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The commodities revival

Is there energy left in the bull run? Alex Newman and Mark Robinson report
December 16, 2016 & Mark Robinson

When we put together our review of commodity markets a year ago, there were scant signs of hope. Our prediction that 2016 would be a good 12 months for gold and silver proved prescient, although it was the rattled nerves of global markets rather than a balancing of fundamentals that sent investors flocking back into the safe-haven metals. But even that rally - which went into reverse following the US election - was surpassed by the broader rebound across natural resources.

For the big miners, the year got off to a torrid start, with the share prices of debt-laden Glencore (GLEN) and Anglo American (AAL) hovering perilously close to the abyss. But since then commodities have been one of the best places for an investor to be. And just as with the sharp declines in previous years, the rally was largely unexpected: from coal to iron ore to copper and oil, most commentators had predicted further commodity price deflation and more pain for the industry. Throughout the year, the consensus has been blindsided by three key factors: costs, supply and China.

 

How low can costs go?

The dramatic nature of the commodities revival was perfectly illustrated in a recent note from Macquarie Research. In January, with a barrel of Brent crude at $27 (£21), global demand on the rocks and metal prices at multiyear lows, analysts at the bank estimated that more than a quarter of the supply of zinc, aluminium, alumina, iron ore and coal was losing money on a cash basis. Those costs exclude the capital needed to sustain - let alone grow - operations (not that many natural resources groups were focused on growth at the start of 2016). Fast forward 10 months and, according to Macquarie, "less than 2 per cent of global supply is now losing money". By any standard, that's an unprecedented swing to profitability.

This was partly down to higher futures prices, but the scale of many miners' cost reduction programmes has been staggering. Energy costs - which have still spent most of the year beneath multiyear forecasts - have helped flatten the dollar-denominated expenditure of many fuel-guzzling extractive industries. Miners and oil companies are also capable of self-help measures through 'high-grading', which involves digging or pumping the best stuff now. According to analysts at Vontobel Asset Management, this is what allowed many shale oil producers in the US to stay afloat throughout the downturn. It also partly explains why the proportion of lossmaking copper and nickel miners fell even before the recent surge in those commodities.

Evidently, such changes to mining plans cannot be sustained indefinitely. This was the central charge made by Fortescue Metals (Aus:FMG) founder Andrew Forrest at his company's annual general meeting last month. The iron ore group's chairman, who has a long history of criticising his larger peers, accused Rio Tinto (RIO) and BHP Billiton (BLT) of putting short-term profit ahead of the long-term value of their operations in the Pilbara region. "If you boast about your high-grade (mines)," Mr Forrest told The Australian, "you're really boasting about shortening your mine life by making your ore bodies less valuable over time".

Looking to 2017 and beyond, this is an area that should concern investors. That's because average ore grades across many base metals are slowly declining, due to maturing assets and the proliferation of large-volume projects favoured by the largest miners. This can only lead to higher costs, as projects become increasingly complicated and focused on resources that are deeper in the ground, as well as longer-term risk factors such as water scarcity and political upheaval.

A higher-cost future involves transition, and in the case of the larger diversified miners, this may mean waiting for prices to rise further until the next generation of projects are sanctioned. Add this to the drops in annual greenfield and brownfield investment - down 41 per cent and 50 per cent respectively since the 2012 peak - and there are reasons to question longer-term sources of supply. These concerns - which might begin to coalesce in 2017 - are the likeliest sources of the next upturn in the commodities cycle.

 

How long for oversupply?

When commodity prices were at their lowest in January and February, everybody agreed that there was too much supply. The hard call was how fast and to what extent lossmaking producers would be priced out. In the event, it hasn't been quite so straightforward.

Iron ore, the market for whichwas and remains one of the most parlous for suppliers, has shown signs of a return to sanity. Cuts to domestic supplies of iron ore in China followed the reduction in first-half guidance from several of the largest diversified miners, including Rio and BHP. Those cutbacks have had the effect of raising iron ore prices, although most majors are expected to build year-on-year production at the start of 2017, which could kick-start a further period of oversupply.

In the case of zinc, redressing the supply imbalance was largely due to the unilateral decision of one major actor. Last October, Glencore cut 500,000 tonnes of production - or around a third of its output - in a calculated effort to boost prices. The gambit worked perfectly, as zinc prices almost doubled from their lows to a nine-year high, which according to Liberum forecasts could help Glencore's zinc division to a 76 per cent increase in cash profits this year, up to a whopping $1.89bn. The success of the ploy has many traders betting that Glencore is prepared to repeat the trick in 2017, letting prices rise further before restarting previously mothballed production.

Coal provided another interesting case study in 'supply rebalancing' in 2016. In a calculated push to raise prices, the Chinese government opted to lower coal mining productivity, rather than deal with the bad loans and unemployment that would result from the forced closure of uneconomic mines. Interestingly, this has helped to make thermal and coking coal two of the best-performing commodities in the past year, although few in the industry anticipate the rally continuing into 2017.

 

China still dominates

As if another were needed, the shock to the coal price provides yet another example of China's dominant role in commodities markets. The coming year will be crucial to understanding the length and force of the next cycle, and China's role within it. For many commodities traders, the defining event of 2017 will be the Nineteenth National Congress of the People's Republic, in which the world's largest natural resources consumer will set out its economic priorities for the next five years. From a commodity investor's perspective, there may be reasons for bullishness. "Chinese authorities will seek political stability," argues ETF Securities strategist Nitesh Shah. "That could mean that the reform agenda could take a back-seat and overproduction of several metals could persist." If that results in an uptick in steel production - never much of a sure thing - Chinese metal buyers will be hoping for weaker nickel and chrome ore prices, which have surged in recent months, benefiting the likes of BHP Billiton, Glencore and Tharisa (THS), the only producer to list on London's main market in 2016.

These patterns underline a maxim that investors should always hold on to when investing in the sector - that commodities trade on their own fundamentals. But there are some reasons to suspect 2017 might still be a good year for natural resources in the main. The prospect of higher inflation in the US under a Trump presidency - and the knock-on effect on the dollar - should be good news for commodities, particularly if interest rates continue to lag. Secondly, a number of metals continue to be priced far below the levels that will incentivise developmental capital. Contrarian strategies, which have worked well for natural resources investments in 2016, may well round on nickel, copper, uranium and platinum metals as tempting bets in the years ahead. Against this backdrop, we are more bullish about commodities in 2017 than we have been in several years.

Such views and arguments should be tempered by the sector's volatility, of which 2016 has been another text book example. Furthermore, if ructions in the global economy and financial system finally light up the spectre of recession, then commodities are once again likely to do very badly. AN.

 

Oil: finding the new normal

The oil market in 2016 took on the shape of the classic three-act play. The scene was set with a crisis, as Brent crude fell to an almost unbelievable $27 a barrel at the start of February. The market then spent most of the year in the woods, trying to adjust to prices below $50 after years of largesse and wild exploration. The play's third and final act, which took place at the end of November in Vienna, saw a resolution of sorts, as Opec delegates tentatively agreed to the cartel's first production freeze in eight years. If the intransigence of the past two years is anything to go by, the agreement's implementation is likely to be fragile, and reliant on not only peace between the Kingdom of Saudi Arabia and its Shi'a rivals on the other side of the Gulf, but the participation of non-Opec producers.

For those economies whose budgets were relying on $100-a-barrel crude for the next decade, the Opec deal for a cut of 1.2m barrels of daily oil production from January couldn't have come sooner. And, judging by the state of Venezuela, some of the damage may prove irreversible. But a tighter market means tighter supply and higher prices, and for oil companies of all stripes that's normally good news.

As we detailed in our recent cover feature, the narrative that the market can simply find a 'new normal' seems too convenient. The simply enormous cuts to capital expenditure, combined with mature fields' declining rates, have had a serious effect on medium-term sources of production. And for all the bullish noise from the US, shale oil will not be able to make up the gap that Saudi Arabia et al have closed.

Incidentally, a firmer oil price couldn't have come at a better time for the House of Saud, given the Kingdom's intention to float a portion of Saudi Aramco at some point in the next 18 months. At present, the state oil company - reckoned to be the largest company in the world - has not confirmed on which stock exchanges it tends to list a portion of its equity. But if the IPO gets off the ground, it will be significant for a number of reasons. Firstly, it will probably be the biggest stock market listing in history, even if just 5 per cent of Aramco is offered up to global investors, as has been suggested. Secondly, a listing will also be an unprecedented exercise in transparency for a state company whose reserves have always been guessed at, and never publicly quantified.

And while the offering will have no shortage of buyers, Saudi Aramco's arrival on public markets will sharpen the focus on the merits and logic of long-term investment in non-renewable energy. In deciding whether to weigh into the IPO, large funds will probably be forced to explain to their investors why they are putting long-term capital into a commodity that could come under increasing pressure in the decades ahead.

Nearer term, investment in lower-cost projects is certainly needed if the market is to prevent the spectre of a deficit. BP (BP.), which did not cut capital expenditure as sharply as rival Royal Dutch Shell (RDSB) in 2016, was clearly waiting for an Opec deal. Just hours after the cartel's cut, the major sanctioned a $9bn investment in its enormous Mad Dog 2 project in the Gulf of Mexico, which should come into production in 2021. Investors can only hope that the industry has learnt the lessons of the past two-and-a-half years, and won't mark the next chapter in the oil price with a new generation of unfeasibly expensive projects. AN.

 

Iron ore - struggling under the weight of capital indiscipline

"My eyes are too big for my belly" is a familiar refrain during the festive season, and one that's curiously analogous to the experience of the extractive industries over the past 10 years. The iron ore market provides a prime example. In the early part of the new millennium, mining executives essentially abandoned capital discipline in expectation that the growth rates underpinning China's rapid economic industrialisation would be sustained indefinitely. What followed was a period of unbridled capital commitments; a series of long-dated, front-loaded iron ore projects that drove up capacity even as the commodity cycle moved into downtrend, with the result that the extra supply pushed prices down even faster.

 

China steel - the pitfalls of unbridled growth

Shareholders have been living with the consequences of this overindulgence on the part of the mining industry, but we shouldn't be too censorious. After all, China's steelworks, propped up by parochial regional governments and cheap loans, also leveraged themselves to the hilt in a bid to drive capacity. China forges almost as much steel as the rest of the world combined, but the supply-demand balance has been out of kilter for some time, feeding through into increased spare capacity, falling rates of utilisation, low profitability and capital returns.

Although domestic consumption has held up reasonably well due to the Communist Party's bid to drive economic growth in China's western regions, the country's steel exports peaked in 2007 - and haven't recovered since. And the industry is now hamstrung by heavy debt commitments. Even China's state bank regulator has warned that caution should be exercised with respect to lending money to steel companies.

Unfortunately, global iron ore producers remain in thrall to China's bloated steel industry. This time last year, as benchmark iron ore was testing the $40 a tonne mark, we said this was due to "heady assumptions on Chinese demand growth" that fed through to "rapidly expanding leverage ratios" and the resultant danger that prices could collapse towards "the lowest marginal cost of supply". In the event, the average in the first 10 months of 2016 was in line with the previous year, but the market has been subject to wild price gyrations, as traders increased long positions over conjecture linked to inventory levels and prospective stimulus measures in the People's Republic.

Speculation aside, the axiom that the best cure for low prices is low prices could now be playing out in global iron ore markets. The slump in prices resulted in cancelled projects and forced some low-margin producers out of the market. However, only three projects have been cancelled by the top-tier miners this year, against 18 in 2015. This suggests that the market could be heading back towards the point of equilibrium, or more likely that we're about to exit the bottom of the commodity cycle, a view supported by The World Bank.

 

Don't bank on a Trump-inspired revival

It is also worth noting that the average capital intensity of iron ore projects has nearly halved from its 2014 peak. That's good news for producers, but investors banking on speculation that an incoming Trump administration would unleash $1 trillion in infrastructure initiatives might be sorely disappointed. There is still such a thing as congressional oversight and it's doubtful that even a Republican-majority congress would rubber-stamp spending increases on this scale. Realistically, any demand-side impetus is likely to look rather anaemic when set against the campaign rhetoric, and it is unlikely that any large-scale infrastructure projects would get off the ground before 2018 anyway.

The possibility does exist, however, that the Trump administration could follow through on its promise to bring in punitive tax rates on Chinese steel imports. The trouble is that the bulk of steel produced in the US is now made from iron and steel scrap, rather than iron ore - hardly advantageous for miners in Pennsylvania and Indiana, at least initially - in terms of input-substitution. The bottom line is that you need to manage your expectations with regard to the iron ore price through 2017; producers stand to benefit from an industry-wide fall in capital intensity, but we think that average prices will settle well below the current rate of $78 a tonne - most of the risks remain to the downside, even with The Donald in charge. MR

 

The orthodox view on gold

Whenever you talk to someone about the gold price, rather than the actual miners of the metal, you run the risk of getting bogged down in abstractions. That's because few commodities divide opinion among investors as to their intrinsic worth as gold does. It's a debate that has been going on since the American Civil War, when the Lincoln administration issued two types of paper currencies, the so-called 'greenbacks', neither of which were backed by gold or silver, but, instead, relied solely on the credibility of the US government.

That last point is worth considering given the experience of our recent past, when we've witnessed traders going long on the US dollar and commodities (including gold) simultaneously. That's at odds with the pattern established in the postwar era; lest we forget that commodities crashed in an inverse fit with a surging dollar for two years through to mid-2016. But, then again, we're moving through a period in which economic and political orthodoxies are being put to the test.

So where are we with the gold price? Well, conventional wisdom certainly points to near-term weakness as recent positive US economic data raised the prospect of an increase in US interest rates. That view is supported by a fall-away in speculative trading positions in gold futures, as per the latest report issued by the US Commodity Futures Trading Commission, although the decline in net long positions is also explicable in terms of market anxiety in the run-up to the recent Italian referendum.

 

The limits of presidential power

Even though the markets haven't behaved logically of late, it seems slightly curious that we haven't witnessed increased support for the gold price in the wake of Donald Trump's election triumph, particularly given his campaign promises that, if implemented, would feed into inflationary pressures, increased infrastructure spending, and fast-rising (and perhaps illusory) growth rates. For unlike the quantitative easing (QE) programmes carried out by the US Federal Reserve - which have left capital idling on Wall Street balance sheets - the stimulus measures outlined by the president-elect would expand US money supply (M0) significantly. New policies linked to restrictions on trade and immigration could also give rise to inflationary pressures, particularly as the economy is already operating at near-full employment with rising wage pressures.

However, even if Mr Trump makes good on his campaign promises - and that's a very big 'if' given likely opposition from Congress - there's no guarantee that investors will pile into gold as a bulwark against inflation. That gold acts as a hedge against inflation is held as an article of faith by some investors, the same people who would drone on endlessly about the damage done to 'sound money' when Nixon took the US off the gold standard in 1971. But the issue is not cut and dried; several studies have been carried out that cast doubt on whether any statistically significant correlation exists between inflation rates and the gold price.

Anyway, it's improbable that any big-ticket infrastructure projects would be approved by congress before 2018, as there are apparently few 'shovel-ready' options. We're not looking that far ahead, so we see central government policy in both China and India as the chief determinants on gold pricing through the first half of next year.

 

Gold premiums and black money

Gold premiums in China (the excess of purchasing power of gold currency over paper money) have recently reached three-year highs. That has resulted from limited supply of the yellow metal as Beijing turns the screw on imports in a government effort to limit outflows of the yuan, after the currency slumped to its weakest rate in more than eight years.

The price of the yellow metal in India is also under pressure due to central government policies designed to restrict imports, weaning the nation off a love affair that represents a structural impediment to growth and the reduction of India's current account deficit. Roughly four out of every five rupees held as savings is in the form of the physical metal, little surprise when you consider that the bulk of the population doesn't have access to banking facilities. Consequently, any increase in aggregate savings doesn't necessarily increase the available funds for lending within the banking system, as the metal is financially unproductive.

Various measures have been undertaken by the Modi government to curb the estimated $25bn in annual imports, including tariff increases and the issue of a sovereign gold bond, but nothing has had a lasting effect on import volumes. However, Delhi's crackdown on outflows of so-called 'black money' from the economy, including the overnight removal of legal tender status for high-denomination 500 and 1,000 rupee notes, has led to speculation that the government is considering a temporary ban on imports of gold, which plays a significant role in India's shadow economy. We feel such a drastic measure is unlikely to play through, but you never know.

We believe that physical markets are likely to have a greater bearing on gold prices than the trade in derivatives - at least in the early part of 2017. That could reverse as soon as the Federal Reserve tightens monetary policy, real Treasury yields increase and the US currency rises. That's the orthodox view, at any rate. MR.