Hot, and getting hotter

By Martin Li, 14 September 2010

Martin Li, IC companies writer, discusses the outlook for commodities and oil and gas with John Wong, portfolio manager at New City Investment Managers, and Richard Nolan, Daniel Stewart oil and gas analyst. For further insight and additional share tips, listen to the discussion in full by clicking here.

Martin Li, IC commodities writer: Why are commodities important and why do investors need to include them in their portfolios?

John Wong, portfolio manager, New City Investment Managers: Commodities are a part of our lives. Our houses, cars, phones and infrastructure all depend on commodities and no matter where we are in the cycle, provided there is any economic activity, commodities will play an important role.

Richard Nolan, oil and gas analyst, Daniel Stewart: The energy sector makes up 10-15 per cent of the market so it's difficult to ignore, and oil and gas is a sector that for the most part continues to perform very well. Secondly, you can't get by on this planet without energy, and it's a depleting commodity. There are more people chasing a scarce resource and over time it's likely to rise in price.

ML: What are the most important drivers of the commodities and oil and gas sectors?

JW: Two massive factors are driving commodities. First, the tightness of supply hasn't changed much in the last five to 10 years, despite the boom in commodities. Overcapacity in the 1970s and 1980s led to oversupply, since when there has been little investment in new supply. Demand has caught up with supply. However, it takes eight to 15 years to build, permit and get a new mine into production. Second, the continuing urbanisation of China and India demands commodities for roads, railway lines, pipes and buildings. It's not surprising that we are where we are in the commodities cycle.

RN: The extent of the recovery in some of the more developed markets will drive the oil price on a day-to-day basis. In the 1990s, we had just north America, western Europe and a couple of other industrialised countries consuming oil. With the collapse of the Soviet Union and the emergence of China, all of a sudden you add a billion-plus people chasing a commodity. Add the underinvestment in the sector in the 1990s and you start to see continued upward pressure on both oil and gas prices.

The oil price is stuck in the $70-$80 per barrel trading range for the moment, which is about right in this period of recovery. Going forward, the higher oil price level is here to stay. It's difficult to see prices below $70-$80; in fact you start thinking of triple digits again.

ML: Have we seen anything like this before?

JW: It's not that uncommon. The commodities boom of the 1970s and 1980s was driven by growth in Japan and before that in the 1900s when the US started to grow. We're currently seeing a few big countries growing very fast at the same time.

ML: Could the rate of Chinese urbanisation slow significantly?

JW: The rate of growth in China is unsustainable, although as each year goes by and the base from which growth is measured gets bigger, it's no longer small in world terms. Even if China's rate of growth slows, I don't think it will change much in terms of demand for commodities. The urbanisation of China will probably continue for the next five, 10 or 20 years, perhaps at a slightly slower rate, but compounded over this period, it will be huge.

ML: Which commodities offer the most attractive investment prospects?

JW: Copper probably has the best outlook within base metals, from the fact that supply is still limited, at least over the next five years. Within bulk commodities, coking coal is still going to remain tight and there will be a lot more growth to come.

Gold and silver will have a phenomenal time for at least five years. Central banks are realising that gold has a place in their reserves. Investors, seeing that currencies are far less stable, are realising it is much safer to hold a quasi-currency like gold.

I also like platinum. Seventy per cent is mined in South Africa, and people are beginning to realise that the growth in South African platinum supply will not come through. If demand for catalytic converters continues, platinum offers long-term growth.

ML: It's often said that all the 'easy oil' has been found and that it's getting harder and more expensive to extract what's left. If this is true, what regions of the world offer the most attractive returns to oil companies and their investors?

RN: All the $40 per barrel oil has been found. There's plenty of oil out there at $100-$200 per barrel, but it's an issue of commerciality. We see it in Canadian oil sands. At $10 oil, nobody cares. Hit $100 oil and you start to dig up Canada.

As for geographic regions, always look where others have found oil. For example, Canada, the US, southeast Asia, Indonesia and Nigeria are all major prolific oil provinces.

Most of the Middle East has been well explored, except for Kurdistan in northern Iraq where for years there has been no exploration. We are now starting to see exploration and the results are stunning.

Gulf of Mexico discoveries can have phenomenal flow rates, as illustrated by BP's ill-fated Macondo well, which reputedly had the highest flow rate of any well in the Gulf. This proves there's a lot of oil there but it's going to come from deep water. It's a good place to be, although politics at the moment make it difficult.

ML: What are your thoughts on peak oil?

RN: I think there is a physical conclusion to oil and the world is perhaps starting to experience the early symptoms of that. Oil originates from animal and plant material, so it's in finite supply. Over the last hundred years, a vast amount of oil has been extracted. At some point in time we will end up at a natural limit and production will stop increasing or plateau. Growth of demand will exceed production. You will start to see volatile swings in the prices of oil and gas - which could be triggered by very small things - because it's so tight.

ML: What is the best way to invest in commodities - for example, through physical metals or mining shares?

JW: Gold companies have the advantage of growth - they can reinvest and find more gold cheaply, and they tend to get more leverage to a rising gold price than physical gold. This means mining shares generally provide a higher return than physical gold when the gold price goes up, although they can go bust, so it's important to do your research. My personal view is to take a portfolio approach: some high-risk positions with explorers but balance that with some producers and physical bullion.

ML: What are the advantages and disadvantages of investing in diversified majors compared with juniors?

JW: A diversified portfolio of projects provides more safety by being able to balance poorly performing prices with better performers. Majors will track general commodity bull runs but don't get the same leverage as companies with a single asset if the price of that asset goes up. You get far more beta with a single asset or one or two-project companies compared with a diversified mining house, but you have less safety if that commodity doesn't do well or if the project fails. Majors provide profitability, cash flow and dividends, but growth tends to be a problem. Smaller companies offer growth and capital returns but not often dividends.

RN: If you want something that's highly cash generative and stable then look at integrated majors. If you want high upside of say five or 10 times your money in fairly short order, then look at high-impact exploration and production companies. When these drill and find oil, they can see tremendous rises in their share prices and very attractive capital returns. However, they carry a lot more risk than integrated majors, and if they drill and don't find anything, you have a problem.

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