Winning With Consumable Commodities

Winning With Consumable Commodities

Steel can be made with iron ore or with recycled scrap metal. A coal-fired power plant can only be run with freshly mined coal, since there's no such thing as recycling used coal—once it's burned it's gone forever. Looking at commodities through this lens changes the way you look at miners and might just lead you to alter your portfolio if you own any natural resource companies.

Here now and forever
When it comes to commodities, metals quickly come to mind, including gold, silver, iron ore, copper, and many others. There is only a finite amount of each of these commodities in the Earth, which is good for companies that own notable reserves. However, the use of these materials generally doesn't destroy them, so they stick around and get recycled and reused.

That means that companies like Freeport-McMoRan Copper & Gold have to rely on ever increasing demand to ensure growth. As the company's name suggests, the bulk of its revenues come from copper and gold. This pair gets used in products ranging from computers to jewelry, most of which could be recycled.

Poof, it's gone
Compare that to Peabody Energy , which is among the world's largest coal producers with operations in the United States and Australia. It only mines coal and every ton it sells is burned away, creating heat and energy. There's no recycling burned coal, so there's just less and less in the world, a long-term benefit in the supply/demand balance. And, because it is a consumable commodity, there's a core underlying demand.

That's not to suggest that coal prices will rocket to the moon or that demand can't fall. The current coal market is proof that prices and demand are subject to change. For example, natural gas is displacing coal for electricity in the United States. However, any power plant that uses coal still needs a steady stream of it to operate—and gas is a long way away from replacing coal. That's why players like Peabody are struggling today, but have a brighter future than many believe.

Some more consumables
Oil and natural gas are also key consumable commodities. That's one of the reason why Freeport bought Plains Exploration & Production. Although mining still makes up the bulk of the business, it now gets around 25% of the top line from consumables, an important long-term business shift.

Another miner shifting toward consumables is BHP Billiton , which is investing billions to open a potash mine in Canada. And it, too, has been building an oil and gas business of late. Although iron ore is still the largest contributor to the company's results, representing over 50% of earnings before interest and taxes, consumable commodities make up about 30%. And when the new mine opens, consumables will make up even more of the total.

Of course there's no shortage of oil and natural gas companies in the world, with such giants as ExxonMobil offering direct exposure. However, Exxon doesn't have the same portfolio diversification as BHP or Freeport. That said, the oil major has a beta of around 0.9 compared to BHP's beta of 1.6. Beta is a measure of stock market sensitivity, with betas below one suggesting less volatility than the market and betas above one more. So there's a lot to consider when adding a commodity company to your portfolio.

Gone today, still gone tomorrow
Still, when looking at a commodity company, particularly miners, it pays to think about the consumable/non-consumable nature of its business. This isn't the only issue to consider, but it can provide an insight into both current and future demand dynamics. For example, massive growth in China's cities means more demand for steel and energy producing coal. When the cities are built, however, steel won't be as important any more—but coal will still be needed to help keep the lights on.

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Reuben Brewer has no position in any stocks mentioned. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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