John Stepek and our panel of experts discuss commodities – and where they would and would not place their own money in today’s markets.
John Stepek: The global economy is still not in great shape. Yet oil is at $80 a barrel and copper’s not far off its all-time high. Why?
George Cheveley: China. If you look at Chinese demand last year, it represented 40%-50% of world demand for most metals. That compares to 10% a decade ago. Was there some restocking? Absolutely. But if demand is growing, you need to build stocks as well. China will buy when things are cheap. Last year they were, and China bought more than it perhaps needed. But does that mean it’s all going to be sold this year? No.
Simon James: That China has higher inventories now than it might have had in the past is entirely rational. If the Chinese think prices will keep rising in the very long term, and they reckon their current cost of capital is very low, then when prices are down, they’ll buy.
George Lee: What confuses me on the industrial side is capacity utilisation. If you look at the steel industry, for example, which represents end demand for many metals, production is way below peak levels. And no one has actually taken capacity out – it’s just been temporarily mothballed. It’s odd that a lot of commodities are back at their highs despite the fact that real end demand simply isn’t there.
John: How long can that situation last? Aren’t oil prices at these levels self-destructive?
Our Roundtable panel
Portfolio manager, Investec Asset Management
Simon James
Founding partner, Gore Brown Investment ManagementGeorge Lee
Fund manager, Eclectica Agriculture FundHugo Rogers
Co-manager, Thames River Water & Agriculture FundDaniel Wills
Senior analyst, ETF Securities
Daniel Wills: Well, it’s interesting to look at longer-term views for the energy market – particularly if you factor in suggested rates of depletion from existing fields.
George L: But that doesn’t appear on the oil curve. Oil is basically flat now. The 2018 contract is down 15% this year – it’s back at $94 or so and the spot price is $82-odd. So the full curve now has a 10% contango (explained on page 52) over ten years. That’s very different from a year ago. The long-term arguments are absolutely correct, but they don’t explain why the spot price is so high.
George C: We’d agree. Oil cartel Opec has control, and will do for the next 18 months because it’s got five million barrels offline. But there’s little reason for oil to go much higher. It should probably come off. The same goes for base metals in the short term. We’ve had a big demand pull, but probably need a pause.
What happened in the last 18 months is no surprise, in terms of the basic inelasticity of demand in metals and oil. Oil had to rise above $120 – and gasoline above $4 a gallon – to stop people driving in the US. That’s the price you need to choke off demand. Then, once demand drops, you get oversupply. When the market is in oversupply, prices must fall to a point where producers cut production. What did it take for Opec to agree quotas? Oil below $50 a barrel.
Now, everyone says it’s speculators and we’ve got to regulate all this. But commodities have always behaved like that: they have big run ups and collapse. The price difference between what forces producers to cut supply and what forces consumers to cut demand is huge. For copper, that’s $3,000 to $8,000 a tonne. There’s nothing irrational about that.
John: Are inflation concerns driving people towards ‘real’ assets?
Simon: The hards soared because of demand – it had nothing to do with inflation. But we’ve recently come out of hard exposure because we’re concerned that people’s expectations of demand are too high. We think the market will retreat again. We don’t know if it’s this month, or in the middle of the year. But as interest rates tighten around the world, when the inventory rebuild peaks out and people start focusing again on how Western consumption growth will be muted for years to come – expectations about everything being back to the races again are going to be confounded.
George C: But that’s why we have funds where we go short as well as long, because these things are cyclical.
John: So will prices be lower by the end of this year?
George C: Copper and oil will both be lower. But precious metals and some of the softs could be higher. And coking coal is interesting. It’s in very tight supply, and demand is rising. We’ve potentially got the same amount of global steel production this year as we had two or three years ago. Now, I wouldn’t be bullish on steel at all. As George said, there’s a lot of capacity in steel production. But there isn’t in coking coal. That’s because China will produce 100 million tonnes more of steel, while the West will produce 100 million tonnes less. Chinese steel production is mainly blast furnace production, whereas the West produces more scrap. That means you’ve got about 60 million tonnes more of coking coal demand than two or three years ago, even though steel production is the same.
John: Are any producers worth buying?
George C: BHP Billiton (LSE: BLT) is the world’s largest producer of coking coal. Obviously, it’s a huge miner, so it’s not the purest play. But it’s well-exposed. A lot of people say BHP is expensive compared to its peers and that it’s undergeared. But in the current environment, being slightly defensive isn’t bad. It has good exposure to iron ore, and to oil – we’re not bullish on oil short term, but the long-term outlook is very good. BHP’s mix of commodities is attractive in the current climate.
If you allow for the fact that BHP has got a lot more growth than it necessarily shows, it’s not that expensive. Like all big miners it has a large number of potential projects that just aren’t valued. There’s stuff sitting in BHP that the company doesn’t even bother to talk about, and which junior miners would be ramping up at this stage.
John: George, you run an agricultural fund – what soft commodities are you interested in now?
George L: The first thing to say is that the utilisation point I made on steel is completely the opposite for agriculture. Production last year was running at 100%, simply in terms of the amount of acreage in the world being used. Despite that, in pretty much all the major commodities, bar wheat, we’ve actually drawn down inventories this year.
We got away with it because we had great weather through most of the northern hemisphere. So prices of softs have gone sideways because production has been able to meet demand. But inventories are still very low in historical terms, so I’m optimistic. Just compare corn, which has gone nowhere, to oil, which has gone up by 100%. You are now seeing the ethanol industry start to ramp up capacity because the price differential has got so big.
John: Is ethanol still a major driver of the softs story?
George L: It is. We’re awaiting news from the US Environmental Protection Agency about the next increase to the blending mandate. Currently, 10% of US petrol comes from ethanol.
John: And they’re going ahead even though it’s a stupid use for food?
George L: It’s not stupid if you’re American. Look at Britain. With petrol near 120p a litre, people are saying: “Why don’t we produce oil from hemp on our own agricultural land?” That’s basically what the Americans are doing. They’re saying: “We’re importing half our oil from countries we don’t particularly like and don’t trust. But we’re also growing 40% of the world’s corn and export more than half to people we don’t like. So why not balance things out by turning our own food into fuel?” Geopolitically, it gives them more power vis-a-vis Saudi Arabia, Iran, and so on. I don’t think they’re looking at it from the ecological, nor the pure economic, point of view.
And we’re talking big numbers. If the US provides 40% of global corn supply, and a third of its own corn harvest goes into ethanol, then if you raise that blending mandate to either 12.5% or 15%, you’re adding either 3%-4% or 6%-7% to global corn demand over a period of, say, three or four years. Given that the industry only grows at 2%-3% a year, that’s quite a big increase.
Hugo Rogers: We think you should be long softs in the long run. But there’s no need just yet. 2009 was such a record year that we don’t see inventories being critical at the current levels. The US Department of Agriculture estimates that by the end of this year inventories will be down to about 63 days. That’s from 70 now. But when prices spiked in 2008, inventories had fallen to 55 days, which is much more critical. For that to happen, we’d have to see a marked increase in ethanol usage.
Simon: To what degree are the inventories affected by better inventory management, logistics, and all that?
Hugo: Over the last couple of decades, that’s taken the figure down from a norm of around 70-75 days, to perhaps 65.
George L: They can get away with it because, since the Berlin Wall came down, and we’ve had 20 years of not fighting each other, everyone has been able to use these inventory management systems and has been able to kid themselves that grain sitting around in other parts of the world will always be there. But the trouble is, what you find is that when there’s any shortage at all it all gets squeezed by government policy, because a lot of inventory is held by producer countries rather than consumers. It’s very rare that Saudi Arabia or Britain sits on lots of grain inventories, because they don’t need to.
In 2007, for example, both wheat and rice prices spiked. There was a physical shortage in wheat because of a bad harvest in North America. But there was no rice shortage. In fact, there was a record harvest. Yet because, with oil and food prices rising, all the exporting countries were worried about inflation, they banned exports to keep local prices down. Suddenly, the actual availability of stock went from 40-odd days to ten days, and 15 world capitals had people on the streets.
John: So what about longer-term problems? Water and land shortages – is there any sign of these problems being solved? How does GM fit in?
Hugo: GM isn’t the solution. It’s much more about infrastructure and appropriate agronomic practices. When you look at yields per hectare in the US, they are four or five times higher than in many other places. Europe has 60% of that level. So it’s about agronomic practices and consolidation. GM can help. It can lift yields by 10%-15%, and we’re starting to see it being adopted. But it’s not a silver bullet.
John: So it’s more about moving from smallholdings to big farms and the unpopular, big agribusinesses that everyone complains about?
Hugo: Yes. And it’s not hard to envisage in a number of areas. In Latin America the average farm size is already more than 2,000 hectares. In the US, it’s about 1,000. But on a global basis it’s still about one hectare. So that’s a major change that could solve the problem.
George L: It is coming, it just takes time. Places like Thailand and India made huge progress with yields through the 1960s and early 1970s. Farms remained small, but they put lots of research dollars into agronomic practices. They found out about better-yielding seed varieties, how to use artificial fertilisers and herbicides. And there’s a lot of research and development in most parts of the world. Everyone focuses on what Monsanto and Syngenta are up to with the US corn crop, but there are smaller companies out there looking at high-yielding rice varieties for India and Indonesia. The Indonesian corn yield is half of what they get on the southeast Asian mainland.
Simon: The story is surely generally all about efficiency of provision. Whether it is agronomics, logistics, or relative usage of fertiliser, it’s all playing in the same direction. For us, the point of having exposure to water and agriculture is that while we acknowledge the long-term supply-stress argument, we also believe there is a high risk that in the next few years there will be repeated demand scares. Indeed, water is arguably in an even more critical state.
Hugo: Water investment was really the origins of our fund. Water is something you can’t get any more of. You can use a bit less, but it’s hard to extract any more. And the price of water is rising. It’s up four-fold in California over 12 years because of the droughts and so on. In Australia, water rights are also at high levels. And China has 20% of the world’s population but 7% of its water resources. We talk about China feeding itself. It already consumes 65kg of meat per head, compared to 75kg for Europe, so there isn’t necessarily a massive swing in demand still to come. But any demand swing has to be imported, because it can’t lift its production.
Simon: Water is also going to be the big security issue over the next few decades. Israel and Palestine are in the news right now, yet nobody ever talks about the state of the aquifers.
Hugo: Yes, the Israelis are withdrawing a lot of water from underneath the West Bank and there are very heated discussions about this.
John: Where would you all invest now?
Hugo: Protein manufacturers – firms rearing pigs, chickens and cattle. Why? Because capacity was cut sharply in 2008 and 2009 as profit margins were hammered by the spike in grain prices. But now, with capacity slashed, the producers have pricing power while the price of raw materials remains stable. Smithfield Foods (NYSE: SFD) is the largest US hog producer. It reported its first quarterly profit in eight quarters last quarter. We think the stock is trading on about 8.5 times mid-cycle earnings and the cycle continues to improve.
We also like seafood producers. The wild catch of seafood is falling. But demand growth is about 6%-7% a year, so this all has to come from farmed fish. My pick is Austevoll Seafood (NO: AUSS). The company catches anchovies and mackerel off Peru and uses them to produce fishmeal and fish oil. The fishmeal is not only used to feed farmed fish, but also to feed pigs in China, which is where half of the world’s pigs are reared, slaughtered and eaten. Inventories in China are very low.
As a result, fishmeal prices have doubled in the past 12 months. They’re unlikely to come down, because the Chinese don’t have an alternative source of high quality protein. The melamine scare [where milk powder in China was tainted with an industrial chemical] means they will now only use the highest-quality proteins. On our estimates, the stock is trading on about six times this year’s earnings.
On water infrastructure, I like Insituform Technology (NASDAQ: INSU). The company inflates resin sleeves down old, rusty pipes, then hardens them with steam. So you get a pipe within a pipe, so you don’t have to dig up the road. It’s benefiting from fiscal stimulus. It looks expensive on about 20 times earnings, but we expect earnings growth of 35% a year over the next two to three years.
George L: First Tractor (HK: 38) is a Chinese tractor manufacturer. It trades on 0.35 times sales. It’s a big beneficiary of people in China starting to consolidate bits of land, which means bigger farms and more mechanisation.
And given that we’ve got a bit of a water thing going on, I’ll go for Lindsay (NYSE: LNN). It’s the purest listed agricultural irrigation play in the world. It manufactures big, centre pivot irrigation systems and it’s the world leader in its field. It’s right at the bottom of the cycle – the stock went from $20 to $120 and has come back to around $40. Capital expenditure has been decimated in the last 12 to 18 months so currently it trades on a terrifying short-term p/e multiple. But over the long term it’s the best company in its field for exposure to broad acre irrigation.
John: Where would you invest, George?
George C: On the metal side, we prefer some of the precious metals. On gold, while we think the price will go up, we’re more certain that it won’t go down. So we prefer equities over gold itself because there’s more value in equities if the gold price stays where it is.
We like Palladium (LSE: PHPD), which you can buy via an exchange-traded commodity (ETC). You’ve got precious metal exposure. You’ve got good demand recovery – auto production is rising rapidly, particularly in China, where on the whole they use palladium rather than platinum as a catalyst. And you have a supply issue.
The major producers of palladium are in Russia, but there has been no investment in supply for a while. Russian stockpiles have been funding the difference. It’s impossible to know, because it’s a state secret, but we think Russia has run its stockpiles down substantially over the last few years. So we think the outlook is very positive right now.
Platinum (LSE: PHPT) is also attractive – there were supply problems in South Africa and demand is recovering. It’s not as good as it was nine months ago, but there’s still potential upside there.
Daniel: That’s interesting. We’ve seen massive interest in those ETCs this year.
George C: On the base metal side, because I’m not particularly bullish, one of our bigger positions is Short Zinc (LSE: SZIC), another ETC. People are very excited about base metals because destocking has ended, so demand has picked up very rapidly. But supply in some of these commodities has reacted quite quickly as well. Whereas zinc’s supply was cut back a year ago – more than 20% of mines shut down at the low point – they’ve all come back on. Zinc prices have more than doubled, which helps. So while we were very bullish on zinc a year ago, we’re now quite bearish.
One caveat is that March and April are strong months for industrial demand – holidays are over and the northern hemisphere construction season is getting going – so you’ll see stocks drawn. If you don’t, it’s very bearish indeed.
John: Are there any other areas you like?
George C: US shale gas is interesting. Exxon buys stuff very rarely. The fact that it bought gas shale producer XTO, its first purchase in about ten years, is a green light to the industry. We saw mega-consolidation in the oil industry ten years ago. We think a US gas story is playing out this year. If you look at the prices paid, some of the listed companies look very, very cheap – firms like Ultra (NYSE: UPL), or Quicksilver (NYSE: KWK). These firms have reserves that will outlast us in terms of their acreage.
While we’re not incredibly bullish on gas, it should certainly rise from here. Remember, when you open up a shale gas well, it comes out under huge pressure, like champagne. It pops, but then it just dribbles out for another 20-odd years. After one year, your decline rate is 80%. So you’ve had a huge surge in supply with all the wells drilled two years ago. But about half of the production is from wells that are less than two years old. And fewer wells were opened up last year, so in real terms actual production is probably falling.
Our Roundtable picks
| BHP Billiton | LSE: BLT |
| Smithfield Foods | NYSE: SFD |
| Austevoll Seafood | NO: AUSS |
| Insituform Tech | Nasdaq: INSU |
| First Tractor | HK: 38 |
| Lindsay | NYSE: LNN |
| Palladium | LSE: PHPD |
| Platinum | LSE: PHPT |
| Short Zinc* | LSE: SZIC |
| Ultra Petroleum | NYSE: UPL |
| Quicksilver Res | NYSE: KWK |
| *Note: before you buy short ETCs, ensure you know how they work. See: www.moneyweek.com/etfguide.aspx | |
• This article was originally published in MoneyWeek magazine issue number 479 on 26 March 2010, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don’t miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now
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