Rudi's View | May 23 2012
By Rudi Filapek-Vandyck, Editor FNArena
There is (much) more to commodities than growing demand from awakening economies in Greater China and elsewhere in the developing world, as investors have learnt post 2007, either the hard way or otherwise.
For starters, the fact that prices will stay at elevated levels for at least another decade or so has a lot to do with rising costs levels at producers of these raw materials.
Consider, for example, that while the technical picture for aluminium reportedly looks decidedly bearish on price charts, from a fundamental perspective it is simply inconceivable the metal will remain at today's prices (or fall even lower) for a prolonged time as most companies in the industry are believed to be barely profitable, if not already suffering losses.
The same logic applies to crude oil where industry estimates are that -all costs, fees and taxes incorporated- the world now needs a sustainable price well above US$100 per barrel or there's no financial incentive for companies to drill for extra reserves and develop new sources of supply.
For gold, believe it or not, the estimated all-important price levels are US$1700 per ounce and US$1500 per ounce. The first price level represents the minimum price to provide enough incentive for explorers and producers to spend millions to find and add tomorrow's new sources of supply. The second price level is where a large chunk of the industry stops operating at a profit.
All this in large part explains why company profits have failed to keep up with the parabolic price rises for commodities since the start of the new millennium. It didn't seem too much of a problem in the years leading up to 2007, but it has proved to be more of a challenge since. This, in return, explains partly as to why investors and shareholders have failed to enjoy similar benefits in the post-2008 era as they did in 2004-2007.
A few weeks ago (*) I reprinted a table put together by analysts at Citi and I have again incorporated that same table in today's Weekly Insights as I think it's worth pausing and reflecting upon what these data are actually telling us. They are showing us that while prices for most raw materials have skyrocketed in the decade past, costs for producers have risen at an even higher rate.
A second major quandary for the industry is the fact that new developments of additional supply have become so costly. Expansions and new projects that cost hundreds of millions of dollars only a decade ago, today cost billions with costs rising further as delays kick in and projects take longer to complete.
This means that if prices don't settle at higher levels soon, companies worldwide will inevitably delay commissioning further mega-investments. This, in return, will have an impact on future supply.
In a mix of such tight relationships it becomes incredibly difficult to make any long-lasting predictions as bad news today is likely to translate into more promising news tomorrow, and vice versa.
As far as the demand side of the equation is concerned, one factor that is not well-understood by many investors and commentators is that the years leading up to the late 2008 meltdown (for resources stocks) had been characterised by possibly the strongest and most uniform synchronisation of growth across the world's largest and most important economies.
This goes much further than simply keeping a close eye on what happens in China or even the BRIC economies. Most importantly, this unique synchronisation is unlikely to be repeated anytime soon. What used to be a collection of fast growing economies -each to their own phase of economic maturity- looks in 2012 more like a mixed bag with some economies slowing (China, Russia and Brazil), some struggling (US, UK, India) and some staring into the abyss (Europe).
To be honest, I am not really certain where Japan fits into this picture, but does anyone still care?
Then there is, of course, the extreme leverage to global money flows, central bank liquidity and investor optimism, otherwise known as risk appetite or risk aversion when optimism temporarily leaves the scene. When all these factors work in unison they represent one mighty drive beneath prices of commodities and by association for share prices of companies leveraged to these product prices.
When these factors unite against the sector, however, investors beware. This is why I have remained adamant in my assessments and reviews in years past: share prices of commodity producers cannot be "defensive". This is what the Romans would call a "contradictio in terminis". It simply is not possible.
Hence picture my surprise when I was asked earlier in the year, by the Sydney Morning Herald, to provide three stocks for a defensive approach to investing in the share market in case the future was to turn out not so rosy (I guess that what we are experiencing today). I suggested Breville ((BRG)), Transurban ((TCL)) and Ardent Leisure ((AAD)).
No commodity companies thus (for reasons explained above). To my surprise all the other experts that participated in the SMH survey nominated BHP Billiton ((BHP)).
I guess we've all witnessed this month and in fact over the twelve months prior how "defensive" the world's largest diversified mining company is when global risk appetite leaves the stage. As Borat would put it: BHP is a very defensive investment…. Not!
Resources stocks may not be defensive, BHP and gold miners included (more about the latter a few paragraphs further below), but they are post the carnage this month and last year unmistakably cheap.
They look cheap vis-a-vis other stocks in the share market and they look cheap in comparison with historical valuations. Some might even argue they look cheap in relationship to growth projections for next year and beyond, but here the big question mark remains how much needs to be cut in case product prises don't rise (that too is part of the leverage attached to the sector).
While I haven't been supportive of owning resources stocks for a long time, as most of you no doubt will know, I am cognisant of the lessons that can be drawn from the past and one of these lessons is that resources stocks are best bought when cheap.
Take the past two years as an example: while owning resources stocks has been a disappointing experience for longer term investors, for those market participants with a shorter term, trading-oriented focus buying into Q2 weakness has in each year proved to be a profitable strategy. As things seem to be lining up for a similar blueprint for 2012, it may just be that the same strategy might again work well for the third year in a row.
Investors willing to take the punt should keep in mind that history never repeats itself in exactly the same manner, no matter the conviction of some technical chartists. Also keep in mind this strategy comes with higher than usual risks attached to it. Resources stocks might be cheaply priced, but this by no means excludes the possibility that prices can still go a lot lower in case of more negative developments.
The global economic outlook for the present quarter remains questionable at best and there are at this stage no signals whatsoever that any of the major central banks is about to embark on yet another round of liquidity stimulus (commonly known as "money printing").
Note, for example, commodity analysts at Deutsche Bank predicted on Monday spot iron ore prices will fall below US$120/tonne from circa US$135/t last week in the coming two months as the traditional summer lull combines with yet another season of heightened global risks.
In my view, investors planning to play the Q2 weakness theme yet again this year should take a good look at local and international gold miners.
Gold equities have seriously underperformed the metal in years past and gold has, true to tradition, initially suffered from the same margin calls and funds outflows as all other commodities. At some point, one would expect, gold's role as "hard currency" will regain the upper hand, especially if the situation worsens and anticipation of more quantitative support from central bankers regains traction.
However, the gold market has its own Sword of Damocles hanging over it. With European governments in deep strife, it is not inconceivable at least one of them will sell some of its gold bars at some point. Such event could have a significant impact on the price at that particular point in time.
As said previously: playing the beaten down resources stocks is not without its risks, but the short to medium term rewards could be above average too.
In case anyone had any doubt: I remain of the view that, with the global outlook as is for the years ahead, resources stocks remain a questionable asset for investors with a longer term focus. But they are prime material for trading strategies. Always have been and probably always will be.
(This story was written and published on Monday, 21 May 2012. It was published in the form of an email to paying subscribers on that day).
P.S. Investors with less risk appetite and long term strategies might be better off reading my recent stories "All-Weather Performers Rule", "Are You In Tune?" and "Yield Stocks: Where Are The True Opportunities?"
(*) Table first published in "More Questions Than Answers For Resources Companies"
Investors should note all names mentioned are for educational and informational purposes only. Investors should always consult with a licensed professional before making investment decisions.