The ultimate resources shares

Enough chief executives' heads have rolled this past year to make Henry VIII grimace: Rio Tinto (RIO), BHP Billiton (BLT), Barrick Gold (ABX-T) and Anglo American (AAL), to name but a few, have all seen their leaders step down after wrongly pursuing 'growth for growth's sake' – sanctioning expensive acquisitions near the top of the cycle that were quickly followed by massive write-downs.

The FTSE 350 Mining Index, meanwhile, has tumbled 40 per cent from its peak in early 2011. But that's nothing compared with the carnage being played out within smaller companies: the Alternative Investment Market's (Aim) Basic Resources Index has plunged 64 per cent over the past two years and continues to plumb new depths month by month, as capital for speculative ventures completely dries up.

Catching a falling knife

Yet is now really the time to load up on cheap resource equities? History would suggest not. The last major bear market for metals and mining (not including the 2008 financial crash) arguably lasted six years, from 1997 to 2002. The bear market before that - from 1992 to 1994 - lasted three. From a technical perspective, we've been in this one for just over two years now.

We don't think this bear market has run its full course yet, either; after all, commodity prices are only down a quarter on average from their all-time 2011 peaks. But if you're going to stick it out and hold natural resource stocks through the cycles - which we suggest you do - here's what you should own.

We've run the rule over hundreds of natural resources equities to find the best shares in the sector - those that will not only survive the current downturn, but stand to flourish in the years ahead.

We've also come up with an investment strategy for commodities during these troubled times that we think will deliver long-term, above-average growth, propped up by a modest but healthy dividend stream. Central to our strategy are preservation of capital and diversification among different asset classes. For although it's tempting to lump all natural resources together under one sagging roof, some commodity-related equities have outperformed their lagging peers.

Follow the leaders

FTSE 350 oil producers, for example, have performed decently enough over the past two years. The index has retreated just 7 per cent from its overly buoyant early 2011 peak - less than the 9 per cent fall in Brent crude oil over the same period. Moreover, the five oil services companies in the FTSE 350 experienced share prices rises of 6.7 per cent on average last year - although this was admittedly tempered by two companies leaving the index after sharp share price declines caused by severe cost overruns.

Other positive performers have been polished diamonds, prices for which have risen between 10 and 20 per cent since early 2011, depending on carat size. Agriculture and livestock, meanwhile - key members of the S&P GSCI (formerly the Goldman Sachs Commodity Index, a widely used industry benchmark for commodity futures) - have also trended sideways or upwards these past few years, albeit with significant volatility in between.

Past performance is no guide to the future, however. So which commodities will outperform over the coming years? We set out our recommendations for specific commodities below, along with what we think is the best way to play them.

The ideal resources portfolio

We divide our portfolio into the following sectors and suggest weighting them accordingly, in order to concentrate on commodities that we feel have the best supply and demand fundamentals going forward: Energy (42.5 per cent), Agriculture (15 per cent), Precious Metals & Gemstones (15 per cent), Industrial Metals (17.5 per cent), and cash (10 per cent). Just to be clear, we do not recommend you only hold natural resources-related equities in your investment portfolio; rather these companies should form only a small part of your wider holdings.

OIL & GAS

We have weighted the portfolio heavily in favour of energy, or specifically energy derived from oil and gas. There are a number of points to consider on this matter. We have already touched upon the relative scarcity of readily accessible crude oil deposits, but that doesn't mean to say that people are going to suddenly stop topping up their motors with regular or diesel anytime soon. Admittedly, over the next decade or two we are likely to see an expansion of electric and/or hybrid vehicles on our roads, but any fall-away in demand for petroleum linked to improvements in technology are likely to be off-set by the rapid increase in the level of private vehicle ownership in emerging economies. The rate of expansion of US unconventional production through this decade has probably taken everyone by surprise, but we doubt whether the drop-off in US demand, or possible US exports, will depress prices for Brent crude below $100-a-barrel for an extended period of time. Other than the US, non-OPEC production will struggle to keep pace with Asian crude demand alone.

Most analysts - and in fact most of the oil majors - believe that the global market for natural gas is going to grow at a faster rate than crude oil, or any other form of energy. That's simply because energy deficits are growing, while more and more countries have prioritised gas-generated electricity over that by coal, nuclear, oil and renewable sources. Critically, China now appears to be seriously trying to wean itself off coal as air quality within many of its industrial centres reaches crisis point, while Japan, post-Fukushima, will need to replace around 20 per cent of its nuclear generating capacity by 2017 - and a good deal more thereafter. The US economy, though, is receiving a much-needed shot-in-the-arm through the cheap energy brought about by the unconventional gas boom. The eventual benefits accruing to the US economy are obviously impossible to quantify at this stage, but Washington is likely to do everything in its power to make sure that domestic gas production remains profitable - even if that means insulating 'Henry Hub' prices.

INTEGRATED OIL & GAS

Which companies do we think have both sufficient financial clout and the optimum business mix to exploit the rise of natural gas globally? Our first preference is Chevron Corp (NYSE: CVX) because of its exposure to the big Asian growth markets, combined with promise afforded by the fact that it has the second-largest acreage position in the hugely prospective Marcellus Shale in Pennsylvania. Chevron is also the largest holder of natural gas assets in Australia, which are earmarked to fuel the fast-growing economies of the Asia/Pacific region for decades to come. On the home front, we think Royal Dutch Shell (RDSB) is an ideal candidate for the portfolio, as the Anglo-Dutch giant’s long-term prospects are underpinned by the fact that it shares many of the strategic advantages of Chevron. For a start, more than half of its production (54 per cent) now comes from natural gas and this is set to increase, with significant production projected to come online from its assets in Queensland's Bowen Basin. Shell is basing its future earnings growth on its ability to supply energy-hungry economies such as China and Japan from Australia and Qatar. First-quarter earnings beat City estimates on a current cost of supply basis due to a continued ramp up in operations such as its Pearl gas-to-liquid plant in Qatar, together with improved refining margins and rising oil output.

OIL SERVICES & EQUIPMENT

There is no shortage of worthy LSE oil services candidates for our ultimate resources portfolio - Kentz Corp (KENZ) and Petrofac (PFC) spring to mind. But we would like to highlight the investment case for a US player, National Oilwell Varco (NYSE: NOV), particularly because the group offers broad exposure across E&P segments, whether it be offshore, conventional, tight gas, shale, etc. NOV is the supplier that oil and gas producers go to in order to get the equipment they need, including derricks, blow-out preventers, mud pumps, and other drilling components, as well as the control systems and instrumentation necessary to monitor and guide drilling operations. As its products and expertise are utilised virtually across the entire industry, it is not subject to demand slumps that affect specific segments of the oil and gas industry from time to time. NOV's operational performance is reflected through consistent revenue growth, a sound financial footing with manageable debt levels, and strong cash flows.

The principal reason for gaining long-term exposure to the oil services and equipment sector is as straightforward as it is compelling. Put simply: no new large-scale oilfields (>10bn barrels) exploitable by conventional drilling technologies have been discovered since 1979 (Tenzig, Kazakhstan). What remains is essentially more difficult and expensive to commercialise. Identifying, appraising and extracting the world's non-conventional and deepwater hydrocarbon deposits increasingly requires specialist, high-tech, and in many cases, bespoke solutions. Add to that the growing influence of - and demand linked to - National Oil Companies, and the long-term investment rationale can be readily appreciated. True, exploration and production (E&P) spending has trailed away since the end of February as Brent Crude prices flagged, but such is the narrow global supply/demand balance that it would only require a modest rebound in OECD growth, or regional supply disruption, to drive crude prices higher. Even with a faltering Chinese economy and Europe remaining in the doldrums, the Paris-based International Energy Agency predicts that global consumption through 2013 will still increase by 795,000 barrels a day, or 0.9 per cent. When the world economy returns to something approaching equilibrium, then oil demand across OECD markets should bolster China's existing annual run-rate of 3.5 per cent. The price floor that underpins oil companies' long-term E&P spend now ranges from $80-$85/barrel - even given existing anxieties and somewhat mixed indicators for the global economy, Brent crude is now at $103/barrel.

There is no shortage of worthy candidates among the oil services and equipment companies, including Kentz.

EXPLORATION & PRODUCTION

Premier Oil (PMO) has been a mainstay of London-listed oil producers for decades and there's a simple logic behind adding it to our portfolio. The company has consistently rewarded investors over the years by making shrewd investments in emerging oil destinations and reaping the benefits from project development amid rising oil prices. And judging by the company's current strong pipeline of development assets, this trend should continue for years to come. In fact, this year Premier declared its first annual dividend in more than 15 years.

Another reason we like the company over the long term is that it holds a diverse mix of assets spread across the North Sea, South East Asia, Africa, the Middle East and the Falkland Islands, from which it can grow production substantially as well as add value through the drill bit. This year Premier plans to drill 14 exploration wells and increase daily oil and gas production by 30 per cent as two North Sea projects come to fruition. Granted, it's pretty leveraged to oil prices, with net debt around 57 per cent. Yet the shares trade on less than 10 times forecast earnings for 2013, just below the sector average, and we’re comfortable Premier can safely ride out any minor volatility in the oil price.

Ex-BP chief Tony Hayward's Genel Energy (GENL) is a current IC buy tip and we won't go into too much detail here about its investment proposition, as we've covered the company extensively in recent months. While the company's political risk profile isn't ideal for this portfolio - the company mainly operates in the semi-autonomous Kurdistan region of Iraq, and has exploration assets in Africa and Malta - we're willing to make an exception here because we simply don't want to miss out on one of the fastest-growing, most prospective oil provinces in the world. Most of the major oil producers have acquired licences there in recent years and Genel is quickly becoming a top player in Kurdistan - it's growing production rapidly and drilling four huge new oil prospects in 2013 that should provide significant upside potential.

Our other, smaller, E&P, Parkmead Group (PMG), is almost the complete opposite of Genel. Slow and steady production growth, minimising risk, and focusing on good-quality assets in safe jurisdictions is what Parkmead is all about. One thing the two companies do have in common, though, is a high-profile manager. Parkmead is run by Tom Cross, who made a big impression on investors by selling his previous North Sea oil company, Dana Petroleum, to a Korean oil group for £1.87bn in 2010. He is setting out to create Dana II with Parkmead, and seems well on the way to doing so. Over the past year, Parkmead has made two transformative acquisitions that will boost oil production by 400 per cent this year, added gas production from the Netherlands, successfully completed horizontal appraisal drilling at the Platypus field, and been awarded 25 exploration licences across the UK Continental Shelf. The current share price of 12p is a good entry point and we think the shares will turn out to be a great long-term buy.

PRECIOUS METALS & GEMSTONES

Gold: Admittedly, we foresee the price of gold slipping further from here as bullion looks to be in a short-term technical downtrend. The question is: how low can gold go?

The next major support levels are around $1,200 (£792) an ounce, widely considered the average all-in cash cost level for miners, and around $1,000 an ounce, the level gold hovered around shortly before and after the financial crisis – that is, before the price ratcheted upward on the back of successive rounds of quantitative easing.

We think a significant tumble in the gold price would provide a major buying opportunity, however, as we remain positive on the yellow metal's long-term prospects. As our charting expert, Dominic Picarda, recently stated in the article 'Is it over for gold?' (IC, 3 May 2013): "History tells us that big bull markets often involve big pull-backs. In 2008, gold suffered an even sharper drop, before romping 165 per cent higher. And halfway through the bonanza of the 1970s, the yellow metal shed half its value, before increasing eightfold. I have not given up on the prospects for new highs above $2,000, therefore, but am waiting for confirmation that the lows are in before buying again."

Our strategy for the purposes of this portfolio is to short physical gold in the near term and look to buy back in around $1,000 to $1,200 an ounce.

We would do this through ETFS Physical Gold (SGBS), a reputable exchange traded fund that is backed by physical gold and is listed on the London Stock Exchange. Barring a few exceptions, gold mining equities have dramatically underperformed the metal itself and we foresee that trend continuing this year and next. Shorting individual mining equities at these depressed levels is too risky a proposition for us, however, as we think the few good-quality companies that deliver on their production and cost targets will eventually be rewarded by the market.

One of those companies is undoubtedly Archipelago Resources (AR.). Not only did the company meet guidance for its first full year of gold production at 139,000 ounces, but it kept cash costs down to an industry-low $635 an ounce. Strong cash generation enabled it to pay down debt and issue a maiden dividend, too. Guidance for 2013 is similar to 2012 and we think Archipelago's new status as a dividend-paying producer will play well with the market.

Silver: We expect the combination of new mine supply and sluggish industrial demand to keep silver prices under pressure. Even though silver prices broadly track movements in gold, we feel more positively about the latter for supply-side reasons.

Platinum: We're tempted to hold our noses and snap up a small stake in cheap platinum mining equities, but assuming such huge risk within the portfolio just isn't worth it given the unfinished issues with South African labour unions. Pass for now.

Diamonds: Polished diamond prices have performed well enough over the past few years, with larger and coloured stones performing best. That said, rough diamond prices - what diamond miners receive - have been softer, although it's more difficult to track prices due to the opaque nature of diamond tenders.

Still, we are broadly positive on the sector over the medium to long term. That's because western jewellers are starting to have success in wooing the growing Asian market, while a budding economic recovery and improving consumer sentiment in the United States should bolster prices. Nevertheless, we couldn't find a diamond miner listed in London that met all of our investment criteria for the near term. A Canadian company, Dominion Diamond Corp (DDC-T), fits the bill nicely, however, and improves the portfolio's regional exposure. Run by Robert Gannicott, an experienced diamond profiteer, Dominion recently acquired all of BHP Billiton's (BLT-L) diamond assets - of which the jewel in the crown is definitely the Ekati diamond mine in Canada's Northwest Territories. Dominion picked up the mine at a bargain basement price and we're betting Mr Gannicott can produce a repeat of his Harry Winston Inc transaction; Dominion bought Harry Winston's assets for C$250m (£159m) in the mid-2000s and sold it seven years later to Swatch Group for C$1bn.

AGRICULTURE

Here's an investment theme that is already backed up by the personal experience of far too many people across the globe. The United Nations has estimated that between now and 2050 the global population will increase from the current 7.12bn to around 9.1bn. It is also thought that a much higher proportion of the global populace will adopt the type of high-protein diets prevalent in the west.

More meat consumption presents a practical dilemma when you consider that more than one-third of the world's grain harvest is already used to feed livestock, and a gallon of petroleum is required to produce a pound of grain-fed beef. The stark demographic challenge is made all the more daunting by the fact that the rate of increase for grain yields is slowing even for countries that utilise intensive farming methods. Yields are now imperilled by increased natural resistance to pesticides and fungicides, soil degradation (loss of topsoil to development, erosion and desertification), water shortages and forecast fertiliser deficits. To overcome these problems, and avoid - or at least delay - a Malthusian catastrophe, farmers across the globe will need to resort to advanced biotechnology solutions (including genetic modification), advanced water management systems and mechanisation. The opportunities opening up for agri-business are legion, so we've identified three stocks (including two old IC favourites) that stand to profit from the changes in global farming.

As with the US gold rush of the 1840s, when the best way to profit was by supplying picks and shovels, so too with the new agrarian revolution under way, the surest route to prosperity is by concentrating on the industry's leading providers of agri-chemicals, biotechnology, proprietary seeds, fertiliser and farm machinery. It's a long-term thematic call on the market, but there are a number of candidates you could add to your portfolio if you want to tap into the expansion of modern farming technologies.

A prime candidate is Syngenta, a leading provider of crop protection products, and the third-biggest seed supplier. The group, which is listed on both the Zurich (SWX: SYNN) and New York (NYSE: SYT) exchanges, came into being at the start of the millennium when Novartis and AstraZeneca merged their respective agri-business and agro-chemicals set ups. An annual research and development spend of around $1.1bn has allowed the group to develop leading novel technologies and keep the competition at bay. First-quarter sales were up by 6 per cent year on year to $4.6bn, and with sale improvements across most regions Syngenta has attained a market-leading position in the growth markets of Latin America, eastern Europe and southeast Asia. The Swiss group is starting to reap the benefits of a strategic restructuring of its marketing model.

Maverick investor Jim Rogers, a zealous advocate of the farming investment theme, once said that: "Soon, stockbrokers will be driving taxis, while the farmers are driving Lamborghinis." Well, perhaps so, but we can be pretty sure that in 30-years' time farmers the world over will be 'driving to the office' in a John Deere tractor or combine. Deere & Co (NYSE: DE), incredibly, has been in business longer than the IC, and has become the world’s leading manufacturer of agricultural machinery. As mentioned, mechanisation and high-intensity grain production is on the rise. Yet much of the world's arable farmland is still tilled manually - around 44 per cent in the case of China. No surprise, then, that Deere is expanding beyond its North American home market. Midway through last year, the group initiated plans to build seven new factories in growth markets, including three in China, two in Brazil, a tractor factory in India and a facility in Russia. Over half of Deere’s workforce is now located outside the US.

Canada's PotashCorp (TSX: POT) is the world's biggest producer of fertiliser, so an obvious candidate if you're looking for a high-beta play on agricultural markets. Resources giant BHP Billiton (BLT) certainly regarded PotashCorp as a worthwhile strategic target when it launched a $39bn bid for the group in 2010, which it was ultimately forced to abort by Canadian regulators. That ostensibly a mining/energy group such as BHP wants to secure a market-leading position in farm inputs speaks volumes about the growing global importance of the sector.

INDUSTRIAL METALS

This statement from Citigroup analysts - who, it should be said, were one of the first set of mining analysts to make well-publicised 'sector sell' calls on mining equities - reflects our own concerns about the future of industrial metals: "The downward shift in China's economic growth rate, combined with the decline in the commodity intensity of growth, have a permanent and profound impact on global markets. China has reached a new phase, less focused on infrastructure and urbanisation, both of which are highly commodity intensive."

Our view is that prices of the industrial commodities peaked two years ago and are now stuck in a flat or declining price environment for the foreseeable future, as demand growth slows down and new mine supply continues to come onstream. True, there will likely be volatile price swings in both directions during this time. But we can't see minor production increases and cost-cutting measures being enough for the majority of the industry to see significant share price appreciation during this phase of the cycle.

Our portfolio is therefore light on industrial metal miners and focuses mainly on finding high-yielding, low-cost miners with healthy balance sheets. In addition, we look for 'emerging production' stories that can make up for commodity price declines by derisking their operations and by delivering large production increases.

DIVERSIFIED MINERS

The newly merged Glencore Xstrata (GLEN) presents an intriguing option for investors. Out of all the big mining resource companies, it is the only one still in expansionary mode. It is trying to position itself in leading positions across a range of commodity markets in the mining and energy segments through organic growth, acquisition and a growing number of off-take agreements. The growth of the group's resource base should bolster its trading activities over time, and unlike any of its listed rivals, these trading activities could theoretically insulate the group to a certain extent against the vagaries of spot markets. It's worth mentioning that the combined group is also seriously intent on expanding its agricultural division. A shareholder revolt at the group's first post-merger annual meeting resulted in the residual Xstrata directors, including chairman Sir John Bond, being removed from the board due to the payment of loyalty bonuses that were deemed excessive. The remaining Glencore directors, including chief executive Ivan Glasenberg, control just under a quarter of the group's shares - an unlikely, although welcome, factor for a FTSE 100 constituent with a large free-float.

SMALL-CAP MINERS

Copper: The red metal is widely touted by analysts and fund managers as the best of the industrial commodities - but we're not totally convinced. Bearish Citigroup expects mine supply growth to increase 7.1 per cent this year - notwithstanding the recent strike-related losses - pushing the market into a net surplus for the first time in years; we think this will soon pull down copper from its current level of around $3.30 a pound to $3 or $2.50.

Against this backdrop, we can't see any of the big London-listed copper miners experiencing significant substantial share price rises this year. So, as for gold, we add just one small producer to the portfolio: high-yielding Central Asia Metals (CAML).

The Kazakhstan-focused junior copper miner has deservedly gained credibility with the market, having brought its Kounrad project into production last year on time and under budget. The company has a decent cash pile, no debt, an impressive 7 per cent dividend yield and is expected to generate $22.5m of net operating cash flow in 2013. Best of all, Kounrad boasts industry-low cash costs of just 71¢ a pound of copper, leaving plenty of room for error should the price of copper drop significantly. Two upcoming catalysts could provide share price upside in the second half of this year, too: Central Asia is on the verge of signing a deal to buy back a minority stake in Kounrad from a government-related entity, and it will also provide guidance on plans for a second processing plant after conducting some additional test work.

Iron ore: Our view on iron ore has been largely bearish in 2013 as new supply and soft demand drag on prices. True, spot iron ore prices had an exceptional start to the year, averaging around $150 a tonne. But they've since dipped to $115 a tonne, and we're wary of consensus long-term broker forecasts predicting $80-a-tonne iron ore prices by 2015.

Aluminium, nickel, lead, zinc: Prices for these base metals are very depressed and we can't see a major recovery occurring in the next two years or so. We have consequently left them out of the portfolio.

Coal: Coal is cheap and coal mining equities even cheaper. We don’t particularly like the near-term prospects of either thermal coal (used in power generation) or coking coal (used in steelmaking), but the entry price is so tempting that we’ve decided to take a small punt on an emerging coking coal producer, Beacon Hill Resources (BHR).

After several frustrating years of delays, Beacon Hill's strategic investor cleaned out the former management team in 2012 and installed the current set of executives who include plenty of ex-BHP mine manager types. The company raised $21m in March to finish building its small but high-quality Minas Moatize mine in Mozambique, and expects to start producing coking coal by the end of this quarter. Granted, coking coal prices are down 50 per cent from their lofty heights in 2011.

But Beacon Hill's shares are down five-sixths over that time and the company should be able to make decent money at or around current coking coal prices. So, at 3p a share, Beacon looks good value trading at a sixth of what broker Canaccord Genuity believes is the heavily risked net present value for Minas Moatize, $220m, from which it generates a target price of 12p a share. Buy.

The ultimate resources portfolio