Global Natural Resources Outlook
By Tom Nelson
At a glance
- Commodity prices will be less correlated to each other than they have been in prior cycles. Supply and demand trends in individual commodities are different, and changing fast
- Supply will continue to be a more important driver than demand, as it has been in 2016. This also means that commodity prices are less sensitive to economic cycles, which is why they could see growth in a low growth world
- Equity over commodity: companies are still cutting costs, selling assets and focusing on returns rather than growth
- ESG and climate change. The focus on this sector will only intensify from here. Companies need to be transparent about carbon, co-operative with shareholders, and act as responsible asset owners
“Things take longer to happen than you think they will, and then they happen faster than you thought they could.” Professor Rudi Dornbusch, MIT economist
Less correlation equals opportunity
2016 has been a better year for commodity prices. Many of the key physical commodity prices have moved higher (crude oil, iron ore, coal, gold), which has driven outperformance from natural resource equities and improved confidence in the sector. One thing that has become clear is that commodity prices have become less correlated and we believe this will present investment opportunities in the coming year for the specialist investor.
“Commodity prices have become less correlated and we believe this will present investment opportunities in the coming year”
There are many drivers at play, which have led to sharp changes in the individual market fundamentals of commodities:
- Government enforced supply cuts, including Opec
- De-leveraging and cost reduction
- Investment vacuums due to periods of ‘lower for longer’ commodity prices
- Demand dynamics
- Consolidation through M&A
- Disruptive weather patterns
One recurring characteristic is the linkage between supply reductions and commodity price appreciation. Zinc and coal are the clearest examples of this over the course of the year, while crude oil has seen the most recent supply related price activity following the Opec meeting in late November.
Figure 1: Positions of key mined/extracted commodities in the fundamental cycle – arrow shows two-year progression
Source: Macquarie Research, September 2016
Commodity producers have done a lot to help themselves. Cost-cutting, reduced investment, asset disposals, debt reduction and a clear focus on returns rather than growth have enabled companies to capitalise on a more supportive backdrop than we saw in 2015. Looking into 2017, we expect more of the same. Commodity prices will continue to be driven more by supply than demand, which will lead to continued variability within the commodity complex. The ‘value over volume’ mantra will continue to drive improved cashflow and profitability at a company level.
Within our portfolios, we seek to identify companies which benefit from both improving commodity fundamentals and ‘self-help’. These companies are battle-hardened, right-sized for a lower growth world, and have the financial flexibility to withstand the inevitable macro uncertainty.
In terms of specific commodities where we see improving fundamentals in 2017, we highlight crude oil, gold and copper – exactly as we did at the end of 2015!
We will take a more in-depth look at the crude oil story and how the shifting supply dynamics have the potential to drive future prices. Since Opec, primarily Saudi Arabia, surprised the world in October 2014 by abandoning its role as oil market moderator, the market lost all confidence in Opec’s willingness and ability to intervene and support prices. Opec’s intention to protect market share resulted in increased production into an over-supplied market: in other words, ‘volume over value’, rather than ‘value over volume’. This now appears to have been reversed, starting with the meeting in Algiers in late September, and cemented by the Vienna meeting on 30 November. As a reminder, the meeting concluded with an agreement to reduce production by 1.2 million bl/day, the first formal cut to production since the global financial crisis. The cut is effective from January 2017, with a review meeting to be held in late May. This agreement has restored cohesion within Opec, and is an interesting signal that regional tensions in the Middle East can be overcome when objectives are aligned. The addition of potential production cuts from non-Opec countries is also important, particularly from Russia, which has delivered strong growth recently. There is a risk that the agreement with non-Opec producers is not finalised, and that compliance with agreed cuts is weak, however the quantum of the cuts is significantly greater than we calculate is needed to balance the market.
“The quantum of the cuts is significantly greater than we calculate is needed to balance the market”
Of course, the natural question to ask is why this apparent policy reversal has come about and what will it mean for the sector?
- First, the data suggests the main producers are struggling to maintain investment at recent oil price levels and are producing at close to maximum – in some cases, at rates they are uncomfortable sustaining
- Second, maintaining low oil prices was becoming self-defeating as it was causing excessive financial pain to Saudi Arabia and other central Opec players
- Third, the sale of a stake in Saudi Aramco via an IPO was likely a motivating factor in Saudi Arabia doing everything it could to create an agreement; and looking longer term, as the new regime in Saudi Arabia has been endeavouring to do, there is a chance the Kingdom is pre-empting a future price spike
We believe Opec knows that if oil prices do not recover relatively quickly to US$60/bl, investment levels will be insufficient to balance the market in the future. The US shale industry was more innovative and resilient than expected.
On the demand side, 2016 looks likely to see demand growth of 1.2-1.4m bl/d – in line with the 20-year trend on a percentage basis. Of course, the demand outlook for oil is changing too. The outlook for global oil is best defined by a tension between growing population consumption and transportation on the one hand and fuel efficiency, electric vehicles and climate change on the other. Oil demand continues to grow at over 1% per year, led by gasoline demand and the developing world (India accelerating while China slows) but it seems logical that over the next 20 years there will be a transition away from the Internal Combustion Engine (ICE). The speed of the transition is difficult to predict: while it is tempting to bet on the unstoppable force of human ingenuity and scientific progress (electricity storage, battery technology), we do not underestimate the immovable object of man’s love affair with the ICE. It is telling that the debate has shifted from peak oil supply to peak demand in less than ten years but we would not be surprised to see oil demand continuing to grow until 2025-2030, with transportation demand the hardest to displace. In the near-term, we do not expect the adoption of electric vehicles to be rapid enough to displace oil demand within five years.
It is not only in the oil market that we have seen 2016 supply moderation. Below is a table of year-on-year supply reduction in certain metals. The correlation with recent price growth in metals, such as coal and zinc, is clear.
Figure 2: Expected supply growth, 2016
Source: Wood Mackenzie, Macquarie Research, September 2016.
Opportunity in equities over commodities
We believe that 2016 marked the bottom of this cycle for commodity prices and corporate profitability in the sector. Heavy de-stocking of physical commodities and panic around balance sheets at the end of 2015 saw capitulation by many equity-holders, exacerbated by a wave of short-selling. It appears this period of low prices has seen miners re-emerge with a new ‘value-over-volume’ philosophy, particularly in Chinese production. After nearly a decade of massive volume growth in response to China’s demand surge, the last few years have seen metal markets struggling to rebalance. Companies have tried to restructure operations through widespread cost-cutting, asset disposals and focusing on costs and capital spend rather than just driving volumes.
“We believe equities will outperform the underlying commodities for the next phase of the cycle”
This change in strategy by many mining companies is a sign we are moving to the next stage of the cycle when profits normalise and volatility subsides. If we are correct in our view that efficiency and productivity improvements will continue to drive earnings and returns growth, then even at current commodity prices, we have potential upside to many equities. For this reason we believe equities will outperform the underlying commodities for the next phase of the cycle. For example, we see good opportunities in gold equities and believe a well-constructed portfolio of gold equities should also offer better returns than physical gold in the current environment, without foregoing the defensive qualities which gold offers.
“We are confident that we have seen the bottom of the cycle in the oil market”
We are confident that we have seen the bottom of the cycle in the oil market. Most importantly, the oil price crash has caused a re-evaluation of oil company strategies, just as we saw in the mining sector starting earlier in the decade. In the last cycle, oil companies chased production growth which led to escalating costs, poor project delivery and deteriorating returns – even with significantly higher oil prices. The industry needed to control costs, improve efficiency and allocate capital correctly. We believe that the ‘value-over-volume’ mantra should improve return on capital (ROC), dividend pay outs and total shareholder return over the next cycle. We continue to look to the tobacco sector 1999-2016 as an interesting case study for improving profitability and tremendous shareholder returns in a sector which faced similar structural challenges in terms of demand substitution, regulatory intervention and taxation. Could ‘big oil’ follow ‘big tobacco’s, lead?
We have previously noted that the agriculture sector contains companies that can perform well without rising prices for bulk grain commodities. We are positioned more towards recipients of these commodities rather than input providers, given our current lower crop price outlook. However, we stand ready to re-align the portfolio towards beneficiaries of increasing grain prices as soon as fundamentals start to improve for corn, soybeans and wheat. Another area which we believe will continue to drive returns is the salmon-farming industry. We saw evidence of strong margin growth in 2016 and the best-in-class Norwegian producers have worked hard to get their cost inflation under control. We believe further price and margin gains will be realised into 2017.
Environmental, social and governance (ESG)
“We are acutely aware of our responsibility as shareholders in the commodity and natural resources sector”
We are acutely aware of our responsibility as shareholders in the commodity and natural resources sector. The focus on climate change and other ESG issues will only intensify from here. Companies need to be transparent about carbon, co-operate with shareholders and act as responsible asset owners. There is an economic risk of value destruction through stranding of assets, and there is risk of damage to the environment through carbon emissions. The two are clearly linked. As a result, understanding and quantifying ESG risk is a key part of fundamental stock analysis. We use a combination of our own proprietary inputs, based on our in-depth knowledge of the companies and MSCI ESG scores. Most importantly, we believe that ESG analysis in this sector must be fully embedded in the equity analysis, rather than as a separate procedure.
Major risks for 2017
Given the lack of clarity around the new US administration’s policy, investors will inevitably approach 2017 with caution. Furthermore, with two populist election results in 2016 and three major European elections in 2017, investors may reasonably expect more of the same. We expect a protectionist agenda from President Trump alongside support for US ‘old industry’ sectors. This should help the energy and mining sectors. We could also see dollar weakness, which may support commodity prices. However, at a geopolitical level there is widespread risk and US relations with Russia, China and the Middle East will change in 2017.
Ill-discipline within Opec
The market will remain healthily skeptical about Opec cuts until it sees physical evidence of reduced production levels. Imports of oil into the US and OECD oil inventory levels will remain under close scrutiny. If Opec member countries do not adhere to the new production levels, this will have a compounding negative effect: the supply reduction will be delayed, the credibility of the group will be further damaged, and their ability to enact a cut in the future will also be reduced.
Chinese fixed asset investment (FAI) strengthened in 2016, compared to 2015, which aided the supply-led recovery in metals prices, particularly in the second half of the year. Given the importance of China for metals demand, a significant slowdown in China FAI in 2017 would put pressure on metals prices and negatively affect mining company profitability.