Accept No Substitutes: Why Natural Resource Stocks
Are a Bad Way to Get Commodity Exposure

Abstract

In recent years, more investors are considering an allocation to commodities, typically motivated by a desire to tap the inflation fighting or diversifying properties of this asset class. However, many investors (and consultants) argue that this commodity exposure can be accessed by owning a portfolio of natural resource stocks. The argument typically includes the notion that the largest driver of the price of these stocks is the price level of their underlying commodity (e.g., an energy company’s share price is largely driven by the price of crude oil). This intuitive argument has not held historically, however. In fact, price movements of natural resource stocks exhibit dramatically different return patterns from their associated commodity in both the long and short term. As a result, natural resource stocks demonstrate substantially less correlation with inflation than commodities. Also, versus an exposure to commodity futures, natural resource stocks demonstrate higher levels of correlation with the equity asset class while exhibiting significantly higher levels of volatility. This finding has important ramifications for the overall return and volatility of an investor’s portfolio. All in all, the intuitively appealing substitution of natural resource stocks for a futures-based commodity exposure results in a less effective solution for inflation protection and diversification.