As the Investec Commodities and Resources Team consider the year ahead, Bradley George, head of the team and portfolio manager, discusses the disconnect between three key commodities to watch in 2012

In summary:

The market for the latter half of 2011 has been focused on the risk of a demand shock, instigated by a European credit shock and manifesting itself as a global recession. While this risk remains, the market is showing that it is starting to look past a credit-shock risk and more towards the underlying fundamentals of the macro economy and the micro level of the markets of which it is constituted. For a handful of commodities, we see this as a very positive development. Importantly, in our view the change of perspective will help correct the significant divergences that occurred between commodity producers and their underlying commodities which in some cases have produced a historically wide valuation gap over the course of 2011. While we see evidence of this in all commodity sectors, we explore our outlook for three key commodities in more detail below.

While gold has outperformed most other commodities and asset classes, it illustrates that in this year of volatility, that broad equity markets have generally ended the year not meaningfully changed from the beginning. Consider that the MSCI All World Index total return is flat and the S&P 500 Index total return is actually 2.1% higher. This holds true for the energy sector (MSCI All Countries World Energy Index down -0.2%), though the materials sector has been deeply battered with MSCI All Countries World Materials down -19.8%. The divergence between these markets reflects perceived differences in the fundamentals of the energy and materials sectors.

Some of that perception is certainly rooted in solid fact. Marginal energy projects are near $100/barrel (bl), consequently supporting current prices trading at $110/bl. In addition demand has been robust, spare capacity tight, and reserves low; against a backdrop of political turmoil of which the latest threats from Iran regarding the Strait of Hormuz are potentially the most serious to the global energy supply since the 1981 embargo. In spite of these strong underlying fundamentals (and strong relative performance of crude oil prices), energy equities have decoupled as much as we have seen in the history of our energy data sets (which go back around 13 years), when oil was trading at $20/bl.

This decoupling is equally prevalent in the materials sector. While the materials space may as a whole be more sensitive to a global recession or credit shock, there are a number of commodities in the materials sector where fundamentals are similarly as robust as the crude market with respect to marginal cost support, supply constraints and exceptionally tight stocks. While we have seen robust fundamentals in a number of commodities (and in some cases - prices that reflect those fundamentals), until there is better clarity on the macro themes that governed trading in 2011, it will be a challenge for the market to address the mispricing between resource producers and their underlying commodities.

Please read the full Commodities Indicator here:

•    Crude Oil Producers
Energy majors have de-rated significantly over the last ten years. These companies offer attractive dividend yields covered by impressive free cash generation. Despite this de-rating these names remain the premier players in the energy space and as such, tend to command the highest valuations. We have written throughout the year how many energy companies have de-rated from what has proven to be a robust and stable crude oil price.

A powerful catalyst to re-rate energy company multiples would be a resumption of M&A activity which has been largely absent since the acquisition of Petrohawk by BHP Billiton in August. According to our analysis, US exploration and production (E&P) companies are currently trading at around $11 per proven barrel of reserves, while it costs US and European integrateds between $20 and $25/bl to develop organically. It is much cheaper to buy oil and gas on Wall Street than it is to explore for it. We believe there is a good chance that the energy majors will be doing just that in 2012 with positive implications for the whole sector.


•    Gold and Gold Equities
While many may think of 2011 as a poor year for gold, in fact the commodity was up 10% on the year, making it not only one of the best performing commodities, but best amongst the asset classes. The structural price drivers that have supported the steady rise in gold over the past decade remain in place. The primary price driver, of course, is gold as a store of value. Gold is the ultimate hard asset and has been used as a hedge in monetary instability (not to mention financial or political) for millennia. The strong relationship between gold as an inflation hedge is illustrated by plotting the gold price to the implied yield to maturity of a benchmark US Treasury Inflation Protected Security (TIPS), which is US debt that offers a yield based on trailing inflation. TIPS yields have steadily fallen and are now negative as inflationary pressures remain in the US (and may in fact be building in part from the extraordinary Fed stimulus actions such as quantitative easing (QE)), while monetary policy is to peg short-term rates at near zero levels through to 2013. Despite gold’s increase in 2011, it still underperformed TIPs in the final quarter of the year.

Because of these inflationary and US dollar pressures, international central banks are increasingly converting part of their US dollar reserves into gold holdings. Mexico, India, China, Turkey and the Philippines all made sizable purchases of the metal last year. But while gold has had a good if somewhat turbulent year, the underlying producers have not - with the HSBC Gold Mining Index falling 14%. The rise in gold prices combined with a fall in equity prices have seen a price to net asset value ratio (P/NAV) of the sector fall by around 33% over the past 6 months. Some of this fall can be understood from rising cash costs (around 40% of the cost of mining gold is energy related), and the diversification by Barrick into copper with the Equinox acquisition. However, at current prices many gold producers enjoy $1,000 margins, costs appear to have stabilised, and the fall in valuations will help spur a well-capitalised sector (precisely due to healthy margins) into renewed M&A activity. The year-end offer of Eldorado to purchase European Goldfields is a case in point. Even though the environment remains constructive for gold, gold equities do not need gold prices to strengthen in order to perform well.


•    Potash
The increasing demand in emerging markets for primary energy sources has been matched by increased demand for food stuffs. Consider that Brazil, Russia, India and China (BRIC’s) represent around 40% of the world’s population. As these economies have transitioned to more developed ones the appetites of their extremely significant populations is moving towards higher caloric and protein intake. The latter is particularly important as livestock farming is materially more calorie intensive (i.e. grain feed for livestock). With arable land in some regions falling (i.e. urbanisation in China causes a 6% loss on farmland per decade), the solution to the world’s food needs is increased productivity of current assets. One key form of this is increased fertiliser usage and improved usage (as land degradation in part due to fertiliser is a critical issue for land availability). Amongst the primary fertilisers, potash has garnered the greatest demand growth over the past few years, a condition we see persisting well into the decade. With supply and demand finely balanced, the concentrated potash market has been able to push through material price increases. Canadian producers have increased contract prices from $470/t in late 2011 to $530/t for the start of 2012. We forecast prices to rise to $575/t by 2014 as the supply/demand balance looks to remain in favour of the producers over the next few years.

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ENDS

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