BASIC MATERIALS

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Chapter 7 — BASIC MATERIALS
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BASIC MATERIALS

BASIC MATERIALS

Basic Materials is one of the industrial sectors that includes companies that are involved with the discovery and refinement of raw materials. It includes companies that are involved with metals, chemicals, and forestry products. It is sensitive to changes in commodity prices and the business cycle. Economies of scale are important for this sector.

Basic Materials

ENERGY (OIL & GAS)

Energy, is one of the Basic Materials, which is supplied by oil and gas on 2/3 and often categorized into its own sector. You can think of it as its own sector if it makes your analysis easier.

Because oil & gas companies are often heavily integrated, the industry includes four different segments: Exploration and Production (finding); Pipelines (transport), Refining; and Marketing (gas stations). The most profitable and promising segment is exploration and production.

The key to investing in this industry of Basic Materials is the price of crude oil. It is highly cyclical, but the cycles do not last long. The effect of this is that when oil companies appear expensive (high P/E), it is often because the price of oil is unusually low. When the price of oil rebounds, the company’s true value is revealed.

Crude oil prices are also heavily influenced by the OPEC cartel, so it is worthwhile to review OPEC’s strength and their target for oil prices.

Because oil & gas is a commodity business, economies of scale are a major factor for success. Most oil companies are very large, very old, and very profitable. As an investment, you will want to see a debt/equity ratio of less than 1, consistent profitability over a period of 5 years, and a nice dividend.

CHEMICALS

the next component of Basic Materials is Chemicals. The part of the chemicals industry that falls within the basic materials sector has three major segments: Basic Chemicals, which includes plastic resins and dyes; Specialty Chemicals such as adhesives, sealants, lubricants, and water treatment; and Agricultural Chemicals such as fertilizers.

The chemicals industry is basically a refining industry. Most chemical products are produced from further refinement of crude oil or natural gas, which is then mixed with other compounds. An increasing number of chemicals are also produced by organic (biological) processes.

Specialty chemicals also heavily influenced by commodity prices and is very cyclical. The chemicals industry benefits from research and development. Economies of scale exist for most chemical products, but chemical companies that do not actively spend on R&D will eventually lose ground.

As an investor, evaluating research and development is probably the most important part of the chemicals industry. Since chemicals are influenced by commodities, you should be able to find solid, stable returns in very large companies (similar to what is offered by oil & gas), but the best returns come from R&D spending on specialty chemicals. The patents protecting these R&D investments provide a critical competitive advantage.

MINING, HARVESTING, AND MILLING

Mining and harvesting are incredibly important representatives of Basic Material. Almost everything that we use today came from raw materials that had to be mined or harvested from somewhere. This includes anything from the traditional currency metals such as gold, silver, and copper; industrial raw materials such as bauxite, iron, and tin; or rocks such as coal, granite, and marble. Paper and wood products originally come from harvested forests.

Mining companies are almost entirely dependent on commodity prices, and because they so closely follow commodity price cycles, they are often considered an alternative to directly investing in commodities. They are primarily used as a hedge against inflation, but finding the lowest cost producer is a way to offset declines in commodity prices.

Milling is one step farther than mining. It is the process of taking these raw materials and refining them into a form that can be used to produce finished goods. This can be anything from steel and aluminum to plywood or cardboard.

As a business, the returns in the milling industry have not been very good. While it is difficult to build new milling plants, there is an intense competition that keeps profits so low that even the lowest-cost producer can sometimes struggle to remain profitable.

The best potential investments in this sector might be found where there is a geographic advantage (for example, if there is only one paper mill within a 100-mile radius). Like the chemicals industry, there are also some specialized production facilities, but they are very rare and hard to find unless you are an expert in the industry.

 

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