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Investors in Commodity-Related Companies Need To Be Aware Of This Risk

The business of producing or trading in commodities have always been volatile.

The fact that no player in the market has the ability to control the pricing of the underlying commodity they’re involved with makes it extremely challenging for any commodity-related business.

Tough steel

Steel manufacturer BlueScope Steel Ltd is a great example of how difficult it can be to be a commodity producer. Even though BlueScope Steel is the largest company of its kind in Australia, the Wall Street Journal had reported earlier today on the firm’s warning of weaker profit margins in the coming months.

This comes amid sharp decline in steel prices. According to the same WSJ article, “[t]he spot price of Chinese flat-steel exports have tumbled 18% since the start of the year.” And to make matters worse, there’s still an oversupply of the metal from emerging markets such as China and India.

These dynamics – especially the outlook for lower margins – have caused BlueScope Steel’s shares to fall by 8% yesterday despite posting its highest half-year net profit in the past five years.

The not-so-golden oil

Palm oil producers are another good instance for the struggles commodity producers can face.

Despite having one of the largest oil palm businesses in the world, Golden Agri-Resources Ltd (SGX: E5H) has been turning in poor economic performances over the past few years.

As my colleague Chong Ser Jing noted previously, the “palm oil producer’s returns on equity have deteriorated significantly since 2008, and came in at just 3.6% in 2013.”

This has happened despite Golden Agri’s borrowings having ballooned over the same time frame (theoretically, a company can increase its returns on equity if it takes on more borrowings). The above dynamics are apparent in the chart below which is produced by Ser Jing:

Golden Agri-Resources' return on equity (ROE), total cash, and total borrowings

Source: S&P Capital IQ

Unfortunately, there really isn’t much the company can do to improve its fortunes as the selling price of its product – crude palm oil (CPO) and its derivatives – is dictated by the market and all the company can do is to try to control its operating costs.

Ser Jing had also previously noted that the price of CPO had fallen steadily by nearly 44% from February 2011 to December 2014. This had resulted in the share price declines of many palm oil producers over the same time frame and caused many of those companies to experience difficulty in generating growing operating cash flow.

Gaining scale without profits

Noble Group Limited (SGX: N21) might not have much of a presence in the production of commodities, but it’s still intimately tethered to the commodities space given that it’s in the business of managing global supply chains for agricultural, industrial, and energy products.

It’s a tough business to be in. Despite seeing its revenue more than triple in four short years from US$31 billion in 2009 to US$98 billion in 2013, Noble Group’s profit actually fell by nearly two-thirds from US$556 million to US$214 million.

Noble's return on equity (ROE), total cash, and total borrowings

Source: S&P Capital IQ

The chart above, courtesy of Ser Jing again, gives us a good overview of how Noble Group’s business-economics have deteriorated over the years given the falling returns on equity despite the growing debt levels.

Foolish Summary

So, the commodities business is tough and unforgiving.

As you can see, companies which are in the commodities world see the health of their business being very much tied to the prices of the commodities they’re dealing with, prices which no one has full control over.

Investors interested in commodity businesses need to be aware of this risk when investing in such companies.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim doesn’t own shares in any companies mentioned.