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Resources: Greed gives way to fear

Investors in natural resources stocks have endured a torrid time through 2014, but it may pay to take a counterintuitive view of markets in coming months.
December 19, 2014

We move into 2015 with spot prices for iron ore, metallurgical coal and crude oil at multi-year lows. And the portents are far from encouraging, with numerous negative price levers cited in the financial press, ranging from Saudi Arabian intransigence to excess steelmaking capacity in China. However, the outlook is slightly brighter in the industrial metals complex, while a prolonged oil price slump could work counterintuitively where the gold price is concerned.

 

The barometer for the global economy

The price of the bellwether commodity - copper - staged a somewhat stilted recovery following a sharp first-quarter contraction. The Chinese shadow lending scandal provided an unlikely catalyst for prices during the year. The widespread use of copper as collateral in the Chinese domestic loans market was to blame. It emerged that some lenders had been engaged in sharp practice, by utilising the same ingots of physical copper as collateral for multiple loans. When Beijing announced a crackdown, fears mounted that Chinese investors would look to alternative forms of collateral to underwrite financing. The copper, much of which is held in non-bonded warehouses, could have potentially found its way back on to global markets as unscrupulous lenders attempted to cover their tracks. In the event, this has yet to transpire, but it did lead to increased volatility during the first half of 2014.

A number of copper projects have been put on ice over the past 18 months, leading some analysts to venture that global supply will slip into deficit during the second half of 2016. Unfortunately, we've been here before. The trouble about these types of predictions is that they're often predicated on trade data provided by Chinese government agencies, the reliability of which is regularly brought into question. As China accounts for around 40 per cent of global imports, this presents something of a problem for industry analysts. But as Glencore founder Marc Rich once said: "Secrecy is an important factor of success in the commodity business" - for "secrecy" read inscrutability.

We do know for certain that there are pointers to weakening copper prices over the near term. According to the US Commodity Futures Trading Commission, the net short position for trades on the metal has expanded rapidly over the past 10 weeks. So the copper price - viewed by many as a barometer for the global economy – appears to be clicking back into reverse.

 

Through a glass darkly

Investors in natural resource stocks have endured a torrid time through 2014. Alas there are precious few signs of respite. Morgan Stanley now predicts that Brent crude will average $70 a barrel in 2015, down $28 from a previous forecast, and be $88 a barrel in 2016. The Bloomberg Total Return Commodity index sits at a five-year low after contracting 11.1 per cent over the year to date (3.9 per cent in November alone). And even if you've managed to reduce exposure through your personal equity portfolio, you're still likely to feel the pinch. With five constituents of the FTSE 100 - BP (BP.), BG Group (BG.), BHP Billiton (BLT), Rio Tinto (RIO) and Royal Dutch Shell (RDSB) - accounting for over a fifth of the benchmark weightings, any fall-away in valuations has a pronounced effect on managed funds and pension schemes.

An inherent problem for investors in the broader natural resource sector is that - for the most part - commodity-linked stocks have limited pricing power; industrial end users can often simply trade away from one producer to another or run down existing inventories. And while this hasn't always been an acute problem for oil producers, the current glut in petroleum export markets is trimming margins for higher-cost producers. A limited ability to pass costs on to customers, coupled with rising extraction costs, has resulted in many resource companies reducing their headcounts and mothballing capital projects.

 

Scale-benefits and supply-side options

Moreover, the general pullback in commodity prices, although problematic for large-scale producers, is potentially ruinous for industry minnows. In October, Western Australia's State Premier, Colin Barnett, accused both BHP Billiton and Rio Tinto of acting in concert to drive out competitors. The assertion, though certainly not fanciful, is still wide of the mark. In essence, the heavyweights are reaping scale benefits linked to their massive iron ore investments in Western Australia's Pilbara region.

If prices for iron ore remain in the doldrums it's inevitable that expected new tonnage coming on to global markets will be pared back as yet more expansion programmes and virgin projects are canned. Mr Barnett suggested that the logical business reaction to falling iron ore prices would be to cut back supply, not to increase it. But the two mining heavyweights are able to sell increasing tonnage into an oversupplied market simply because the superior ore grades at Pilbara translate into lower unit cash costs. It may be painful for operators with lower marginal rates of profitability, but that's hardly the fault of the big Pilbara operators - after all, the state government approved their mining plans in the first place.

 

Consolidation on leveraged plays

The iron ore price has halved through 2014 to just above $72 (£45) per tonne as the biggest iron ore producers have chosen to bump up production despite oversupply. Industry analysts think there's more pain to come; Citigroup recently slashed its quarterly estimates for 2015, with forecast prices oscillating around the $60 market during the second half of the year. It's certainly going to be a difficult reporting season for iron ore producers; there will be more job cuts announced over coming weeks and months, along with project delays and cancellations.

And we might realistically expect further consolidation in the sector, perhaps even with Chinese buyers moving on highly leveraged smaller operations in a bid to secure future supplies. China has made no secret of its determination to ward off any perceived price collusion on the part of the big global producers, so it's conceivable that Chinese investors may be willing to provide financing in return for production offtake agreements, albeit on highly favourable terms. With an industry-wide shake-up in the offing, 2015 might eventually come to be seen as a pivotal year for iron ore but, given the Darwinian logic at play, we still think large-scale, low-cost operators will prevail over the long-run.

 

Iron-clad investments

The slump in ore prices means that Rio and BHP are trading at or near five-year lows, while offering gross yields of 4.7 per cent and 5.6 per cent respectively. The commodity hit for BHP has been exacerbated because of its substantial energy division, much of which is linked to US shale oil production. Rio's chief executive, Sam Walsh, believes that demand from steelmakers will remain strong over the long term due to the urbanisation of developing countries. If, like Mr Walsh, you view the current malaise as cyclical in nature, then the fall-away in share prices for the two big miners has opened up attractive entry points for investors.

 

Nickel, aluminium and zinc

Although possibly counterintuitive, three industrial metals - nickel, aluminium and zinc - recorded solid price growth in 2014 despite a third-quarter fallback linked to the strengthening greenback. Prices for both nickel and aluminium had been on the slide since 2011, and while it's too early to say if this year's rises have arrested a downward trend, there are some reasons to think that prices will retain support through next year.

While there has been no sustained increase in industrial demand, nickel prices should continue to receive support as a result of export restrictions from Indonesia, which are expected to lead to a supply deficit in 2015. Early this year, Indonesia implemented a ban on the export of mineral concentrates; initiating regulations that require miners to build smelters and refine ores domestically. It's having an effect across a range of industrial metals, but nickel has been the chief beneficiary.

Aluminium prices have struggled in recent years due to severe overcapacity in the market. As a consequence, the industry has been undergoing a period of rather drastic housekeeping. Now some analysts think that (non-Chinese) industry rationalisation has run its course. A downsized sector reduces the possibility of further price contraction, particularly as there is little prospect of major producers like Alcoa and Rusal reactivating capacity - at least not over the medium term. But the reality is that the aluminium market would need to be in a supply deficit for years in order to mop up excess inventories in global markets.

 

Gold, crude oil and the greenback

You'll always be hard-pressed to find an objective stance on the gold price. The worth of the yellow metal tends to polarise opinion from an investment standpoint. John Maynard Keynes famously dismissed gold's link to the money supply as a barbarous relic, but there are also any number of zealots out there who take the opposite tack. We shan't dwell on gold's relative merits here; suffice to say that its average price over the past 12 months - $1,267 an ounce - is in line with the all-in cost floor that we've been promulgating since the first-quarter sell-off in 2013.

It's also worth noting that, although Brent crude is trading at a five-year low, the gold price is holding up reasonably well. Weak oil prices usually undermine gold demand by boosting US growth and ultimately the value of the dollar. However, things are hardly encouraging from a geopolitical perspective. As a result, demand for both gold/dollar assets, although nominally at odds, could coalesce as global worries intensify. The flight from the Russian rouble has already bolstered inflows into both gold and the greenback as the international sanctions start to bite. Gold/dollar demand is also being reinforced by fears over growth prospects in China, Japan and the eurozone, which could prompt further loose monetary policy initiatives. It's certainly conceivable that just as the US Federal Reserve is contemplating raising interest rates, the ECB and the Bank of Japan could well be in the process of expanding their balance sheets.

Here's another seemingly contradictory scenario whereby weakening oil prices could support precious metals. In a bid to rein in a persistent current account deficit, the Indian government has introduced a succession of measures that restricted gold imports to the country - traditionally gold's most important marketplace. The measures helped narrow the country's trade, as well as its current-account gap, but imports surged in November after Delhi relaxed the curbs. However, as India is a huge net energy importer, the rebound in gold demand will be offset by the fall in crude oil prices. Again this is somewhat at odds with the prevailing view on the relationship between the two commodities.

 

Platinum prices and inflection points

And while we're musing on the counterintuitive dynamic, we should highlight the example of platinum prices, which slumped to a five-year low despite a bitter five-month strike in South Africa at the beginning of the year. Production was down by 1.3m ounces, severely impacting full-year figures for Amplats, Lonmin (LMI) and Impala. But the expected price spike never materialised as big industrial end users of the metals, such as European auto manufacturers, had been building their inventories in anticipation of the industrial unrest.

Still, according to newly formed industry body the World Platinum Investment Council the market is in supply deficit to the tune of 885,000 ounces in 2014. According to the council, above-ground stocks (a chief break on the platinum price) have been whittled down to 2.56m ounces from 4.14m ounces at the end of 2012. This has been due not only to repeated deficits in the market caused by supply disruptions, but also to large inflows into exchange traded funds. Looking ahead, it seems likely that overall demand could soften in 2015 as increased utilisation of the metal in autocatalytic and jewellery manufacturing is outweighed by a fall-away in investment growth. Over time, excess above-ground stocks will be leached away, but after this year's experiences we're unwilling - and unable for that matter - to shed any light on the probable inflection point for prices.