We continue to believe that strong underlying fundamentals provide an opportunity for resources equities. Global demand remains robust, whilst numerous years of low capex from mining companies has left little organic supply growth in the pipeline.
We are now seeing producer discipline which is in complete contrast to the prior boom that ended following investment in excess supply which was supported by a low interest rate environment post the financial crisis in 2008.
A common misconception was that the weak resources market was led by soft demand from China, but we would highlight Chinese imports of most metals have remained incredibly resilient despite recent market volatility.
Commodity prices have improved significantly from the lows of 2015, meaning valuations now look attractive, given improving underlying market trends and a favourable commodity price outlook.
This backdrop of slowing supply growth and the consistency of underlying growth in demand is leading to tighter market conditions for commodities, especially base metals.
The long lead time for mining companies to bring on new supply suggests this environment should remain positive for a number of years, assuming no unforeseen shocks to demand.
Generalist fund managers’ exposure remains underweight offering potentially favourable rotation of fund flows back into the sector.
We remain encouraged by the continued fiscal discipline from the major mining companies who continue to focus on de‐levering their balance sheets and increasing dividend payments. We are not claiming this time is ‘different’, but believe there has been a notable change in corporate management style, looking to improve free cash flow generation and shareholder returns. This should extend the period of tight market conditions.
For resources equities 2017 has seen a slower price appreciation than was seen in 2016. This is despite continued underlying improvment of supply and demand fundamentals, especially in base metals.
Against a backdrop of constrained mine supply commodity prices strength has been led by continued demand growth, especially out of Asia. We anticipate continued growth from this region and note that China’s $2trn Belt & Road Initiative, highlighted at the recent Chinese 19th National Congress, could provide incremental demand growth over the next decade.
Perhaps the most significant Chinese impact we see for resources today actually affects commodity supply, where China’s increased environmental focus, especially on air quality, has led to the curtailment of polluting domestic production capacity. This has reduced domestic, low grade supply of iron ore, coal and zinc which have seen many mine closures.
Targeted reduction in coal use for power generation looks likely to lift power prices and tightening operating standards will also contribute to increase regional production costs, requiring higher prices to justify production.
Following measures to cool the property market in China, property price growth has slowed considerably from the 30 per cent year-on-year rates we saw 12 months ago. We interpret the moves as an encouraging indication of Chinese planners’ confidence in the robustness of the economy and its ability withstand the measures.
Importantly such intervention should reduce the risk of economic overheating from unsustainable, speculatively‐driven price appreciation. It should also smooth demand out over a longer period of time.
More stable growth may also encourage more sustainable investment growth. Notably despite the more measured pace of property price appreciation continued floor space additions remain supportive for end commodity demand.
Looking beyond the next couple of quarters it is possible that investors focus on the limited growth offered by the many diversified and base metal producers.
Even if new found corporate investment discipline were to cede to growth aspirations, given the long lead time, it will be difficult to deliver new supply in short order.
It is our belief that this will lead to a pickup in M&A as it is currently cheaper to buy assets than build. This is important, because acquisitions don’t bring new supply to the market, instead simply transferring ownership.
Zinc, used to galvanise steel, remains our favourite metal in the short‐term due to the tightening market balance that has seen global stocks fall to 10 days of usage. As one of the strongest metal prices to date there are few pure play producers to invest in, with Canadian-listed Trevali one of our favourite names due to its strong cash generation.
Performance of ETF YTD
Source: FE Analytics
Smaller cap precious metal equities continue to look very reasonably valued versus the gold and silver price. We believe this partly represents a hangover from a rebalancing of the small cap precious metal miners ETF, the VanEck Vectors Junior Gold Miners ETF
(GDXJ), which outgrew its underlying investments and was forced it to reduce its weighting in less liquid equities and increase exposure to larger, more liquid names in June this year. We believe this has contributed to an extreme valuation gap, which should close going forward, driven by improved cash generation and a potential pick up in M&A by larger precious metal miners which have seen a significant depletion in their reserves and are now faced with declining production.
Gold has lagged industrial metals’ performance with prices flat over the last 12 months despite the helpful backdrop of US dollar weakness. More recently increased tensions between the US and North Korea as well as the ever-rising US debt ceiling, which is expected to be reached in December, suggest there is more to the sector than just cheap valuations.
Gold continues to play an important role as insurance against geopolitics, potential systemic market risks and complacency to inflation. Gold now also finds itself competing with the millennial’s love for cryptocurrencies, themselves potentially a reflection of distrust in central bank printed fiat, though we note that in similar fashion to printing presses it is possible that new forms of blockchain can be readily issued.
Performance of Bloomberg Gold Sub over 1yr
Source: FE Analytics
Oil has remained broadly range bound between $45‐55 per barrel over the last year. US shale producers have taken the role of marginal swing producer and we believe they have capped the chances of a sustained rally in oil beyond this tight range. We continue to favour mining companies over energy companies due to better cash flow generation and sustainability of margins. The ability of the mining sector to respond to better pricing is more limited and thus can lead to an extended period of material returns.
Crude prices have stabilised around towards the top of the recent price range as the drawdown of US crude inventories has finally garnered some traction and rig additions by US onshore producers have levelled off and more recently eased back. However, there currently appears less willingness to extend or deepen already reduced OPEC/non‐OPEC production quotas given poor recent compliance and Russia’s intransigence to continued participation. The WTI crude benchmark remains capped in the low $50’s per barrel by a wall of forward selling from US shale producers, highlighting their economic incentive level.
The oil and gas market is transitioning through a technological shift that will change the dynamics for decades to come, with shale production out of the US leading this charge.
The energy market is now able to operate under shorter, more responsive cycles, allowing shale production to be brought to market within six months of initial drilling. This is an enormous shift from large‐scale offshore projects previously taken on, production from which would typically lag investment by 5‐10 years. These shorter cycles reduce the ability to generate strong margins for extended periods.
It is important to consider what are the risks to the positive outlook for miners that we have commented on above.
A decade of low rates and unprecedented levels of QE have inflated many asset classes including equities, bond and property globally.
Europe still needs to deal with the realities of Brexit and the election of anti‐EU leaders in Austria and Czech Republic adding uncertainty to this uncoupling process.
In addition, the continued growth of lowest cost, passive investment may reflect a degree of investor complacency that could be accentuating systemic market risks and drive future volatility which in many cases stands at historically low levels.
Despite this, we believe resources stocks, especially miners which are exposed to these environmental themes, are still well placed to deliver healthy shareholder returns given their reduced debt levels, and as sector valuations continue to recover from a multi‐year bear market. Gold and silver miners especially should provide protection against market risk due to the counter cyclical nature of precious metal prices.
Rob Crayford is portfolio manager at New City Investment Managers. All views are his own and should not be taken as investment advice.