With rising cost curves, Investec’s view is that downside seems limited and current valuations offer an opportunity for investors to reap the rewards of the current pause in a longer-term structural commodity story. “Although we believe resource equity valuations appear generally attractive across the board, certain areas are particularly compelling in the current environment: energy, certain diversified miners, iron ore miners, certain mid-cap gold miners and fertiliser companies,” adds George.
“Many investors remain concerned commodity prices are flatlining while costs continue to rise thus squeezing company margins. While this is true in some cases, we see numerous companies that can improve margins from higher commodity prices by growing volumes and even reducing costs.” According to George, the danger is that many analysts are now assuming not only flat to declining commodity prices, but also ever-rising costs. “In the short term, European financial issues look set to keep markets volatile, but we believe that once China has destocked and begins cutting rates, world growth will not remain below trend and equities should re-rate to more normal valuations,” he says.
Among other catalysts in the market is a return of merger and acquisition (M&A) activity, which is likely given the balance sheet strength of potential acquirers. On 23 July for example, CNOOC (the Chinese national oil company) agreed to acquire Nexen for $15.1bn, a 61% premium to the previous closing price. According to George, this is the largest deal yet done by a Chinese stated-owned enterprise to secure future oil supply. “We see this push from the Chinese (and rest of Asia) for access to long-term resources as supporting our philosophy to invest in companies backed by quality assets,” he adds.
Stock selection
Looking at stocks in the portfolio, George notes Royal Dutch Shell’s strong flow of long-life, low decline rate projects coming on stream over the next two years. “Shell has a 4.9% dividend yield, which is sustainable down to $70/bl,” he adds. “The risks to the European integrated exposure remain centred around the stability of eurozone economies, and a stabilisation of refining margins, which will be driven by underlying demand.”
Other positions in this area include Total, which George believes could surprise on the upside after recent operational problems, and Ultra Petroleum on the natural gas side. “A number of US natural gas companies are looking good value and as Ultra is one of the lowest cost gas producers in the US, we believe it is well positioned to benefit when prices begin to rebound later this year,” he adds.
On base and bulk metals, being overweight iron ore and coal miners hit fund performance when the former’s price fell 30% last August to October, although levels have recovered since. Rio Tinto remains a key holding, offering good upside with a relatively defensive profile according to George. “Growth in copper output, new coking coal production in Mozambique, expanding iron ore and repricing of mineral sands contracts all look likely to deliver earnings growth,” he adds. In agriculture, Potash Corp is among the fund’s largest stocks based on Investec’s view that potash fertiliser will be well supported. “While we do not expect significant price rises in potash, we believe the equity market has priced this risk in unfairly,” says George. “Potash Corp will benefit from significant volume growth over the next five years due to capital expenditure incurred in prior periods, ramping capacity up from 10 to over 16 million metric tonnes from now until 2016.”
Scouting other markets
Looking around other commodity markets, the Investec pair’s picks remain oil and gold. “In the short term, we maintain the crude oil balance will tighten in 2012 and into 2013,” adds George. “The decline in global inventories has stopped but with extremely low global spare capacity and Saudi Arabia producing at 30-year highs, the market is vulnerable to further supply disruptions. We maintain a $100/bl assumption for the long term, with our price estimates reflecting the tightening supply/demand fundamentals plus higher marginal costs of supply.”
On gold, the price has been volatile in recent months and the ongoing flight to quality has focused on Western government bonds and left the precious metal behind. Despite this recent pullback, George says the case for higher gold prices remains in place. “Weaker US growth, renewed European sovereign risks, and resilient physical demand are pointing to higher gold prices,” he adds. “We continue to believe the gold price will rise to $1,800 in 2013 and that gold producers are entering an earnings sweet spot that should persist for several years. “We expect weak economic growth to depress industrial commodity prices, keeping gold miners’ input costs in check, while continued monetary debasement to combat economic weakness should boost the gold price and hence their revenues.”
To date, George says that as far as he is aware there has never been a gold bull market that has ended without the shares participating. “Gold historically enters into prolonged periods of positive momentum before consolidating and we believe it has now finished the latest consolidation phase and should return to uptrend,” he adds.
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