Every so often, the world bears witness to a haboob – a meteorological event whose etymology points to its prevalence in the Arabian Peninsula’s arid climes. Haboobs occur when thunderstorms suddenly collapse; wind directions reverse, rains descend, and desert sands quickly morph into a fast-moving wall of sediment miles wide and hundreds of metres high, cloaking all in its wake.
A similar storm – also of Arabian origin – has been gathering since the dynamics that underpin the oil market were reset in 2014. After first attempting to flood the market with crude, Saudi Arabia saw the unstoppable rise in US output, realised its future as the world’s swing producer was gone, and decided to diversify its oil-based economy, starting with the partial sale of its key asset.
Out of the collapse, a monster emerges. And if the UK government’s pliant overtures have been effective, 2018 could see the arrival on the London Stock Exchange of Saudi Aramco. Capital markets have few precedents for a listing of this scale: even if Saudi Arabia achieves half of its self-estimated value, the state oil company could be capitalised at $1 trillion (£746bn).
With the particulars of the float yet to be determined, it isn’t possible to make a valuation argument. But Aramco’s possible arrival in 2018 does pose two questions for investors. The first: even if the company lists with big dividend promises, is it really an investment for the future? After all, there is a reason why Saudi Arabia plans to sell down its crown jewels. Second, might investment flows into Aramco crowd out capital set aside for the rest of the sector? Could holdings in Royal Dutch Shell (RDSB) and BP (BP.) be reallocated in Aramco, thereby clobbering the incumbent oil majors’ ratings?
To the first, Saudi Arabia has clearly noted global investors’ desperate hunt for income, a relative paucity of large assets, and spies a partnership. The Kingdom wants to raise a jaw-dropping amount of cash, but assuming several major markets (or China) can swallow the Aramco equity, there probably will be buyers, regardless of the corporate governance deficits of a 5 per cent free float.
In fact, the size of the sale may allow Aramco to circumvent a straightforward equity listing. As we wrote back in June, the company could elect to sell global depository receipts (GDRs) – securities issued by banks representing Aramco shares, and traded on foreign exchanges like normal stocks. The LSE rules state that GDRs can be listed on either the main market through a standard listing, or on the so-called Professional Securities Market, which is closed to retail investors.
Such a structure is unlikely to give Aramco a premium over Shell and BP, whose investment cases also hinge on shareholder returns, underpinned by relatively steady-state long-term production. That’s despite the undoubted quality of Aramco’s asset base. For the UK stocks, recent moves to commence share buybacks – and in Shell’s case, scrapping the dilutive scrip dividend – underline their income cases, if not their ability to re-rate. If Aramco does list, we expect most investors will stick with the devils they know.
Fundamentalism
Stepping into 2018, the oil market rests on a potentially complacent assumption: while supply shocks could come (wholesale Venezuelan default, a Nigerian political crisis, or another flare up in the Middle East), demand will solidly rise. And yet the rest of the commodities market fears Chinese demand could contract this year. Alongside this curious disconnect we have predictions of a peak in global demand within the next decade, possibly as soon as 2022.
So here’s another prediction: while demand won’t peak, talk of peak oil will increase. Of that we can be doubly assured if prices rise. Meanwhile, producers and bullish analysts will point to the growth of Asian populations and petrochemicals, technologists will point to vehicle electrification and greener grids, and bears will point to the threat geopolitical uncertainties pose to general economic growth.
Against this, we expect added investor appetite for oil and gas stocks that promise a good level of cash returns on invested capital in the short-to-medium term, and whose production is set to step up before 2020. In this stable we include the European majors Total (TTA) and Eni (IT: ENI) mid-cap stocks including Kosmos Energy (KOS), and Amerisur Resources (AMER), as well as smaller players such as Diversified Gas & Oil (DGOC), Eland Oil & Gas (ELA), Serica Energy (SQX) and President Energy (PPC).
For oil stocks, there’s a growing pressure to meet a consensus view whose horizon is increasingly short term. Perhaps that’s fair. After all, the responsiveness and flexibility of the US shale industry looks set to dampen any potential break-out in prices. Or so everyone says.
The Communist Party of China offers several lessons to the west’s capitalist investor class. Chief among them is the virtue of taking the long view; for central state planning, simply swap in ‘research, buy and then hold for five years’. It’s the kind of horizon we at Investors Chronicle try to encourage (even if the lifespan of our tips sometimes fall short).
Handily enough, we recently received an example of such long-term thinking when Beijing hosted its 19th National Congress in October. Or did we? Although the congress brought a tonal change in the nattily-titled ideological contribution ‘Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era’, it offered little precise detail on the scale and direction of economic growth.
For mining investors, whose fortunes are largely determined by the economic policy diktats of the world’s most populous and commodities-hungry nation, there was both disappointment and encouragement. On the one hand, Xi’s shift in attention toward the better management of “unbalanced and inadequate development and the people’s ever-growing needs for a better life” was cited as a portent of softening economic growth.
Conversely, the congress cemented expectations that the People’s Republic will play an ever more assertive international role over the next five years. And promotion of the enormous pan-continental ‘Belt and Road’ infrastructure initiative will hardly dampen demand for industrial commodities. “The era of ‘hide your strength, bide your time’ is over,” suggests China expert Bill Bishop.
Unsurprisingly, Rio Tinto (RIO) chief executive Jean-Sebastien Jacques honed in on the latter theme when interviewed by the state-owned English language newspaper China Daily. “In particular, we are closely following China’s supply-side structural reform, and the Belt and Road initiative,” he said, adding that the scale of the two developments “will have a huge impact on demand”. Of that there can be little doubt. China – itself a rather large shareholder in Rio – accounts for more than 40 per cent of the diversified miner’s global revenues.
Consequently, the market’s overall verdict onthe congress was neutral. Prices of commoditiesand mining shares neither collapsed nor re-rated.
Perhaps that was inevitable. The assumption that Chinese state planning lacks nuance – or even the widespread application of market economics – may have fed into the anticipation of a sudden shock. Equally, China only has to change gears slightly for the global economy (and miners in particular) to feel it. Yet these tropes may explain hedge fund manager Felix Zulauf’s prediction that China will start to slow down in 2018.
“In 2021 there is the 100th anniversary of the Chinese Communist party and it’s very clear that they want to have a strong economy at that time,” Mr Zulauf recently told Bloomberg. “If you want to have a strong economy in 2021, you stimulate in 2020. And they are central planners. So that means they have to take their foot off the pedal in 2018 and 2019.”
Such a slowdown could be bad for London’s larger miners. When BHP Billiton (BLT), Glencore (GLEN), Anglo American (AAL), South32 (S32) and Antofagasta (ANTO) did well in 2017, it was because China put its foot back on the pedal. This in turn either bid up short-term spot prices, or in the case of copper, increased fears of a looming supply crunch before the end of the decade.
Then again, the politics that might follow from Mr Xi’s strengthened hand may not spell doom for the sector, even if Mr Zulauf’s bet comes off. “We would argue that a slowing China is a good thing for sentiment,” wrote Macquarie’s mining analyst team in a note published last month. “When China grows too quickly, market fears of an imminent collapse seem to expand, and the mining stocks tend to discount this in. We would argue that a China that grows moderately in tandem with broader globally dispersed growth seems to be a better environment for a re-rating.”
On a long-term view, steady growth is probably the best medicine for an industry famed for its hubris and amnesia. Indeed, the “unbalanced and inadequate development” that has characterised the mining sector’s own earnings history this decade could probably do with another reminder to stick to what capitalist enterprises are supposed to deliver: financial returns.
For that reason, we also think 2018 could be a good year for some of the smaller listed miners focused on commodities that are either scarce, or on low-cost projects in tightening markets. Among this group we count chrome concentrate producer Tharisa (THS), prospective uranium miner Berkeley Energia (BKY), and, assuming funding is there for its Mexican lithium project, Bacanora Minerals (BCN).
Precious metals: three in a row?
Why do people want gold? Portfolio diversification, electronics and central bank hedging are all worthy suggestions. But the most obvious answer is also the most accurate. The yellow metal – or the Original Crypto-currency™ as it will soon be rebranded in an effort to lure the mad speculator buck – is sought after because it is hard-wearing and looks pretty. Gold is precious because it is precious.
The reasoning is as simple (and circular) as that, and helps to explain why the biggest market for gold is the jewellery industry. Indeed, the World Gold Council estimates that global gold jewellery demand came to 487.7 tonnes in the third quarter of this year, outstripping all of the purchases by central bankers, bar and coin buyers and exchange traded funds (ETFs) combined. It’s a dynamic that bears repeating, because precious metals markets are often entirely seen through a dollar-denominated, western lens, with its own slant on global geopolitical and financial market risk. In reality, Indian and Chinese cultural attitudes to gold have a greater sway on fundamentals.
So will people want gold in 2018? If we start with what is normally the largest single source of demand – Indian jewellery – the signs are mixed, if affirmative. In July, the Indian government introduced a 3 per cent goods and services tax, which significantly weighed on demand in the third quarter and, according to the World Gold Council, is a “continuing obstacle”. More positive – for gold demand at least – was the suspension of anti-money laundering legislation requiring retailers to file so-called ‘know your customer’ documents for all jewellery transactions above Rs50,000 (£580).
Assuming cultural attachments to gold persist, the wider picture looks good, too. According to the World Bank, India’s real GDP is expected to grow at 7.4 per cent in 2018, a faster rate than any country in Asia. The country’s largely young population is also steadily increasing, providing another background source of demand – although as the Chinese jewellery market has seen in recent years, a general increase in consumer spending provides competition, particularly from travel. Instead, Chinese gold buyers are turning in their droves to gold bars and coins.
The fashion seems likely to be replicated by central banks. As the world moves to a multi-currency system, and demand for the dollar fades, nations have steadily upped their holdings of bullion reserves, demonstrated by the purchase of a whopping 111 tonnes in the three months to September, largely driven by Russia.
Accompanying this trend has been a curious absence of volatility of late. Panmure Gordon commodity analyst Kieron Hodgson recently offered one explanation: “Many will see gold as an opportunity cost, but my view is more that gold is now acting more akin to an insurance policy (capital preservation) as opposed to an investment based on capital appreciation.” So, despite broad market consensus that US monetary policy will tighten, nervous equity investors may well have taken a more favourable – or at least neutral – near-term view on gold.
For shareholders in precious metals equities, however, 2017 has been another good year. The moves in precious metals prices have been less volatile than 2016, when many shares in the sector sharply re-rated. But at the time of writing, London’s largest precious metals stocks – including Polymetal (POLY), Randgold Resources (RRS), Centamin (CEY) and Fresnillo (FRES) – were all up since January, excluding dividends. The one absentee from this pack, of course, is Acacia Mining (ACA). Crushed by a stand-off with the Tanzanian government, and shut out of remediation discussions between its host country and parent company Barrick Gold, we think 2018 could see it descend into further legal woe.
Elsewhere, we remain cautiously bullish on the larger gold miners, which, with the metal at $1,300 an ounce, are (or certainly should be) in strong cash-generation mode in 2018. Market fundamentals should also come in for greater focus: according to numerous analysts, mine production will decline from 2019 as the cuts to exploration and capital expenditure budgets following the 2013 gold price crash are revealed.
