After university, finance and finance-related majors often find themselves working as a junior analyst at an investment bank. In this capacity, they will often do some rudimentary analysis of cash flows, balance sheets, and so on. They will also spend a lot of time doing presentations on business models, market growth, and the qualities that make one company better than its competitors. This is all great training for future work in public equities, private equity, venture capital, hedge funds, and so on.
But none of this will be of any value for trading in commodities.
Commodities operate on very different principles. To understand why, we must first understand how a commodity is different from the product of a differentiated business. Commodities are by their very nature the same. Oil is oil, no matter who produces it or where. Sure, there are varying qualities of oil—some oil is considered higher quality—but this is a very marginal difference that has little impact on the spending decisions of the majority of oil consumers. Companies and consumers will usually look for the cheapest oil or gas they can get, and they don’t really care where it was made or who is selling it to them.
This is very different from, say, cola. There are people with Pepsi tattoos because they love the company’s product so much. When’s the last time you saw a tattoo of a barrel of crude oil?
For this reason, pricing commodities has little to do with unique market differentiation and much more to do with macroeconomic trends. OPEC’s moves, geopolitics, trade embargoes, oil rig growth, population growth—these are the things that impact a commodity’s price more than anything else. And these are the kinds of things fundamental financial analysts are not trained for.
This is why students and analysts must get a firm understanding of what they want to work on in the future. Specializing in energy or in commodity trading is a great niche—but it involves a different skill set, knowledge base, and sensibility. Commodity traders and analysts also have very different clients, working environments, and career tracks.
What about commodity-based equity analysis? Surely analysts who study Chevron (CVX) and British Petroleum (BP) have more in common with equity analysts than commodity analysts, right?
Not exactly. The close directional correlation between commodity firms’ stock prices and commodity prices themselves means there is good reason for commodity stock analysts to be well trained in commodity movements and base their valuations of commodity companies based on their predictions of commodity price changes. To demonstrate this, let’s look at the last 10 years’ returns for WTI oil futures and CVX:
Note the correlation? But also note the higher volatility in WTI prices—the spikes are higher and the lows lower, which means the return on CVX has been much better this year than on oil, while the return on WTI futures was much better in 2008-2009 than on CVX.
So why would you choose to be an analyst for commodities versus an equity analyst working on the energy or commodity space?
There are a couple reasons. Firstly, commodity experts often deal directly or indirectly with corporate clients who use commodity options and futures to hedge their own businesses. For instance, Southwest Airlines (LUV) might want to buy oil futures contracts to hedge their future oil needs; thus if there is a spike in oil, they can avoid paying those temporarily higher prices. But how many contracts should they buy and when should they buy them? What strike price should they target? The answers to these questions have little to do with risk tolerance and expected future returns—they relate directly to LUV’s current energy needs, its flight schedule, and its current fuel reserves. In other words, we would need to cater a custom investment plan relative to LUV’s operations and our expectations of how oil prices will change.
This is a very different job than trying to produce alpha for a hedge fund. It’s also less remunerative and arguably more complicated. Some might find it more fun or more challenging; others might find it less interesting than doing due diligence on existing firms for equity research.
That’s one of the joys of finance: it is a complicated and diverse industry with many different potential roles for budding workers. But it’s also important for budding workers to keep in mind the different skills they will need depending on what pocket of finance is best for them.