such as Oil India and ONGC are a good proxy.

Some commodity companies give a good dividend too, which is an added attraction.

However, commodity stocks are not for the faint-hearted. Even a 5-10 per cent price correction in the commodity may see the stock price collapse. So, within one quarter, a commodity company can move from profit to loss.

But if you are game for action, here are our insights into commodities, their connection with stock prices and how you can place your bets in this space.

In each commodity, the price of the benchmark spot or futures contract in the international market (oil- Brent spot; steel- China HRC steel spot; aluminium - LME aluminium spot) has been taken to study the correlation with stock prices. In sugar alone, where domestic prices have diverged from the trend in the international market, NCDEX spot prices have been considered.

ONGC, Oil India vs. Global Crude oil

Link: Positive correlation

The PSU hydrocarbon exploration companies ONGC and Oil India are a good proxy for crude oil in an investor’s portfolio. Oil prices have a direct bearing on the profits and cash flows of these companies. The correlation between these stocks and the oil price (in $ terms) is at 0.7 now (last one year).

In the past, the high ‘under-recoveries’ of the oil marketing companies used to spoil the party for the upstream companies when oil prices moved up. The two PSU oil explorers compensated oil marketers for their under-recoveries through product discounts.

In the period between May and December 2013, for instance, when crude prices moved up 12 per cent (up 22 per cent in rupee terms), the under-recoveries on diesel for oil marketing companies shot up from ₹3.5/litre to ₹10.48/litre. So, despite oil prices moving up, the stock prices of upstream oil companies ONGC and Oil India dropped 10-15 per cent. The correlation between crude oil (in rupee terms) and the two stocks was a negative 0.7-0.8 in that period.

Interestingly, when crude oil prices started to move down from June 2014 and hit a low of $50/barrel in January 2015, a drop of 56 per cent (both in dollar and rupee terms), the stocks of Oil India and ONGC saw a drop of only 7-15 per cent. The stocks didn’t fare as badly as oil, because the under-recoveries reduced with diesel prices being de-controlled.

However, subsequently, as oil prices slipped further to $30/barrel in January 2016, the stocks of ONGC and Oil India were also equally hurt as the benefits from lower under-recoveries were mitigated by the negatives of lower realisation.

Best oil plays: With petrol de-controlled in June 2010, diesel in October 2014 and LPG subsidy to stop by March 2018, the stocks of upstream oil companies may now more closely track prices of crude oil. So, ONGC and Oil India will become completely a play on oil prices.

The market has been unhappy with Oil India in recent times as its profits plunged significantly in the March 2017 quarter due to royalty expenses on settlement of the disputes with the Gujarat and Assam governments. But, given that it is a one-time settlement, and that the overhang from the contingent liability is now gone, the performance from here should depend on the core business and realisations on oil and gas.

The stocks of oil refiners and marketers Indian Oil, HPCL and BPCL may not be a good proxy for oil, as the dynamics of their business is different. The performance of these companies is dependent on the refining margins (the difference between the price of its products and the cost of crude oil).

Risks: As crude prices vacillate, given an uncertain geopolitical environment and the changing demand-supply balance, the margins and thus the profits of the oil companies will be volatile. If you are making a wager on oil stocks, you should be ready to stomach this risk. Also, since both the oil explorers are PSU companies, there is always the risk of their being forced into sub-optimal investments by the government.

Both ONGC and Oil India get a portion of their revenue from natural gas, where margins are determined by the government’s pricing formula. So, any time the deal is unfavourable for the companies, the market may beat down the stocks as it will impact their overall performance.

Keep an eye on policy developments too. If oil prices rise sharply from here, the oil companies may be in a tight spot again as the government may want to bring back subsidies.

The rupee-dollar exchange rate is also crucial here, and worth a watch.

Balrampur Chini Mills, Dwarikesh Sugar vs. Global Sugar

Link: Negative correlation

Domestic and international prices of sugar do not move in sync now. Global sugar prices have been in a bear market since 2011 (excluding a brief rally between February and October in 2016). But the downtrend in sugar prices in the domestic market ended in 2015 itself. From about ₹23/kg in August 2015, prices (NCDEX spot prices) hit ₹37/kg in August 2016 and are now ruling at about ₹38/kg.

The correlation between international sugar prices (sugar contract 11) and stocks such as Balrampur Chini Mills, Dwarikesh Sugar and Shree Renuka Sugars is between negative 0.7 and a low positive 0.2 now (last one year).

So, if you intend to invest in stocks of Indian sugar mills, you have to be in the know of developments in the domestic sugar market.

The correlation between NCDEX spot sugar prices and Balrampur Chini Mills and Dwarikesh Sugars has been at about 0.8-0.9 since August 2015.

Over the last one year, the tight supply situation aside, the pro-industry policy measures from the government have helped domestic sugar prices decouple from the trend in global markets. The mandate in September 2015, when sugar prices were ruling low, for export of 4 million tonnes of sugar in 2015-16 sugar year, the cane production subsidy announced in December 2015 (of ₹4.5/quintal of cane crushed by mills), and recently, the import duty increase on sugar from 40 per cent to 50 per cent, have all helped.

Best sugar plays: When sugar prices in the domestic market rise, you will find the stocks of sugar mills such as Balrampur Chini Mills, Dwarikesh Sugars, EID Parry and Bannari Amman Sugars too moving up.

Investors who want to bet on sugar stocks now may look at mills from UP such as Balrampur Chini Mills, Dwarikesh Sugars, Triveni Engineering or others.

Risks: While sugar production is estimated to be higher this year, with low opening stock for 2017-18 sugar year (October-September), the Centre can any-time change its policy stance and allow import of sugar if there is shortage. So, traders should play these stocks with stop losses given their high-beta.

For any rise or fall in price of sugar, the impact on the price of sugar stocks is sharply higher. For instance, in the recent run up from mid-November 2016 and now, while sugar prices (NCDEX spot) have gone up by 3 per cent, the stock of EID Parry is up 17 per cent, Balrampur Chini up 42 per cent and the stock of Dwarikesh Sugars has rallied 178 per cent.

Similarly, between August 2012 and February 2014, when sugar prices in the domestic market dropped by about 18 per cent, the stock of Balrampur Chini Mills was down 22 per cent, EID Parry lost 41 per cent and Dwarikesh Sugar was down 58 per cent.

In down cycles, sugar companies see margin erosion very rapidly. As realisations begin to drop while costs remain constant, inventory losses mount, debt goes up and profitability takes a hit.

Investors in sugar stocks are quick to de-rate them, but they also re-rate them just as quickly when the cycle turns. Generally, in sugar, 5-6 years of losses are followed by 1-2 years of good profits for mills.

The other risk with sugar stocks is the uncertain regulatory environment. Any increase in FRP (fair and remunerative price – the minimum guaranteed cane price to farmers) by the Centre or a higher SAP (state advised price) in UP, may see stocks of mills getting beaten down.

In May this year, for instance, as the Centre announced an 11 per cent hike (to ₹255 per quintal) in FRP for cane, the stocks of Dwarikesh Sugars, EID Parry, Bannari Amman Sugars and Balrampur Chini Mills lost out in the next one month.

Tata Steel, JSW Steel and SAIL vs. Global Steel

Link: Positive correlation

The fortunes of steel companies are tied with the price of steel.

The benchmark HRC China Steel prices have moved up from $280/tonne in December 2015 to close to $600/tonne now. The stocks of Tata Steel and JSW Steel have moved up 120-130 per cent in this period. SAIL is up 30 per cent.

Considering the price data since 2008, we find that the correlation between the price of steel (global) and those of stocks of Tata Steel, JSW Steel and SAIL has been always about 0.7-0.9. SAIL has turned an under-performer in the market only in the last two years. Continued delay in ramp-up of new capacities and growing operational inefficiency have seen the market mark-down the stock.

Best steel plays: Analysts are expecting global steel prices to only move up from the current levels as global demand strengthens and China continues to shut capacities. Currently, domestic prices are lower than global prices and there is room for prices to go up given imports are too expensive and, domestically, steel plants are running at utilisation levels of 70-75 per cent.

Investors eyeing steel stocks could consider Tata Steel or JSW Steel. The long-term prospects of the domestic steel sector look good now, with demand set to increase following adoption of the National Steel policy (estimates are that demand may grow by about 7-7.5 per cent a year till 2030), no major greenfield capacity addition in the next three years but for SAIL’s, and the high industry capacity utilisations (70-80 per cent).

Stocks with large debt problems, including Bhushan Steel, Jindal Steel and Power, Monnet Ispat and others, are better avoided. Though these stocks have had a good run in the last one year on rumours of acquisition by large players, they may be a risky play now. SAIL is also not a good proxy for steel now, as operational concerns weigh on the stock.

Risks: Now that the international steel prices are above the MIP (minimum import price — $489/tonne on HR coil imports from China), the anti-dumping duty imposed on 47 steel products in May 2017 for five years has become ineffective.

But if global prices correct sharply and move below $489/tonne, then steel prices in India will get support from the duty and prices will not fall. So, keep an eye on global prices, if prices take an about-turn, your trading strategy may fail as domestic steel prices or stocks may not fall in line with global prices.

It doesn’t look like the Centre will any time soon roll back its protective policies for the steel sector as it is keen to resolve the NPA issues of banks.

Hindalco, NALCO vs. Global Aluminium

Link: Positive correlation

There has always been a strong relationship between global aluminium prices and the aluminium stocks traded in domestic bourses. Between November 2015 and now, while LME aluminium prices have rallied 40 per cent to about $2,037/tonne, the stocks of aluminium manufacturers Hindalco and NALCO, too, have had a spectacular rally.

While Hindalco has rallied 185 per cent to about ₹221 now, National Aluminium Company (NALCO) is up 58 per cent to ₹63. The correlation between the two stocks and the aluminium price in the period has been 0.93.

During the commodity’s down-cycle too, the correlation has been intact. Between April 2011 and January 2014, when LME aluminium prices corrected 40 per cent to $1,663/tonne, the two stocks showed a correlation of 0.8-0.89 with aluminium price.

Best aluminium plays: China has shut down a number of its aluminium capacities in the last 1-2 years for environmental protection and to reduce excess supply. Going ahead, analysts are positive about aluminium prices as the metal’s deficit is likely to widen in 2017.

Investors eyeing aluminium can look at Hindalco or NALCO on equity bourses. For Hindalco, its efforts to reduce costs and increase the share of value-added products should help margins and profitability in future.

Vedanta could also be considered but it has other businesses too — zinc, iron ore and power — and is not a good proxy for aluminium. It also has a finger in the oil pie, with the acquisition of Cairn India.

Risks: Like other commodity stocks that we have seen above, in aluminium too, investors need to keep an eye on government policies — on import/export and mining. One should also watch the rupee’s movement vis-à-vis dollar as the currency can change the value of imported aluminium.

The key risk for aluminium price is the reopening of some of the high-cost plants in China, now that prices have gone up.

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