Why Oil, Gas And Mining Shares Are Not Contrarian Buys

What is the essence of contrarian investing? Well, it is about buying into a company when everyone else is selling, and when a company is far cheaper than your own view of how much the shares are worth.

So are firms like BP (LSE: BP), Shell (LSE: RDSB), Rio Tinto (LSE: RIO) and BHP Billiton (LSE: BLT) contrarian buys? Let’s dig a little deeper….

To understand what’s happening with commodity companies, you should look at commodities prices

Let’s focus on Rio Tinto first. The current share price is 2985p. Last February the company’s shares were priced at 3627p. The value of the business has fallen by 21% over the course of the past 12 months.

Analyse the fundamentals, and Rio Tinto seems reasonably priced: the 2014 P/E ratio is 9.6, rising to 11.6 in 2015. The dividend yield is 4.6%, rising to 5.1%. So surely the company is a contrarian buy?

Now this mining leviathan sells a range of metals and minerals, but it makes much of its money from selling iron ore. Check what’s been happening with the iron ore price, and you start to realise this may not be the obvious buy it first appeared.

The iron ore price peaked in 2011 at $187 per tonne. It now stands at $68 per tonne – that’s a fall of some 63%. The price of other commodities such as aluminium and copper have also been falling. What’s more, these falls seem to be part of a long-term downward trend. As I have argued in recent articles, this is all part of the end of the commodities supercycle that began at the turn of the century.

Never bet against a trend

So just how low could the iron ore price tumble to? Well, at the end of the last supercycle, iron ore traded in a range of $11 to $15 per tonne. Now I’m not saying that the price of this mineral will necessarily fall so low this time, but there is much more potential downside than upside to the current price.

So what happens to the mining company’s share price if the prices of its main products are on a downward trajectory? Well, in the late nineties, during the depths of the commodities bear market, Rio Tinto’s shares were valued, at one point, at 482p.

I could write similar things about BP. Brent crude peaked at $133 a barrel in 2008. It now stands at $50 a barrel. During the late nineties it traded as low as $10 a barrel. The share price of BP was just 100p at the time, compared with 398p currently.

So now I think you understand why oil, gas and mining shares are not, at this time, contrarian buys. The value of these companies is falling, but there is a real reason why this is happening.

During the nineties people were saying there was an endless supply of oil, they were buying gas-guzzling cars, and no one was thinking of investing in oil and mining companies. This was the time to buy into these companies. But at the moment the trend is still downwards.

Investing is all about predicting trends; it's about looking beyond the numbers to understand the future prospects of the business. That's why picking successful long-term investments is far from easy.

But our financial experts at the Fool have chosen a series of companies which they believe will stand the test of time. Want to learn more? Just click on this link to read "The Fool's five shares to retire on" – it's available free and without obligation.

Prabhat Sakya has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.