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Why the backdrop for commodities has improved

01 May 2018

Rob Crayfourd, portfolio manager at New City Investment Managers, considers the outlook for commodity markets during the second quarter of the year.

By Rob Crayfourd,

New City Investment Managers

An already positive backdrop for commodity markets has improved with the recent shifts in geopolitics.

The geopolitical changes of 2018 and their impact on commodity markets can, broadly-speaking, be viewed as increasing inefficiencies within the commodity supply chain, which will ultimately be inflationary for commodity prices as they adjust. For the miners that produce these commodities, that means higher margins and improved earnings.

As outlined below, the primary drivers are proposed US sanctions on Russian oligarchs, potential US import tariffs, Syria, and currency valuations:

Proposed sanctions on Russian oligarchs by the US would curtail production directly. On 6 April the US announced they would look to impose sanctions, which implicitly impacted the companies in which some specific oligarchs have significant influence. For example, as of 19 April, this has seen Rusal’s market capitalisation fall 69 per cent to $2.8bn and the price of aluminium increase 23 per cent due to significant involvement of Oleg Deripaska causing sanctions to directly impact on group funding and operations.

The US also proposed the implementation of import tariffs in March, with 25 per cent tariffs cited for metals such as aluminium and steel, primarily aimed at Chinese production and ultimately targeting a reduction in the US trade deficit to China.China has subsidised these primary industries for many years, which has depressed the cost curve and removal of these subsidies would raise prices globally. China retaliated, proposing their own tariffs. This tit-for-tat escalation presents risks, but appears more of a public negotiation than the end game.

The US, UK and France fired missiles on Syrian chemical weapon facilities in response to Assad allegedly using them on his own people, which has supported the oil price on concerns of escalating regional tension, with Russia and Iran supporting the Assad regime.

Finally, wrapping in with the prior three developments, is a focus on reducing currency valuations, with the US dollar, Russian rouble and Chinese yuan weakening. This is in part an attempt to improve their domestic competitiveness on global markets and to offset the potential impact from tariffs.

 

Metals & energy

Encouragingly, spending on new projects remains minimal, with the large-cap producers’ continuing to prefer paying down debt and increasing dividends. As a result we are seeing little supply response to improved demand, especially in metals. China’s environmental focus continues to restrict domestic supply, adding to the weak supply response and increasing their reliance on seaborne imports.

As we have flagged previously we prefer the mining sector due to the longer cycles versus the shorter cycle market we now see in energy, with shale production techniques enabling a rapid response to improved pricing. The longer cycle dynamics allow extended periods of superior margins and resultant free cash flow for the mining sector. We believe equity valuations remain attractive, with small cap equities continuing to trade at meaningful discounts to larger peers.

In oil we prefer low cost projects such as Hurricane Energy’s Lancaster discovery in the North Sea which will still be profitable at $40 per barrel.

Precious metals

Precious Metals should be a key beneficiary from increased global uncertainty, providing an important insurance policy, with gold showing reasonable performance, up 3.7 per cent YTD in US dollars. Although when the 3.2 per cent fall in the US dollar versus the euro is factored in over the same period, it appears very little risk premium is actually being attributed to gold for the topics mentioned above.

Smaller-cap precious metal miners are our preferred way to gain exposure to this theme as they continue to trade at a meaningful discount to their underlying fundamentals and large-cap peers. This is primarily due to the continued fall-out of the rebalance of the small cap precious metal ETF (Van Eck Junior Gold Miners) which increased its market cap requirements, forcing them to sell down the smaller capitalised positions, but also competition from other speculative investments such as crypto currencies and cannabis stocks in Canada taking the marginal investment flows that would have invested in these names. This is providing significant valuation opportunities in Canadian listed equities especially, where for example Guyana Goldfields trades at 0.6x its NPV versus the larger producers at 1.6x, despite having a high quality, low cost 250k oz/year mine in a safe jurisdiction like Guyana an ex-British colony.

We believe against this backdrop the recent strength in sterling, despite a lack of clarity on Brexit, provides opportune timing for a UK-based investor to increase their exposure to real assets, given their depressed foreign currency denominations and the positive outlook for the sector outlined above.

Rob Crayfourd is portfolio manager at New City Investment Managers. The views expressed above are his own and should not be taken as investment advice.

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