Whilst the whole commodity space is broadly impacted by similar forces such as global growth dynamics, we believe that superior risk-adjusted and uncorrelated returns can be generated by focusing on specific areas within the latticework. In this short article we would like to give you a sense of what we perceive to be driving strong commodity prices and how long we think it could last. More importantly, we hope to convey what we see differently from the market and how we go about generating returns for investors.
The commodity price story: fundamentals and new money
High commodity prices have been caused by the confluence of two factors which have impacted the supply of and demand for resources. On the supply side there is clearly an inability to provide sufficient resources to meet demand. In oil the International Energy Agency has recently indicated that it is preparing to revise down its long term oil supply forecast, as it sees increasing difficulty for production to rise from current levels of 87 million barrels a day given ageing oil fields and constrained access and investment.
Similar issues constraining supply are visible across the resources complex, whether we are looking at electricity, wheat, copper, vanadium or coal. The cause of this is a general underinvestment in productive capacity over the last few decades, with the result that today there are insufficient power stations, oil pipelines, drilling rigs, mines, geologists, mine managers and so forth to satisfy the world’s hunger for resources. And the world is getting hungrier.
Excess capacity for supplying resources has been steadily whittled away since the end of the 1970s but it was only at the turn of the millennium that the world started to notice thanks to the signal provided by rising commodity prices. What changed was the beginning of the massive global structural change driven by the industrialisation and urbanisation of China and India.
“Quand la Chine s’éveillera, le monde tremblera” said Napoleon, and whilst he was probably not referring to a commodity price supercycle, his words have relevance nonetheless. China is awakening and the world is indeed trembling as we struggleto supply the resources needed to satiate its hunger as it develops.
One of the questions that regularly arises concerns the degree to which commodity prices have been inflated by financial investors and whether one should therefore fear a swift reversal in prices. It is easy to see why people are concerned as investors continue to pour money into the sector – commodity index investment grew US$50 billion in 2007 and in the first quarter of this year by another US$26 billion i.e. at nearly three times the rate of 2007, and by the end of March there was US$260 billion invested in commodity index funds. Portfolio diversification into uncorrelated assets and hedging against inflation and dollar depreciation are the most commonly cited reasons for this influx of new money.
Financial flows into resources clearly do have a role to play in moving commodity prices but in our view the involvement of speculative money in the resources space is more a symptom of high prices than a cause. Not all rallies are driven by speculation. Fig.1 illustrates this point by showing the relative price changes of exchange traded commodities, which are affected by financially oriented commodity investment, versus non-exchange traded commodities which are not open to financial investors. All have moved upwards indicating that there must be something other than speculative money driving up prices. Ironically it appears that non-exchange traded commodities have increased more than their exchange traded brethren.
Fundamentals still play an important role in setting commodity prices, which can be illustrated by looking at the same commodities but over a shorter period. Fig.1 also shows that in the last year commodities like iron ore or coal, which are not open to speculators have increased significantly in price, whereas zinc and nickel, which are exchange traded, have both halved in the past year. The forces driving these divergent price moves are changes in production and inventory levels. The Zinc market has edged from deficit to surplus as new production has come online rapidly. As inventories have risen, so prices have fallen.
One of the critical questions when considering whether to invest in a resources strategy is to ask oneself how long this cycle could last. We have looked to history for guidance.
Fig.2 shows real commodity prices going back over 200 years. It shows that supercycles in the resources sector can be traced back to the 1800s and tend to move in sync with global economic change. The forces driving such changes are typically a major industrialisation or urbanisation somewhere in the world (Europe, the US, Japan), or the rebuilding that follows a significant war. The current cycle started in 2000 from an all time real price low after a 60 year bear market.
Taking in the bigger picture shows that the current upswing in commodity prices, which is powered by the industrialisation and urbanisation of China and India, is no different from the past. Historic cycles have lasted for between 15 and 40 years, and it seems to us that China’s urbanisation still has considerable scope to run, with per capita income and metals consumption still only in line with those of developing Asian economies in the 1970s and 1980s and post-war European Economies. Each year 15 to 20 million people urbanise in China and currently only 45% of the total population lives in cities versus 75% in more developed economies. Urbanisation is a relatively slow, resource intensive process and it is going to take a long time to catch up.
In addition, as a middle class emerges and incomes rise, so consumption patterns will change. Purchases of refrigerators, air conditioners and cars, amongst other things, will push up consumption of metals and oil to developed economy levels. People’s dietary preferences will also change, as they consume more meat, and therefore demand for animal feed will grow significantly. Given the significant increases in soft commodity prices seen in the lastyear one could argue that this change is already taking place and manifesting itself in market prices.
Another approach to determining how long the cycle could last is to look back at historic phases of investment and exploitation in the resources space. Previous investment phases in the commodities sector have lasted for 15-20 years, implying that we are approximately halfway through the current cycle. It is simply not possible to throw trillions of dollars at the commodity space and expect production capacity to materialise instantly.
The bottom line is that we anticipate high levels of activity in the resources space for another decade to correct the current market imbalances, reflecting the time lag in bringing new capacity to market and the incremental growth in demand from these emerging economies.
Resources investment: the opportunity
Commodity prices are first and foremost a signalling mechanism to providers of capital that they need to invest in new infrastructure to bring additional resources to market, and accordingly, the invisible hands of supply and demand have responded to higher prices since the year 2000, and are pushing a wave of capital investment through the resources complex.
The way we generate returns for investors from this phenomenon is by finding the key areas of bottlenecks and pinch-points in the resources space, and surfing the investment wave at those points. We do this by investing in the equities of companies that are exposed to the themes that we find most compelling. The point made previously about the divergent paths taken by different metals highlights the importance of positioning oneself in the right places within the resources latticework to maximise returns.
Viewing the resources space in a holistic way means that our opportunity set is extremely broad, comprising oil and gas producers and services providers, energy mining (coal, uranium, oil sands), energy infrastructure, base metals, precious metals, new metals, alternative/renewable energy, water, soft commodities and agriculture. The way that we sift through this broad universe is by taking a thematic approach followed by valuation filtering and then in-depth financial analysis. This approach has drawn us to a number of compelling themes, from Ukrainian and Eastern European gas and North Sea oil exploration, through copper, aluminium, agriculture, and uranium to power shortages (specifically their implications for the production of certain metals). The number of countries now suffering from energy shortages is probably in the double digits, from China and India, through South Africa and even Russia.
Of particular interest to us are the problems in South Africa which have led to production problems in the mining sector and are likely to derail the growth ambitions of many metals companies in-country. We have, therefore, targeted companies that produce metals where South Africa is a significant or dominant producer, such as platinum, vanadium and ferrochrome.
Following the power shortage theme in another direction, aluminium is one of the most energy intensive metals to produce, which creates a strong relationship between the energy complex and the metal. As Fig.1 demonstrates, it is a metal whose price has significantly lagged that of the other base metals, which not only leads us to believe that there is far less downside in aluminium price in the event of a broad commodity price correction, but in fact we believe that the opposite will happen: aluminium prices are set to increase significantly over the next 12-18 months. This stems from our observation that China has clamped down on exports of aluminium from its highly inefficient domestic smelters which are cheap to build but expensive to run, putting them at the top of the cost curve. By exporting aluminium China is effectively exporting energy from an economy that is chronically short of energy, and it is taking action to stop this, reducing the supply of aluminium to the global market. This shift in behaviour will remove one of the headwinds that has held back the aluminium price, and the way we express this thematic view is by going long on low cost aluminium and bauxite producers, both of whom are positioned to benefit from a secular rise in the aluminium price.
Resources equities: an investment framework
If we reverse engineer the share prices of oil or metals producers we find that the market in general appears to be pricing in declines in commodity prices. This is a critical area where we differ from many market participants. The equities of resources companies have underperformed their commodities, particularly over the last six months, representing a significant opportunity across the resources space. It is important to note, at this point, that we do not assume that resources prices are going to increase significantly from current levels, but we do believe that they will maintain elevated levels for much longer than many believe, and that this is not reflected in equity prices.
We are however cognisant of the risks to our central thesis of sustained commodity prices. Financial and index commodity investors contribute to increased price volatility and a reversal of speculative money flows could cause commodity prices to retrench rapidly. A more concerning medium term risk is a stalling of the Chinese and Indian economic engines – China’s trade surplus could rapidly disappear as it turns from a net exporter of grains and energy to a large net importer. Subsidising domestic food and energy production could become prohibitively expensive, causing its budget deficit to soar. If this happens, the disinflation caused by globalisation since the early 1990s could reverse, causing inflation to increase significantly and demand to weaken. Incremental risks are introduced by inflated commodity prices which leads to unpredictable and potentially undesirable outcomes.
Accordingly, we do not rely on higher prices when making investment decisions. A strict valuation-oriented approach is used when selecting which companies to invest in. Our financial analysis takes account of both bullish and bearish scenarios for commodity prices and operational delivery from the company we are analysing. We firmly believe that the only consistent way of generating outperformance in the financial markets is to have some kind of variant perception, and for every company we invest in we try to ascertain exactly what we see differently from other market participants. Once we have ascertained our variant perception and its valuation implications, we look for catalysts to crystallise the effects. We look for the share price of the company we are investing in to move based on those specific catalysts, as we believe that good investing is not just about finding the right opportunities, but about knowing how and why one is making money. Just as important is knowing when to take money off the table and reduce the risk profile: our valuation work and our catalyst-driven approach act as our guides in doing this and help us in our quest to generate superior returns that are uncorrelated with commodity price indices and equity markets.
In conclusion, we recognise that high commodity prices bring their own risks with them. We do not assume that Malthusian economics will kick in, bringing intense competition, protectionism, nationalism and population decline to solve the issue of limited resources. Instead we choose to have faith in the ingenuity of mankind. The prize of ultimately higher living standards for all global citizens is worth pursuing. We are optimistic and look forward to continuing to surf the ebbs and flows of the resources sector for many years to come.
TAL LOMNITZER Partners
Tal Lomnitzer is Investment Leader and Portfolio Manager for NewSmith Asset Management’s Resources and Energy strategy.
Ed Johnson is an analyst for NewSmith Asset Management’s Resources and Energy strategy.
Keith Ellam is an analyst for NewSmith Asset Management’s Resources and Energy strategy.
NewSmith Capital Partners
NewSmith Asset Management is part of NewSmith Capital Partners, an independent, international investment firm with offices in London, Hong Kong, New York, Singapore and Tokyo. The firm manages investments in alternative asset classes and selected long only equity funds, focusing on the needs of institutional investors, including leading corporations, governments, pension plans, insurance companies, endowments and foundations, as well as high net worth individuals