Commodity Currencies

• The Bottom Line: Commodity currencies are the national currencies of countries whose economies heavily depend on the export of raw materials, making their value dance to the rhythm of global commodity prices.
• Key Takeaways:
• What it is: A currency whose value is strongly correlated with the price of one or more key commodities (like oil, copper, or iron ore). Examples include the Australian Dollar (AUD), Canadian Dollar (CAD), and Norwegian Krone (NOK).
• Why it matters: For a value investor, understanding commodity currencies is crucial for assessing the hidden risks and earnings volatility of companies operating in or sourcing from these resource-rich nations. It directly impacts a company's intrinsic_value.
• How to use it: Use the concept not to predict currency movements, but to stress-test an investment thesis and demand a larger margin_of_safety for companies exposed to the boom-and-bust cycles of commodities.

Imagine a small town, “Ironville,” whose entire economy is built around a single, massive iron ore mine. The town's local currency is the “Ironville Dollar.” When global demand for steel is booming, the price of iron ore soars. The mine in Ironville is shipping out tons of ore and receiving a flood of foreign money (let's say U.S. Dollars) in return. To pay its local workers and suppliers, the mine must exchange these U.S. Dollars for Ironville Dollars. This huge demand for the local currency causes its value to rise sharply. Suddenly, an Ironville Dollar is worth more U.S. Dollars than before. Life is good. But when a global recession hits, construction slows, and the price of iron ore plummets. The mine's revenues dry up. The flood of foreign money turns into a trickle. There's far less demand for the Ironville Dollar, and its value tumbles. That, in a nutshell, is a commodity currency. It's a national currency that behaves a lot like the “Ironville Dollar.” Its country's economic health is so tightly linked to the export of natural resources—oil, gas, copper, iron ore, coal, agricultural products—that the currency's value rises and falls with the global prices of those commodities. The most well-known commodity currencies, often called “comdolls,” include:

• The Australian Dollar (AUD): Heavily influenced by iron ore, coal, and natural gas prices.
• The Canadian Dollar (CAD): Often called the “Loonie,” its fate is closely tied to the price of crude oil.
• The New Zealand Dollar (NZD): Nicknamed the “Kiwi,” it's sensitive to the prices of dairy, meat, and wood products.
• The Norwegian Krone (NOK): Deeply connected to North Sea crude oil prices.
• The Russian Ruble (RUB): Driven by oil and natural gas.
• The Chilean Peso (CLP): Its value is a strong reflection of the global price of copper.

These currencies are a direct reflection of the world's appetite for raw materials. When the global economy is humming and building, demand for these materials is high, and the commodity currencies strengthen. When the global economy sputters, demand wanes, and these currencies weaken. For an investor, they are a real-time barometer of global economic health and a critical factor in analyzing businesses tied to these nations.

“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.” - Warren Buffett ¹⁾

A value investor seeks to buy wonderful businesses at fair prices. The core of this process involves calculating a company's intrinsic_value based on its ability to generate predictable, growing cash flows far into the future. Commodity currencies throw a giant wrench into the predictability of those cash flows. Here’s why this concept is not just for currency traders, but is fundamental to value investing:

• It Reveals Hidden Earnings Volatility: Imagine you've found a wonderful Canadian manufacturing company. It has a great brand, loyal customers, and a strong balance sheet. However, it pays all its expenses (salaries, rent, local supplies) in Canadian Dollars (CAD) but earns 80% of its revenue in U.S. Dollars (USD). When oil prices are high, the CAD strengthens against the USD. Suddenly, every U.S. Dollar of revenue converts into fewer Canadian Dollars. Its revenue in its home currency shrinks, and its profit margins get crushed, through no fault of its own operations. This currency effect can make a stable business look wildly cyclical, making it much harder to confidently forecast future earnings.
• It Forces a Deeper Look at Costs: Conversely, consider a European retailer that sources many of its products from New Zealand. If dairy prices fall, the New Zealand Dollar (NZD) will likely weaken. For the European retailer, this is great news. Their Euro can now buy more NZD, making their inventory cheaper and potentially boosting their gross_margin. Understanding this link helps you see a potential tailwind (or headwind) to a company's profitability that isn't immediately obvious from its financial statements.
• It Expands Your circle_of_competence: You cannot competently analyze a major Australian mining company without understanding the relationship between the AUD and iron ore. You cannot properly value a Norwegian salmon farmer without understanding the NOK and oil prices. Ignoring the macroeconomic stage on which a company performs means you are missing a huge piece of the puzzle. Acknowledging the role of commodity currencies is a prerequisite for including such companies within your circle of competence.
• It Demands a Wider margin_of_safety: Because commodity currencies introduce a layer of volatility and unpredictability that is outside of a company's control, a prudent investor must demand a larger margin of safety. If your valuation of a company is highly sensitive to the price of oil, you must buy it at a significant discount to your calculated intrinsic value. This discount is your protection against a sudden, sharp downturn in oil prices that could decimate the company's earnings and stock price. It's a risk premium for dealing with the inherent instability of commodity-driven economies.

In short, commodity currencies are a powerful force of macroeconomics that can directly impact a company's bottom line. For the value investor focused on the long-term fundamentals, understanding this force is not optional; it's a core part of rigorous risk assessment.

The goal for a value investor is not to become a currency speculator trying to predict the future direction of the Australian Dollar. That is a fool's errand. The goal is to understand the risks and opportunities that currency fluctuations create for a specific business you are analyzing.

Here is a simple framework to incorporate this concept into your investment analysis:

1. Step 1: Identify the Exposure. When looking at a company, ask these questions:
   • In which country is the company domiciled and what is its primary currency for reporting and paying expenses (like salaries)?
   • From which countries does it generate the majority of its revenue?
   • From which countries does it source its key raw materials or products?
   • If any of these answers involve a commodity-driven economy (like Canada, Australia, Chile, etc.), you have identified a potential exposure.
2. Step 2: Analyze the “Currency Mismatch”. Look for a difference between the currency of a company's revenues and the currency of its costs.
   • Negative Mismatch (Margin Squeeze Risk): This occurs when a company earns in a foreign currency (e.g., USD) but pays costs in a commodity currency (e.g., CAD). A strengthening CAD will squeeze profit margins.
   • Positive Mismatch (Potential Tailwind): This occurs when a company earns in a strong, stable currency (e.g., EUR) but has significant costs in a commodity currency (e.g., NZD). A weakening NZD will lower its cost base and boost margins.
3. Step 3: Check for Mitigation Strategies. A smart management team is aware of these risks. Look in their annual reports (in the “Risk Factors” or “Management Discussion & Analysis” sections) for evidence of:
   • Currency Hedging: Do they use financial instruments like forward contracts to lock in exchange rates? This can smooth out short-term volatility but doesn't eliminate the long-term risk.
   • Operational Hedging: Do they have a “natural hedge”? For example, a company that both earns revenue and has significant costs in the same foreign country is naturally hedged.
   • Geographic Diversification: Is the company so globally diversified that a swing in any single commodity currency has a muted impact on its overall results?
4. Step 4: Stress-Test Your Valuation. This is the most crucial step. When you build your financial model to estimate a company's intrinsic_value, don't just use the current exchange rate. Create a “worst-case” scenario.
   • Ask yourself: “What happens to this company's earnings and my valuation if its key commodity currency strengthens by 20%? What if the underlying commodity price is cut in half?”
   • If the business is still profitable and your thesis still holds under this pessimistic scenario, you've found a resilient company. If the valuation collapses, the company may be too speculative and lack a sufficient margin_of_safety.

The result of this analysis is not a simple “buy” or “sell” signal. It's a deeper understanding of risk.

• A high exposure to a commodity currency is a red flag indicating volatility, not necessarily a bad business. Some of the world's best resource companies have this exposure, but they are managed by savvy operators who understand the cycles.
• The ideal situation is finding a company with a durable economic_moat that is insulated from these swings. For example, a software company based in Canada that earns revenue globally in USD but also pays its developers in high-demand, globally-priced talent might be less affected by a rising CAD than a traditional manufacturer.
• Look for opportunities during commodity downturns. When a commodity price crashes, the market often panics and sells off everything associated with that country, including high-quality businesses whose long-term prospects are still excellent. A weak currency and pessimistic sentiment can create the very entry point a value investor waits for.

Let's compare two hypothetical companies to see this principle in action: “Canuck Oil Drills Inc.” (based in Alberta, Canada) and “American Airlines” (based in the USA). Both are heavily impacted by the price of oil, but in vastly different ways mediated by the Canadian Dollar (a commodity currency).

Scenario 1: Oil Price Soars (e.g., to $120/barrel)

• Impact on the Canadian Dollar (CAD): As a major oil exporter, Canada sees a massive influx of foreign capital. The demand for CAD skyrockets, and it strengthens significantly against the USD. Let's say the exchange rate goes from 1.30 CAD/USD to 1.10 CAD/USD.
• Impact on Canuck Oil Drills Inc.: This is a mixed blessing.
  • Revenue: Their oil is worth more in USD, which is great.
  • Costs & Margins: The problem is their costs are in CAD. Every USD of revenue they earn now buys them fewer Canadian Dollars to pay their workers. Their profit margin gets severely squeezed. A 15% appreciation in the CAD can wipe out a huge chunk of their profitability, even with high oil prices.
• Impact on American Airlines: This is a double whammy.
  • Their single biggest cost, jet fuel, has skyrocketed. This directly crushes their operating margin.
  • The CAD/USD exchange rate has little direct impact on them. Their primary pain comes directly from the commodity price itself.

Scenario 2: Oil Price Crashes (e.g., to $40/barrel)

• Impact on the Canadian Dollar (CAD): The flow of oil money into Canada dries up. The CAD weakens dramatically against the USD, perhaps to 1.45 CAD/USD.
• Impact on Canuck Oil Drills Inc.:
  • Revenue: Their revenue in USD terms has collapsed. This is very painful.
  • Costs & Margins: However, the weak CAD provides a crucial cushion. Every USD they do earn now stretches much further, converting into more CAD to cover their local costs. This “currency shock absorber” helps them survive the downturn better than a company whose costs are also in USD.
• Impact on American Airlines: This is a huge benefit.
  • Their main input cost, jet fuel, has plummeted. This provides a massive tailwind to their profitability. Their margins expand significantly.

Value Investor Takeaway: A value investor analyzing Canuck Oil Drills must recognize that its profitability is a function of both the oil price and the CAD/USD exchange rate. To invest safely, they would need to model earnings at various oil prices and exchange rates and demand a very large margin_of_safety to protect against the inherent volatility. Conversely, when analyzing American Airlines, the primary focus is the direct impact of fuel costs, a simpler (though still challenging) analysis. The commodity currency adds a complex, second layer of risk and volatility to the Canadian company.

(Of using this concept in your investment analysis)

• Deeper Risk Assessment: It forces you to look beyond the company's financial statements and consider critical macroeconomic risks that can have a material impact on earnings.
• Reveals Hidden Cyclicality: It helps you understand why a seemingly stable business might have surprisingly volatile earnings, allowing for more conservative and realistic forecasting.
• Highlights Management Quality: Analyzing how a company's leadership team discusses and manages currency risk can be a powerful indicator of their overall competence and foresight.
• Uncovers Contrarian Opportunities: During commodity busts, entire national stock markets can become undervalued. Understanding the dynamics can help you find high-quality businesses that have been unfairly punished by association.

• The Folly of Forecasting: The single biggest pitfall is thinking this analysis allows you to predict currency movements. It does not. A value investor's job is to prepare, not to predict. The goal is to understand the range of outcomes and ensure you can survive the worst case.
• Oversimplification: While oil is crucial for Canada, its economy is also highly diversified with strong technology, banking, and manufacturing sectors. Do not mistake a commodity-influenced economy for a commodity-dependent one. The degree of dependency matters.
• Correlation is Not Causation: A currency's value is influenced by many factors, including interest rates, inflation, political stability, and capital flows. While a commodity's price may be the primary driver, it is never the only one.
• Ignoring Hedges: Failing to check if a company is actively hedging its currency exposure can lead you to overestimate the risk. A well-hedged company can smooth out the bumps, at least in the short term.

• margin_of_safety
• intrinsic_value
• circle_of_competence
• risk_management
• macroeconomics
• economic_moat
• inflation