Commodity investors hit a rocky patch

Returns from the resources sector are under pressure and investors are finding themselves navigating a rocky terrain, writes Andy Gardner.

Investors looking at the relatively high price level of bellwether commodities such as oil, iron ore, copper, and gold may be forgiven for thinking that times must be quite good for resource companies once again.

The truth is that the current period of relatively high commodity prices is very different to that enjoyed prior to the global financial crisis (GFC).

To use racing terminology, in the period of 2003-2008, all it seemed you had to do to make money was to back the race. For a time, virtually any resource company or project seemed to be a winner.

Today, the course is more challenging. Commodity currencies, operating costs, capital costs, and geopolitical risks have all risen.

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Meanwhile, heightened market volatility is a reminder of how sensitive resources are to the economic cycle.

With global growth expected to be some 30-40 per cent below its 10-year trend in 2012, our investment strategy is to be ‘generally defensive but selectively offensive’. The opportunity to generate superior returns in the sector remains, but it will require greater skill to separate the winners from the losers.

Commodity exposures

Structural demand drivers are important. China currently has the greatest level of influence on commodities related to early stage industrialisation, accounting for over 50 per cent of global demand in met coal, iron ore, steel, zinc and manganese, which are largely exposed to construction activity.

While China’s urbanisation and infrastructure development still has many more years to run, these commodities will inevitably be the first to see their intensity of use peak out.

On the other hand, consumer driven commodities such as energy, potash, nickel and titanium dioxide will ‘peak out’ at much higher levels of income per capita.

China currently consumes only 12 per cent of the world’s oil each year, despite accounting for over 50 per cent of global oil consumption growth.

Government intervention and legislation can also spur structural demand themes, such as the trend towards decarbonisation – potential beneficiaries may include commodities such as uranium, lithium and graphite.

Supply drivers can also be structural. The decline in mineral grades is reflective of the fact that the best deposits have been cherrypicked and ever increasing repletion rates at existing operations must come from evermore marginal deposits.

To put this into context, Rio Tinto’s copper production has suffered due to declining grades and is 400koz below its peak in 2009 – the tons lost equivalent to nearly seven times the current output from PanAust.

It is important to identify those commodities which are supply constrained.

Further, it is preferable for emerging markets to have a growing reliance on imports of those same commodities due to insufficient domestic production.

The old adage is ‘go long where China is short, and short where China is long’. This is true within the value chain as well as across it. China is short bauxite but it is long aluminium, for example.

Some commodities offer structurally higher returns than others. The shape of the cost curve is critically important in determining the potential return profile of a commodity. The steeper the curve, the greater the ability for low cost producers to lock in a return.

Margins can be protected where high barriers to entry/exit exist – for example, where major infrastructure development (port and rail) is required, and where markets are highly consolidated. Iron ore and oil are notable examples.

Stock exposures

Companies are inherently leveraged to commodity prices through their cost structures and volume growth. While the beta in high cost producers can be rewarding in the short-term when commodity prices are rising, it can prove fatal when prices fall.

Producers such as Mirabella and Kagara have come badly unstuck as zinc and nickel prices have come under pressure.

A challenge for many investors is to determine exactly what true costs are. The now commonly used industry term “C1 cash costs” is very misleading – excluding many significant items such as maintenance, overheads, and royalties.

The best way to militate against negative tail risk is to stick to a core portfolio of low cost, high quality producers.

With prices flattening and costs rising, delivery of low cost volume growth will be an increasing determinant of earnings and a differentiator between companies.

The world’s largest companies will naturally find this more difficult, given the huge scale of their production in absolute terms.

It took Rio Tinto 50 years to ship its first billionth ton of iron ore, but it hopes to deliver its second in only the next five years.

In essence, companies will need to move faster in order to stand still. The world’s largest copper producer based in Chile, Codelco, plans to spend $30 billion over the next eight years just to keep copper volumes flat.

This provides a window of opportunity for the more nimble mid-cap producers.

Capital management is key. Cash generation is king in the mining sector. Good deposits should always generate high returns if well managed, and management should continually optimise their asset portfolio by selling marginal or non-core assets.

Discipline is harder to come by when it comes to deploying that cash. Is it the right time to buy, build, or give back money to shareholders?

While management generally says that organic growth ranks highest in terms of priority, evidence would suggest that an equal if not greater amount of capital has gone towards acquisitions in the past decade in view of the many mega deals that have occurred.

This is somewhat intuitive, given that capital intensity is rising at a rapid pace while acquisitions increase firm production but not industry production.

Large cap miners can capture market share while limiting the commodity price impact. But at the peak of the cycle – when competition for assets, equipment and labour is at its most intense (and expensive) – diversified resource companies should be considering a greater degree of capital return.

To wit, we would not be surprised to see BHP reign in its massive $80 billion plus capital expenditure program and re-evaluate its capital return policies largely in response to these shareholder concerns.

Think small. By far, the greatest opportunities lie in the many exploration and development companies – for those that do their homework. Knowledge of the geology, mineability, and metallurgy of the deposit is required. The history and track record of the asset and management is also important.

Over half of the ‘new’ projects in Australia are in fact restarts or refurbishments of some kind, and many of the same characters are seen time and time again.

The  schematic describes the investment value proposition at various points along the resource development curve.

Momentum investors come into the stock primarily seeking the eureka effect that follows good exploration results. Frequently, these speculators exit their stock positions when the hard yards commence (pre-feasibility study and financing) – causing the share price to peak.

The subsequent dip is called the ‘value valley’. The valley is longer for bulks/energy (infrastructure) and shorter for precious metals.

For a professional investor, on average, the best risk adjusted return usually comes post the release of the pre-feasibility study. This outline (but quite detailed study) can provide enough information for a sector specialist to perform a SWOT and valuation scenario analysis.

This may be 1-3 years prior to production commencing, depending on the project’s infrastructure needs and the specific Government approval process.

Given the restrictive nature of the domestic funds – which often cannot invest in pre-producing companies – investing at this point in time also provides a window of opportunity before the ‘big money’ can begin to follow the stock, led initially by active super funds and followed by passive funds as the increasing market cap propels the stock into a new index.

Seek out takeover targets. Mergers and acquisitions remain one of the best investable themes in mining. The world’s major primary commodity consuming nations (such as China, India, Korea, and Japan) all have dominant industries which have critical supply needs that cannot be met domestically.

In response, the governments of these consumer nations explicitly or implicitly encourage foreign direct investment to ensure security of supply.

Diversify overseas. The wave of acquisitions in the Australian mid-cap mining space over the past few years has limited investors’ options in many sub-sectors.

Despite Australia being one of the world’s largest coal exporters, there are relatively few established producers remaining on the Australian Securities Exchange following the departures of Macarthur, Centennial, Felix and Coal & Allied, to name a few. The copper sector is similarly bereft of quality companies.

Currencies are also a major factor. The movement in the Australian dollar has contributed to a significant loss in competitiveness for those companies reporting revenue in Australian dollars.

When combined with the carbon tax, mining tax, and the rate of general cost inflation, it is easy to see why foreign investors have largely shunned the Australian resource market since the GFC.

Summary

This article has attempted to outline a basic set of principles that investors may follow to help frame the core sector dynamics as we see them at this juncture.

The commodity ‘supercycle’ remains intact, but is entering a new phase of its development. This requires a greater level of discipline from company management and greater levels of due diligence from investors.

By AMP Capital portfolio manager and analyst Andy Gardner.