China's insatiable appetite for commodities and an insufficient global supply of these commodities have helped fuel an impressive revival in the natural resources sector. A weak US dollar, which usually means a rise in commodity prices, has also helped. But with the considerable price rises seen within the sector over 2003 and speculation about the extent to which the steam may be running out of China's impressive economic expansion, many investors are questioning whether they have left it too late to jump on the bandwagon.
They haven't. Two key forces have been driving commodity prices higher - a surge in demand and restricted supply - and both look set to continue into 2004. Even in the worst-case scenario of a slowdown in the pace of economic expansion in China, analysts are forecasting strong GDP growth. Meanwhile, there are some really serious supply issues concerning the mining of base metals. Together, these factors point towards further investment opportunities in the sector, but identifying and capturing the best opportunities will remain key to outperformance.
China has stolen the US lead to become the largest consumer of iron ore, steel and copper in the world. Last year, it consumed over half the world's cement production, 30% of global coal production and increased its nickel imports by 110%. A sustained price explosion in steel, its largest in 30 years, can also be partly attributed to China having ordered 36% of the world's steel production in 2003.
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And with China bidding to become one of the largest economies in the world, this strong demand should continue. China is now considered to be the world's manufacturing hub. Car manufacturing is just one industry in which it is vying for a global leadership position. And its growing middle class has already had a healthy impact on the country's demand for cars: Volkswagen claims that it sold more cars to China than to Germany in 2003. Given that steel constitutes 59% of an average car, the future demand for steel appears intact. Furthermore, if China is to continue to strive for global leadership status, it will have to develop its infrastructure. An estimated US$300bn needs to be spent on developing infrastructure over the next ten years, notably on projects such as a Beijing-Shanghai High-Speed Railway link.
But what of supply? Right now there just isn't enough. Years of low prices have discouraged investment into new production capacity and, as the suppliers failed to forecast the surge in demand from emerging markets, they have not planned a sufficient expansion in new production capacity. The upshot is that supply is unlikely to improve in the short term. Neither nickel nor aluminium will see a pick-up in capacity until 2006, for example. A mine cannot be built overnight.
But even with the demand/supply imbalance set to continue, a selective - and active - approach is essential to pick out the best beneficiaries of this environment. In my view, the best place to look for growth is the small and mid-cap companies that tend to be under-researched by the market. Among these, I have just cut our weighting in the gold producers that were getting relatively expensive, but increased our holdings in companies that mine and refine base metals, in particular copper and nickel. On a geographic basis, I am drawn towards some attractive projects in West Africa, now that the political environment there seems to be improving somewhat.
The current market conditions aside, I do think that the natural resources sector has long-term worth as a part of every portfolio. Indeed, this sector is a natural diversifier because of its low correlation to the rest of the market. That said, the natural resources sector can also be quite volatile by nature, which is why I aim for serious diversification within it. We hold companies involved in everything from the extraction of energy to mining gold.
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