Crude oil and metals look set for further misery over the next year, but the longer-term outlook is more promising.
I have a difficult relationship with the whole commodities spectrum. I’ve been too optimistic about mining and energy stocks for at least the last two years. Even as I’ve continued to put money into energy businesses and mining funds, share prices have continued to drift ever lower.
By contrast, I’ve been wildly pessimistic about precious metals – last year I had a bet with a colleague that gold prices would crash below $1,000 an ounce – yet the shiny stuff has proved much more resilient than I imagined, briefly touching $1,350 back in March.
So what’s my next move? I suspect that most commodity prices are due a good kicking over the next 12 months. A quick look at the three main commodity categories reveals why. In metals, which are dominated by copper, the elephant in the room is China.
The economy is already slowing, and even a revised GDP target of 7% looks ambitious for the next six to 12 months. That’s bad news for copper prices, which are already down by just over 6% in the last 12 months.
In energy, the obvious story is the slide in oil. I now think we could see West Texas Intermediate (WTI) prices plunge past $60 a barrel, possibly even getting within spitting distance of $50.
The catalysts for lower prices are obvious – indiscipline among members of the Opec oil cartel, surging US supplies, and weak Chinese demand. I don’t see these negative drivers abating in the short term.
As for gold, I think we’re on a knife edge. Once the $1,150-an-ounce level for spot gold is tested hard enough, I think the gold bears will push prices below $1,000. Gold optimists talk about any number of positive drivers including an up-and-coming Swiss referendum, as well as producers suffering as prices start to go below the marginal cost of digging the stuff out of the ground.
Physical demand from Asia might also have an impact and we’ve certainly seen the big flows out of gold exchange-traded funds abating. But I also think that institutional investors are particularly worried about a resurgent US dollar, which is not a promising environment for gold.
Growth should pick up next year
In short, we seem to be in a pretty bad place for commodities in the next six to 12 months. But I also think that the medium-term outlook is much better than the bears believe – at least if you agree that the global economy might pleasantly surprise us in 2015. And there are certainly reasons to be upbeat.
To begin with, the absence of global inflationary pressures should allow the US Federal Reserve to keep monetary policy loose, helping to support the American economy. This could give us a repeat of the late 1990s, when US growth proceeded relatively uninterrupted, despite plenty of turmoil elsewhere in the world.
Meanwhile, there are some signs that Europe’s grim economic data might just be turning around. The euro-area economic surprise index has bounced off its lows in the last two weeks, while bank lending to small businesses is growing again for the first.
Recent company results have also been encouraging, with the highest proportion of companies beating analysts since the start of 2011.
In all, it looks like we are in what’s called a ‘growth scare’, where the optimists eventually grab back the investment narrative after a dodgy, volatile few months. If you agree, then I think a bias towards cyclical stocks – which are dirt-cheap right now – makes sense.
Given this, I have two suggestions for natural resources funds that are worth investigating – Baker Steel Resources (LSE: BSRT) and Riverstone Energy (LSE: RSE). Both are listed closed-end funds and both have had a very tough year or so.
Riverstone listed in London late last year at just under £10 a share and now trades at £8.50, while Baker Steel, now around 27p a share, listed in 2010 at 100p a share.
I think both could go even lower in the short- to medium-term, but they are interesting on a longer-term view.
Doubling down
The riskier bet of the two is Baker Steel Resources. This fund has taken a very different tack to the big boys of resource investing, such as BlackRock World Mining or the slew of Investec funds in this area, who have focused on mega-cap stocks with an equity income bias.
That strategy doesn’t look quite so smart now, especially after BlackRock World Mining announced a big loss on a key royalty income asset a few weeks back.
On the other hand, Baker Steel has focused on small caps and privately held investments in earlier-stage mining businesses in places deemed risky, such as Indonesia.
Put bluntly, however, the Baker Steel approach hasn’t paid off and the share price has dived. According to analysts at broker Numis, the net asset value (the value of the underlying portfolio or NAV) has been down around 53% over the past three years, and the discount has widened to very high levels (46%, based on Friday’s closing price of 27.625p).
But Baker Steel managers David Baker and Trevor Steel are experts in the field and they’ve now decided to double up on a number of their core investments, by buying a portfolio of £90m in public and private assets.
To help fund this deal, the managers are looking to issue shares at a 15% discount to the NAV, with perhaps as much as £100m being raised.
The managers reckon the commodities cycle is close to its trough, and that current market conditions represent “an attractive time to be investing in mining and resource assets, many of which are priced well below their risk-adjusted fair values”.
Assets within the fund include iron-ore mines in Indonesia and Canada, silver mines in Russia, copper and gold mines in Africa and the Philippines, and an oil shale business in Australia.
The fund raising and acquisition is a big bet that we are near the bottom – but I think they might be right, in which case the much bigger size for the fund could help encourage investor interest in the future.
A great opportunity for private equity
In energy, my main short-term worry is that oil prices will fall much further than anyone expects. This will be terrible news for the oil-equipment suppliers and high marginal-cost producers within the gas and shale-oil sectors in North America.
It will also kill cash flows and force a huge swathe of the energy sector to consider business-saving mergers and acquisition activity. Put simply, spending will be frozen, businesses will go bust, bonds will default and even successful outfits will have to be rescued.
That may sound grim, but I’d argue that this is almost the perfect backdrop for a private-equity-led approach, focused on buying good-value trading assets at a cheap price. Riverstone Energy is my favourite fund for playing this idea.
This fund is backed by a number of leading oil-industry veterans, including former BP chief executive Lord Browne, and boasts a number of wealthy family investors.
Its approach is classic top-level private equity – support existing managers with great track records in their new ventures, helped along by an internal team of operational experts. It’s an opportunity to buy the right assets and managers at the right price, just as the energy sector goes into a horrible six to 12 months.