2008 witnessed a boom and bust of monumental proportions in the junior mining and oil and gas sectors. From being among the London market's strongest performers, driven by record commodity prices, resources stocks plummeted out of favour even more rapidly to languish among the market's laggards.
Fundamentals remain robust
Although strong recovery is unlikely in the short term, the longer term outlook for resources remains bullish. The world will run on oil for many years to come, and analysts estimate a $70-80/barrel oil price is needed to drive sufficient exploration and supply to satisfy likely demand when economies recover. Growth-driven Asian demand for all commodities, though slowing, has in all probability built up an unstoppable momentum.
Supply-side constraints plus the possibility of a weakening dollar and further falls in equities will create upward price pressure on oil, gold and other commodities. Commodities may start to recover during the year, depending on the severity and duration of the recession. Even if they don't, continued low prices will deter exploration and development, and cause supply shortages, which will simply store upward price momentum to be released when economies eventually do recover. What's more, the depth of the current downturn suggests that post-recession demand could rapidly create supply pressures, an over-correction and renewed price shocks.
Investors are dashing for production and cash flow . . .
Investors still investing in small-cap natural resources are demanding actual or near-term production and the security of cash flow. Exploration potential will be valued at zero until proved commercial.
But cash-hungry companies face closed capital markets
The challenge is that many resources juniors on the Alternative Investment Market (Aim) have long lead-time projects that need cash to develop, but these companies now face debt and equity markets effectively closed except for deeply-discounted secondary issues. Aim will see few flotations in 2009 and new resources entrants are likely to be at more advanced stages of development.
It’s all about survival
The next six to 12 months will be all about survival for resources juniors. Cash will be king and costs pared to the minimum. Companies with good projects and strong management should survive. They will seek increasingly innovative financing through farm-ins (using their hydrocarbon or mineral wealth to attract investment), strategic investments, private equity, asset sales, forward selling, etc. Sector consolidation will accelerate.
The outlook will be grim indeed for cash-hungry companies with single, high-risk assets, or companies that have failed to deliver on promises. These may have to postpone projects, sell assets, accept low valuation takeovers or, ultimately, close. However, losing weaker companies to takeover or administration will be cathartic for Aim’s resources sectors, and the junior market as a whole, and will leave an improved investment environment for higher quality survivors.
Unprecedented opportunities for investors
Investors looking beyond the short-term scariness to longer term fundamentals will enjoy an unprecedented choice of high quality companies priced at ridiculously cheap valuations – trading below cash or demonstrable asset value, or a couple of years' earnings or cash flow – and a very favourable risk-reward balance.
However, investors will need to adopt the necessary long-term view – often lost during the euphoria of raging bull markets – as equities may not bottom out during 2009. Share prices will continue to show little correlation with operations and news flow, further demanding longer timeframes to crystallise value, although distressed selling by hedge funds should finally stabilise.
What to look for in oil and gas
Oil and gas research by broker Daniel Stewart finds that Aim companies with the highest enterprise value (market value plus debt minus cash) are those with over £10m of cash and proved and probable hydrocarbon reserves (defined as reserves having a 50 per cent chance of commercial recovery). The research also points to share prices rising more on the declaration of reserves than the transition from exploration to production.
This suggests investors should look for companies with good drilling prospects such as Faroe Petroleum, Nighthawk Energy and Volga Gas, whereas undervalued high-volume producers such as ROC Oil and Gulfsands Petroleum may eventually migrate from Aim to the main market to seek better valuations.
Without access to debt and equity, companies might be tempted to employ their hydrocarbon wealth too early, thereby eroding value. Look for companies such as Aurelian, Serica and Northern Petroleum that have good records of negotiating favourable farm-in deals that demonstrate underlying asset value.
What to look for in mining
Graham Birch, head of natural resources at investment manager BlackRock, points investors towards companies with long-lived assets in supply-constrained commodities such as gold and platinum. These include gold producers Central Rand Gold and European Goldfields and near-term producer Centamin Egypt, all of which are well financed to weather the current storm.
