What now for commodities?

published 14 June 2006

Every month we ask the best investors we know to join us for dinner and give us their views on global markets. This time, we look at the rocketing oil price and the outlook for commodities and metals

(Our Panel: Tom Leaver, Senior fund manager at RAB Capital; Richard Davis, Director of Natural Resources at Merrill Lynch; Mark Mathias, Chief executive of the Dawnay Day Quantum fund; Ian Henderson, Manager of the JPMF Natural Resources fund; Tim Price, Senior investment strategist Ansbacher Bank; Charles Hansard, Non-executive chairman of African Platinum Plc)

Merryn Somerset Webb: Shall we start by talking about the rise and rise of the oil price?

Ian Henderson: The most surprising thing about the oil price, as far as I can see, is that anyone is remotely surprised about its rise. It's been clear for ages that the supply/demand situation has been getting so tight that prices were going to have to rise.

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Tom Leaver: One of the difficulties when it comes to analysing the situation is that, on the supply side, no one knows what is really out there in the way of reserves. Oil analyst Matthew Simmons has written a lot on this recently and it does seem that there is a big question mark surrounding the real level of Opec's reserves. I'm not sure the situation is quite as bad as he suggests, but it is true that when production quotas based on reserves were introduced in the 1980s for Opec, everyone doubled their reserves overnight to give themselves higher production quotas. So we have no idea what the truth is.

It's the same in Iraq. No one has had a good chance to look at the situation there since the 1960s, so who knows how much oil is really left there. I agree that we shouldn't be surprised by any of this. The age of cheap oil is over and anyone who thinks as a lot of analysts still do that prices will fall back to so-called normal levels in four to five years is going to be disappointed.

Richard Davis: I can't see oil going down in price from here either. In real terms adjusted for consumer inflation oil still hasn't reached anywhere near its 1980s peak. And let's not forget that it is still cheaper to buy oil than bottled water. Petrol costs about £1 a litre. Bottled water costs about £1.25. And if people can pay that for water, they'll pay it for petrol. I have yet to hear of anyone who has stopped driving their car because petrol is too expensive, and we aren't seeing any major recycling of plastic products (made with oil) yet either. In fact, we aren't anywhere near the point where high costs will mean falling demand, and therefore prices. So I think oil can stay 50, 60, 70, 80 dollars a barrel for a very long time.

Tim Price: It isn't true that the consumer isn't feeling the pain. I've read that Canadian gasoline prices are now breaking through C$1.00 a litre and some Canadians are taking to fuel theft. There have been 1,000 "pump and run" incidents at gas stations in Quebec City so far this year. There were only 799 in the whole of 2004. Some Canadian gas stations now have guards at the pumps. The same was reported in the US last month. People don't steal stuff if they think it is cheap. I'm not saying that the oil price will fall I don't think it will just that we shouldn't be complacent about how high oil prices will affect spending patterns and our economies.

Mark Mathias: We have a very strong consensus around this table that oil prices are not going to fall and even that prices are going to be significantly higher in a few years. To us, the fundamentals seem very obvious on the supply side, there have been no new big finds for years, and on the demand side, consumption is rising all over the world. I don't mean in China alone, but all over the developing markets. Brazil, India and Indonesia are all consuming more and more as is the US. But the market as a whole still doesn't seem to get it. If you look at the futures market, you can see that it is predicting prices in five years to be $5 lower than they are now.

RD: Markets have a great tendency to look in their rear-view mirrors when they want to predict the future. And if they do that now, they can see that five years ago, oil was well below $20 a barrel. So they look at today's price and think it isn't sustainable. But it is.

MM: It would be nice to think that alternative energy sources would come into play quite quickly, but they won't. The lead time to develop alternative energy sources to make them commercially viable and get them to the market is very long indeed. Imagine the scenario at the domestic level to use a non-fossil-fuel source of energy in houses, you'd have to get everyone a new heating system, for example.

MSW: What about the biodiesel incentives being introduced in the US? Shouldn't they at least help cut the demand for petrol?

RD: To a degree, but it'll be a long time before biodiesel is anything but a very small component of overall energy consumption creating the infrastructure that will allow it to be produced in quantity and delivered to the consumer will take forever.

TL: And you mustn't swallow too much of the hype about this kind of thing. Take gasohol fuel partially made from corn. Everyone thinks growing corn to make an alcohol to put into fuel is environmentally friendly. It isn't. It takes far more energy to produce the corn than it does simply to burn the hydrocarbon. And even if you do find a reasonable alternative, it is, as Richard says, all about infrastructure. Liquified petroleum gas (LPG) is a great fuel, for example, and gas-to-liquids technology will alleviate some of the pressure, but it is still hugely expensive to create the right infrastructure.

MM: The truth is that there is no other useable and readily available energy source out there. So cheap oil is just over. That's it.

MSW: So how high will the oil price go?

TL: It's hard to say. There has to come a point when the high price will choke off demand. And the price is just a function of how fast we get there. If the oil price keeps moving up slowly, as it has been, you will see more sustainability in terms of the ability to absorb a higher price. Where will it actually end up? Probably in three digits, but I don't know how soon that will be. I certainly think $60 is the floor for the foreseeable future. What the true value of oil is, I don't think anybody really knows.

MM: On a medium-term view, I think a three-figure oil price is definitely on the cards. Even if it slows the global economy down, it will still be a finite and dwindling resource critical to the running of the economy. We are going to carry on using it, and it isn't being replaced.

TL: We also mustn't forget the geo-political situation. Iraq is terribly unstable and there are political problems affecting almost all the bigger producers. Consider the succession issues in Saudi Arabia: its current leaders aren't young and there is no succession plan in operation.

MSW: And there's no prospect of another jumbo oil find? What about off the Falkland Islands?

TL: That would be a big find, but not a jumbo one.

MSW: We haven't mentioned nuclear power as a possible source of alternative energy. How about investing in uranium?

IH: This is a very topical issue. It all depends on how fast the world's stock piles of uranium are being run down. As far as I understand it, the existing stock piles are sufficient to keep the nuclear power industry going for about ten years.

Charles Hansard: They won't last that long at the rate that nuclear plants are being built. The Chinese are planning another 30 and there are 69 currently under construction around the world.

IH: It will still last a while. About 10% of all uranium used is recycled, so it doesn't just disappear. Still, uranium looks good from an investment perspective.

RD: The nice thing about uranium is that the rising price doesn't affect thefinal price of nuclear power very much. The cost is a very small part of the total input cost of nuclear power it could go to $100 a pound (from $30.20 today) and wouldn't really have any impact on a nuclear reactor. Uranium's had a good run, but could go a lot further. Supply is also relatively constrained because, as ever, it takes a long time to bring new mines on stream.

CH: This is the case with practically every commodity at the moment. It isn't just about getting the right permits and that sort of thing. There's also a shortage of a great many supplies and materials. Take the tyres for mining vehicles they're used in incredibly abrasive conditions and they get destroyed on a regular basis (particularly as the mines are being worked harder as commodity prices rise), but there just aren't enough around. Talk to any mine manager with an open-pit mine and you'll find his biggest fear is not having enough rubber tyres. And the tyre manufacturers who don't seem to be convinced yet that this is a long-term bull market in commodities are still loath to up their production to cover the shortfall.

RD: Actually, every aspect of bringing a new mine into production is getting harder. The capital cost of building them is increasing every day because steel is more expensive and so too is oil.

IH: Construction costs of new mines have gone up almost 50% over the past two years. That means that everyone's feasibility studies have become a moving feast. As all the moving parts change, it's tough to make decisions about whether to go ahead. If the price of putting in a deep-water oil rig doubles, do you still go ahead with it?

RD: Staff are also a problem in the mining sector. Quality engineers and metallurgists are becoming very hard to come by in some parts of the world. The long bear market had the effect of making mining-related careers look unattractive. Consequently, not enough people have gone into them.

IH: Camborne School of Mines closed last year and the average age of an engineer working in South Africa is over 50.

TP: So all the people who have just got worthless A-levels in media studies in the UK should now consider doing metallurgy degrees? I see in the papers that there are still plenty of vacancies at good universities for these kind of courses engineering, geology and the like.

CH: I think students will figure it out soon. People in these businesses arenow being paid really good money. That should draw people in, just as the City has over the last decade. Though of course, if you work in the City you can make a lot of money without having to live in a jungle and spend all your days down a black hole. It's probably nicer.

TP: So it's not just going to be oil at triple-digit levels, it's mining salaries up in the six figures.

MSW: So if you had to choose a metal that you would be most bullish on, what might it be?

RD: For me, it would be gold. The supply and demand fundamentals are good, but gold hasn't really performed well compared to other metals it's only gone from $250, its low, to $440, which is a pathetic return compared to nickel and copper, oil and gas, and coal.

TP: The best thing about gold is that it's a several-thousand-year-old store of value and a hedge against anything that might go wrong with paper currencies.

TL: I agree. Irrespective of the supply and demand fundamentals, given all the potential political upsets in the world, I think gold may well come back into vogue as a currency hedge. It's difficult to pick any one metal as a favourite. We like zinc, copper, aluminium, nickel and gold, as well as silver. Overall, there is a fairly strong argument to be made about most of them in supply and demand terms.

MM: The argument behind the base metals seems a particularly good one, given that a lot of the demand for them is driven by growth in infrastructure, something we are currently seeing a lot of around the world. And I'd also say there is an argument for trying to invest in them directly, not via equities, as metal-producing companies are being hit by rising costs (oil, etc). If you are an investor in the physical metal, all you do is you take the price rise, not the costs.

IH: I think the metal that looks best is probably still copper, because of itsdirect relationship with emerging market economic growth: it is highly related to infrastructure.

MSW: What about soft commodities? Jim Rogers something of a commodities guru has been very bullish on soft commodities over the last year or so.

TL: They fall into various different categories long lead time and short lead time commodities. Short lead time commodities are cabbages, tomatoes and grains, and single-harvest commodities. You can have a temporary shortage, but there is always plenty of new land that can be put to the plough, so it doesn't last. Then there are long lead time commodities, such as rubber and palm oil. There might be a bull case in terms of demand growth, but it's hard to analyse. These are also strongly dependent on the weather. And lots of soft commodities are subject to government tariffs and subsidy regulations, and that makes things even harder. There are more trading opportunities here than long-term fundamental investments and that's how we tend to look at it.

IH: One more commodity I think we have to mention is diamonds. The De Beers stockpile is basically gone and there have only been two new mines of any consequence brought on in the past five years. So supply is constrained, but demand is very strong in China and prices are now rising on a regular basis. Prices look like they are going to keep rising.

MSW: Does anyone have any favourite commodity-related stocks?

IH: I think CVRD (NYSE:RIO, $34), the large Brazilian iron-ore producer, is remarkably cheap. It's throwing off enormous amounts of cash, but it trades on only six times earnings. It's got a few problems a historic government stake and a complicated share structure, for example but any downside is more than covered by the enormous amount of cash that the company is generating.

CH: My tip would be African Platinum (AIM:APP, 20p) of which I'm non-executive chairman basically because it represents a cheap long-dated call on precious metals prices. African Platinum's flagship asset, which is located right in the heart of the world's premier platinum mining district, represents one of the largest undeveloped platinum group metals deposits in the world. We've got a top-class management team and there are plenty of senior mining people on the board, including the former CEO of Impala Platinum, to support them. And we have attracted major institutional investors to fund a bankable feasibility study scheduled for the first quarter of next year. When that's out, we'll be looking to secure financing for a 300,000 oz mine. At this stage of the company's development, we look extremely undervalued.

Lonmin is valued at $25 an ounce of resource in the ground and we're valued at more like $2.50. Clearly, they're producing and we are not and that makes a massive difference. But I do think that given the unique size of our asset and the fact that we are moving forward aggressively, we can narrow that gap. Until we do, however, the low value the market is placing on our asset means that investors really do get a very cheap call on platinum when they buy the shares. Ours is a supreme value stock.

TP: I think I'd go for BHP Billiton (BLT, 816p) as a favourite. China and India together still represent a huge growth story and the materials for their growth are provided by the big, diversified miners. This is one of the less risky ways of playing Asian growth. The firm is making serious money and trading on a p/e of only 13.9 times.

MM: I honestly don't think the equity route is the best one into the commodities market. All the academic evidence tells us that every diversified investment portfolio should have direct exposure to commodities. There are several reasons for this. First, commodities have a markedly different return profile to equities and bonds. They produce returns that are roughly equivalent to equities over long periods of time and with the same kind of risk profile. However, they rise and fall at very different periods in the business cycle they have a strong negative correlation to equities, so their inclusion in a portfolio will reduce the overall risk profile and increase the expected return. On the other hand, they have a strong positive correlation to changes in inflation. Equities and bonds both react negatively to increases in inflation. Commodities do not, so they are a great hedge against inflation. The important thing is that the commodities produce good returns in periods of rising inflation. It does not need inflation to be high, only rising. So increasing inflation from 2% to 3% over the next 18 months would be associated with strong commodity returns.

Next, commodities tend to perform best in the late stages of a business cycle, and outperform equities in this period. I believe that we are approaching the late stages of this expansionary phase and therefore expect commodities to continue to be the best asset class for some years to come. Finally, it's worth pointing out that you cannot get the full portfolio benefits of direct commodities by buying shares in mining companies. Over the long term, the returns from physical commodities have exceeded the return from investing in the shares of the companies that mine those commodities: mining shares showed about a 60% positive correlation to the equity index and about a 40% correlation to the underlying commodity prices over the same period. So mining shares are more like investments in other shares than like investments in commodities. This means you lose the diversification benefits and efficiencies of holding commodities if you hold shares instead.

MSW: But how do retail investors do this?

MM: I agree, this is more difficult to do than buying equities, but there are ways. RAB Capital runs a commodities hedge fund, and you can invest directly in the spot gold price with Gold Bullion Securities (GBS), a special purpose company set up to invest directly in the gold bullion market. For more information see www.gold.org. Socit Gnrale also have a Brent Oil Tracker (0800-328 1199).