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New City Investment Managers: The opportunity in resources stocks

30 May 2017

Rob Crayfourd, portfolio manager at New City Investment Managers, explains why near-term weakness is not reflective of underlying supply and demand fivers for commodity prices and resources equity valuations.

By Rob Crayfourd,

New City Investment Managers

The current environment for resources equities presents an opportunity in our view. A few temporary factors have led to near-term weakness which we do not believe are reflective of the underlying supply and demand drivers for commodity prices and resources equity valuations.

We prefer exposure to base metals and precious metals due to the lack of additional supply due to come on line, whilst the energy sector looks more range bound due to increasing supply from US shale production. This will allow mining companies to maintain a longer period of higher margins before we see a supply response. It can take 5-10 years for a discovery to be brought in to production.

We have just seen five years of declining capex across the sector, meaning there are limited new mines due to come on line, whilst we still see strong discipline in to this recovery from the likes of BHP and Rio Tinto, focusing on paying down their debt and increasing their dividends.

Our favourite metal in the short term is zinc, used to galvanise steel, due to a number of large mine closures the market looks to be in deficit for next few years. Inventories are already low at only 11 days of global supply, which historically has been a point where we see price inflexion.

Examples of temporary pressures affecting resource markets are the measures taken by China aimed at cooling their strong property market and latterly reducing leverage through their financial system which has weighed on commodities by forcing a reduction in position sizing by speculative traders.

This does not correlate with the strong import data, double-digit floor space additions and strong GDP growth we are seeing. We believe this deleveraging is short term and focused on reducing market volatility ahead of the National Congress of the Communist Party which takes place this Autumn. Such actions we believe extend the demand cycle.

Additionally to this, Chinese president Xi Jinping is pushing his huge infrastructure plan called the ‘Belt and Road Initiative,’ aimed at improving an international infrastructure network of power, rail and ports stretching from China to Europe. This will be an influence demand growth for the next 10 years plus.

After a period of strength and affected by the short-term measures by China’s planners and some supply chain destocking, benchmark iron ore prices have weakened, falling around 30 per cent from their recent peaks. However, China is also placing much greater emphasis on environmental issues a key theme affecting our commodity allocation.

Authorities are focused on reducing pollution from heavy smog that is severely affecting China’s major cities, and also water quality where bad domestic mining practices have been polluting rivers and harming farm land. The result is a preference for higher grade inputs to reduce the polluting outputs, a policy which naturally favours production from international sources with higher standards of extraction and which represent our investible universe.

In March the US Congress did not approve Donald Trump’s healthcare reforms, which has recently weighed on commodities. Savings generated by proposed reforms were intended to provide funding towards some of the planned infrastructure spending that had driven some of the positive momentum we had seen across industrial commodities.

As a result much of the post-election strength has unwound. We believed the extent of the positive reaction to be extreme as the US demand growth remains a relatively small proportion of global resource demand given the significantly smaller scale of build out and much higher rates of recycling. For example, China announced earlier this year they were building a new city 100km south of Beijing that is three times the size of New York.

We still believe precious metals provide an important diversifier to an investor’s portfolio, preferring exposure through producing equities as they can offer growth and sometimes a yield.

Precious metals provide an insurance policy against times of uncertainty, which given US North Korean tensions as Kim Jong-Un tests ballistic missiles and the current 50 per cent odds with bookmakers of Trump being impeached in his first term.

Small and midcap precious metal equities have seen particular weakness over the last few weeks due a rebalance of the GDXJ (Vaneck Vectors Junior Gold Miners), the ETF focussed on smaller cap precious metal miners. This has caused some forced selling of positions within the sector, presenting an opportunity to benefit from this artificial market disruption between underlying positions.

Oil was softer over the prior three months, trading down to a low of $44/bbl for WTI as the US continues to add rigs and grow production. US shale production has change the landscape for global oil production, as US onshore producers will now act as the swing producer, with an ability to rapidly bring on production when oil is $50 and above. This will provide a cap to the oil price longer term as they continue to see production efficiencies improve year on year, leaving us to anticipate oil to trade in a $45-55 range for the foreseeable future.

Performance of Bloomberg Brent Crude Sub vs Bloomberg West Texas Intermediate Crude Oil Sub over 1yr
Source: FE Analytics

OPEC and Russia have agreed to a nine-month extension of the prior 1.8 million barrels of production cuts, aiming to normalise inventories. The fact oil responded negatively to this nine-month extension is concerning and highlights the supply issues for the sector. Increasing production out of Libya and Nigeria, who were excluded from the prior deal make meeting quota’s more difficult. It is clear that longer term Saudi Arabia is unhappy handing market share to the US and will look to increase production in the future.

Rob Crayford is portfolio manager at New City Investment Managers. All views are his own and should not be taken as investment advice.

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