This year has so far been a promising one for commodities. Where should investors hunt for profits? John Stepek chairs our Roundtable.
John Stepek: Last year was terrible for miners and commodities, but so far 2014 has been much more promising. Can the good times continue?
Will Smith: Commodities have been in a bear market since 2011, and equities in the sector have hit trough valuations – so I think this is a genuine upturn.
Neil Gregson: The sector is under-owned and has been for a while – there’s a big disparity between the performance of commodities and other sectors. Also, as is fairly typical, we’re in the ‘self-help’ phase of the commodity cycle.
The companies have got religion – they’re talking about shareholder value and cost-cutting, and capital spending is falling, so we’re getting higher free-cash-flow generation and dividends.
John: Is this typical of mining cycles? Miners mess it up while prices are rising, and only get a grip as prices fall?
Neil: Unfortunately it is. But everybody’s complicit. When prices are going up, investors ask: “Why aren’t you growing? Go and build some more mines!” So everybody does it at the same time, meaning labour and materials costs go up, and project timelines get pushed out. But the corrective action being taken now is building a base for the next up-cycle – supply is being cut as new projects are scrapped, so the market will tighten again.
Tom Nelson: It’s similar in the oil sector. The European integrated oils (the ‘oil majors’) are later coming to the ‘self-help’ game than miners, in terms of cutting spending and focusing on their best assets. But the stage is set.
Valuations are attractive, whether you look at earnings, cash flow, or yields. Energy stocks outside the US look particularly compelling. We’ve had strong performances from US explorers and oil service stocks, and underperformance from those elsewhere.
John: Is that due to excitement over shale?
Tom: Unconventional sources have driven it, yes. But in our view this is starting to slow down, particularly on the shale oil side, making international opportunities increasingly interesting. The repeatability and consistency of these reservoirs is lower than forecast a year to 18 months ago. The Bakken (in North Dakota) and the Eagle Ford (in Texas) continue to be prolific. But outside those core areas, reservoir properties aren’t consistent.
Initial production rates have been lower, and decline rates (the rate at which the well is depleted) higher. I think this will continue. Almost every US explorer missed its fourth-quarter production estimates. That was partly down to weather and infrastructure issues. But we firmly believe the growth we’ve seen from shale oil in the US will begin to slow. That may surprise some people.
Alex Mirtchev: We’re focusing on gold. We haven’t held it since last March, and we’re not entirely convinced yet, but it’s seen its best start to the year since 1983, so we’re trying to work out where it might go from here. We’re not convinced there is that much upside, given the headwinds of tightening monetary policy. We’re also relatively bullish on the US dollar, which is not favourable for gold.
But on the upside, outflows from gold exchange-traded funds (ETFs) have stabilised after about a third of the money in them was pulled out last year. On the physical side, consumer demand in China and India has gone through the roof. Meanwhile, marginal production costs are around $1,200 an ounce, so that’s a useful floor to have.
John: What about the gold miners?
Will: Even compared to other miners, gold miners generally fall prey to growth for growth’s sake. But even they’re getting costs under control again. They’re not mining ounces for the sake of it – they’re only trying to mine the profitable ounces.
Neil: They’ve been dragged there kicking and screaming. On gold, I agree about the headwinds, but nobody knows what all this money printing is going to do in the long run. So we buy the argument of gold as insurance, as a hard currency.
The trouble with gold miners is that over the next three years an average figure of plus or minus 10% on today’s gold price will be the difference between 70% of them going bust and 90% surviving. So you’ve got to be careful on the equity side.
Back in the 1990s, during the big gold bear market, we could actually make money in gold shares. Take Barrick Gold Corporation. It had no debt, long-life, low-cost assets, and it had hedged the gold price, so it had protection. But today it’s got some of the biggest debts in the industry, no price protection, and it’s having to dump lower-quality assets that don’t make any money. And it still pays its board loads of money.
So, it’s not a case of saying: “I want gold equity exposure, but I’m going to stay cautious and buy the big guys”, because they’re just as dangerous. In fact, some of the smaller firms who have financing have very strong management. I think people are being panicked into the gold sector now though.
Canadian institutions are all short at a time when we’ve seen the sector rise by about 20%-odd. So they want exposure. We recently saw three capital raisings in two days, and they were all heavily oversubscribed.
Nicholas Brooks: Investors have been trying to call the bottom on gold miners for a long time, and it’s been painful. But at a sector level they look pretty cheap. If the gold price can remain stable or rise, and the equity bull market keeps going, it could continue. But we probably need a sustained rise in the gold price to get a longer-term rally.
Tom: On the equity bull market point, I look at it quite differently. I think commodities could be defensive if we get an equity-market downturn, because valuations are so low and expectations so poor. As long as actual commodity prices, namely gold, iron ore, copper and oil, are supported – and I think you can make a good case for each – commodity equities could surprise everyone.
Neil: Yes – I’m not saying it’s the same today, but when you had the tech bust, and global equity markets fell 20% a year for three years, resources were flat.
John: How important is China?
Tom: It depends on the commodity. If you look at China’s share of global consumption, then iron ore is top at 60%-70%, then coal and copper, and then you get to natural gas and crude. China represents around 10%-11% of global crude demand and 45% of natural gas.
Neil: And the nature of China’s consumption is changing. We’re getting slower growth, but from a bigger base. Cement and steel demand growth is slowing. They’ll put more railways in, but you won’t see that boom in high-speed rail – which consumes 70 times as much steel as conventional rail – again. But there’s the supply side too.
Global demand for copper has grown at half the rate of aluminium over the last ten years – yet the price of copper has gone up threefold and aluminium’s barely changed. A fair amount of the demand for copper in China is for electrical power: transformers, air-conditioning units, cars and the rest. About 35%-40% of China’s copper comes from scrap, compared to 20%-odd globally. And the scrap supply from the US has been drying up.
The point is, we’ve had a de-rating of the sector already. Nobody even asks about the ‘supercycle’ any more. Now it’s a case of thinking more about the differences between different commodities over the medium and longer term.
Take diamonds – the recovering US economy is working in favour of diamonds, and you’ve also got the roll-out of the diamond engagement ring in China. It’s achieved 15% market penetration so far, while in most countries it gets to 60%.
John: What’s your take on the supercycle?
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Neil: The stock answer would be that, if it is over, it’s been the shortest supercycle ever. Part of the problem with that argument is that if you read up on other supercycles there were still periods during the cycle in which you might not have made any money for a decade. Also, when the latest one started we were coming off a 50-year decline in metal prices (in real terms – ie, after inflation). So, while compared to ten years ago we’re at elevated levels, we’re not going to go down.
Yes, there’s oversupply in some areas, but there’s been a reaction to that and the scene is set for the next upturn. Lack of investment means that every day these companies are depleting reserves. And it’s getting tougher from a regulatory and environmental angle. Lead times have probably doubled for most projects. I know of one promising copper mine that’s already eight years into what was meant to be a three-year permitting process.
Tom: In 20 years’ time, history will judge this an aggressive pause in the current commodity cycle, exacerbated by the financial crisis. The next phase won’t be the same as pre-2008 – it’ll be driven by supply scarcity in selected commodities, rather than rampant demand from China – but we are heading for another upturn.
Will: Yes, a perfect example is the expansion of Olympic Dam, BHP Billiton’s big mine in South Australia. This was going to supply 9%-10% of the world’s uranium by 2018. It won’t now, because nobody’s going to write that $20bn cheque. That’s just one commodity. We’ll see this time and again over the next few years – the supply will not be there.
Tom: And on the outlook for crude oil, when you look at the oil majors, particularly in Europe, you have both weak production growth and shareholders desperate for cash returns and capital spending restraint. The shares have de-rated on the basis that growth will be weak. But there is also a view that the crude price is going to fall to around $80 or $90 a barrel.
These two views are not compatible. If the oil majors cannot grow production, that tells us something about future supply. The crude market is much tighter than people realise.
John: What about agriculture and ‘softs’?
Will: Sugar, cocoa, and coffee are in uptrends right now. As for grain supplies, they have been run down over the last few years, but we’ve had a couple of pretty good years for global farming, so there’s no immediate problem. But weather can certainly disrupt the balance, and extreme events seem to be happening more often.
John: Let’s move on to tips.
Will: The roll out of unconventional oil and gas production outside of North America is in its infancy. It’s tricky for private investors to pick individual stocks as it’s such a diverse field geographically, but New City Energy (LSE: NCE), a fund that we run, has just changed its focus to unconventional oil and gas companies – not just in North America, but globally.
John: So they’re looking at potential shale plays outside the US?
Will: America’s success has opened a lot of people’s eyes to the possibilities elsewhere. We’ve seen very early stage work in Argentina and Colombia.
Tom: And in Lancashire cabbage fields!
John: Do you think it will take off outside America?
Will: Over a period of time. In Europe, the moment one country proves it is viable then other dominos may fall. But it won’t happen overnight.
Tom: The US has 150 years of history, 220 drilling rigs operating every day, and 30 mid-cap independents who have been trying this since George Mitchell unlocked the Barnett shale. If it is to work elsewhere, it needs capital – real money. It’s going to take more than Total putting £30m into the UK over five years, out of a $25bn capital spending budget.
And with those budgets under intense scrutiny, it’s very hard for Total, Shell, Statoil or anyone else to say: well, this year we’re going to go and spend $500m in the Bazhenov (in Siberia), or in Turkey or China. But it’s a very interesting theme.
Alex: We like Rio Tinto (LSE: RIO). It’s trading at a 15%-20% discount to its peers, so it looks good value. We expect the iron-ore price to fall by 5%-10% over the next year, but we think Rio can more than offset that, by cutting costs and increasing production volumes.
Rio is also well placed to deal with growing pressure to cut pollution in China. It produces a much higher grade of iron ore than its rivals in China. Higher-grade ore contains fewer pollutants, which means Rio could benefit from any regulatory changes.
Nicholas: We mainly buy ETFs, which track the return on commodities. If you take the view that the current run of bad US data is weather-related, and that China will maintain steady growth this year, then you want to look at the more cyclical metals, which should recover with demand.
We’d focus on those with the biggest supply constraints: platinum (LSE: PHPT) and palladium (LSE: PHPD) stand out. Both are used in vehicle catalysts. If European car sales start to pick up then demand will rise, but platinum is really a supply-side story – 70% is produced in South Africa, where there have been various well-documented problems.
I also think gold (LSE: PHAU) makes sense now. It’s come down a long way, and a lot of potential bad news is now in the price.
Neil: We invest in lots of small- and mid-caps. Probably every year one or two have trouble, so just bear that warning in mind when you’re investing in this area. I like Canadian-listed copper company Reservoir Minerals (Toronto: RMC). It’s a resource generator: it finds interesting geology, then farms out the drilling, so that somebody else carries the drill costs.
It has made a big greenfield discovery in Serbia, south of the Bor mining complex. It’s working with mining giant Freeport McMoRan on the project, which brings a lot of credibility. The stock’s done fairly well, but I think there’s more potential – it’s got other prospects, and it’s obviously a target for Freeport.
Another stock, which has also doubled since we bought it last year, but which I think has further to go, is Fission Uranium (Toronto: FCU). It’s made a discovery in the south of the Athabasca Basin in Canada, which has revealed very high grades of uranium. We think this will be a minable deposit. It’s got a $400m market cap now, but looking at past deals, in the fullness of time there’s no reason why somebody wouldn’t pay $1bn-$2bn for this asset.
The other to watch, although I’d want to see the share price come back a bit, is Australian gold firm Northern Star Resources (Sydney: NST). It’s benefited from fire sales by the big firms. Barrick Gold has been getting rid of its marginal Australian gold mines. Northern Star was buying them for $0.25 in the $1, and will be able to run them more cheaply for a profit.
I also like diamonds as a sector. Petra Diamonds (LSE: PDL) is a top holding of ours. It’s done well, but for the first time in a long time analysts have had to upgrade their forecasts. It is growing production significantly over the next couple of years and is very well managed.
Tom: One small-cap explorer I like is Lekoil (LSE: LEK). It was part of the second-biggest oil discovery in the world last year, Ogo in Nigeria. It floated at 40p in May 2013 and has gone to 70p, but if the 2014 appraisal well is successful it could go much higher. We don’t know the gas content of the structure yet, and the drilling campaign was more complicated than expected, but this is one to watch.
On the oil services side, we are most excited about a remarkably unexciting company with a very good valuation – Wood Group (LSE: WG). People have thrown the baby out with the bathwater in the European oil-services sector. They are missing key operating differences between these companies.
Wood Group has a nice mixture of exposure to both capital spending and ongoing operational spending. It is happy going after lots of small bits of business, rather than the sorts of huge, headline-grabbing projects that have been subject to delays and cancellations. So on 12 times earnings, I think it’s a good buy at these levels.
Some of the best value we can find globally in oil and gas is in emerging markets. As far as I’m concerned, some of the high-quality emerging-market oil stocks are already priced for a currency and equity meltdown.
The most compelling opportunity is China National Offshore Oil Corporation – CNOOC (HK: 883), trading on less than seven times earnings, with visible production growth of 5%-8% a year. Compare CNOOC to Exxon, for example.
Exxon is on a multiple of more than 12, yet has zero production growth and to me there’s also a growing threat of it making another big acquisition – whereas these emerging-market oil and gas companies can grow organically, from deep resource bases. So we think the country risks are priced in.
John: What’s your take on Russia?
Tom: We like Gazprom (London International: OGZD). When Europe begins to see a stronger recovery, natural-gas demand will rise. And once Gazprom’s gas sales agreement with China is formalised and better understood, investors will get interested. Gazprom trades on three times earnings and our model suggests a move to pay out 25% of its IFRS net income as dividends would give it a prospective yield of over 9%.
John: I’ve heard this about the dividend a few times, is that still on the cards?
Tom: It’s been delayed and there’s debate as to whether or not it will be retrospective versus forward looking, but the Russian state-owned companies are moving in the right direction. I have much greater confidence in my Gazprom investment today than in the past. And on a price-to-earnings (p/e) ratio of three to four, I’m not having to pay much for it.
John: Will – what others have you got?
Will: Grade is king in so many mining matters. In recent years, we’ve rarely come across a miner with better grade than Sirius Resources (Sydney: SIR), which has a nickel deposit in Australia. It’s at the development phase – there is still the possibility of more exploration success, but it’s hopefully going to put this mine into production by the end of next year.
Nickel is mainly used in stainless steel. I think that, as with many metals, nickel’s going to have supply problems in the future. Indonesia’s having problems with exports and I think prospects for the nickel price look better than they have for a while. But such is the size and grade of this deposit that it should always make money whatever the nickel price.
Agricultural commodities are a difficult area to play. We’re looking for the next firm that’s going to boost crop yields, and we believe that’s going to come from seeds and crop protection. A London micro-cap called Plant Impact (Aim: PIM) mobilises calcium, among other things, at budding time.
It’s done extensive trials over three or four years now, and this method has been shown to increase the yield of the Brazilian soybean crop, where they’ve done some trials, by 5% or 6%.
The challenge for a small firm is to get in with a decent marketing group, but Plant has done that. We think that once the market cottons on to this application, it has terrific growth prospects. As a microcap it comes with all the usual risks, but in looking for agricultural investments this one certainly caught our eye.
John: Alex, do you have a final tip?
Alex: On the oil theme we like Genel Energy (LSE: GENL). It runs two oil fields in Kurdistan in Iraq. Extraction costs are low at around $30 a barrel, and it’s well-run. It’s recently completed a pipeline to Turkey, which will boost capacity.
The company trades on a 25%-30% discount to its risked net asset value (NAV), so we think there is room for it to be re-rated. It’s also starting a big drilling campaign outside of Kurdistan, and it has quite a few interesting prospects in Morocco, Malta, and other areas. So we think those could be accretive to NAV as well.