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Which Miners? Which Commodities?

Commodities | Nov 21 2012

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-Maturing mining boom more complex
-Established producers preferred
-Pure long strategy won't bring the returns
-Investors need to be choosy and nimble


By Eva Brocklehurst

The past decade marked a mining resurgence but will it continue? Are the boom times over? This was the question posed at a recent forum organised by BlackRock Investment Institute and the participants – BlackRock portfolio managers, six industry executives and two experts from research firm Wood Mackenzie – suggest investors need to delve a bit deeper to gauge whether a miner of the glorious past can still perform.

BlackRock suggests the boom is not completely over – just more tricky to negotiate. Supply from new mines is still hitting world markets and metals inventories have been building up in the face of weak demand, with copper the exception. BlackRock expects most metals will likely be in surplus for a while, pressuring prices. However, eventually demand will return, especially from China. Wood Mackenzie expects a turnaround in 2016, when demand for copper, zinc, lead and nickel will start outpacing production from existing mines.

Citi expects a rebound in commodities demand, possibly by the end of 2013. It believes some markets will tighten more quickly than others but as demand rebounds, along with increased growth, prices are unlikely to to move sharply higher. Moreover, the broker believes a pure, long-only strategy will not bring the returns that occurred in 2002-2008. Winners and losers will depend on the supply/demand balances for individual commodities. It'll be complex to navigate. The broker sees seasonality increasing, particularly in oil and agriculture, amid volatile macro economic conditions. This will create new long-short strategic opportunities and new ways to invest across asset classes -such as combining commodities with foreign exchange as well as equities. It's what Citi describes as the 'new normal'.

BlackRock notes shareholders, however, are clamouring for dividends and share buybacks rather than increased capital spending, and hence favour companies which have the assets and the management skill to satisfy both. Overall, the strategists believe greenfields projects are too risky as many of the most promising areas are in unstable countries with little infrastructure. Countries such as the Democratic Republic of the Congo have rich deposits but it's going to take a long time to get them up to speed with the lack of power, infrastructure and political stability. BlackRock also suggests production will be hampered by depleting mines, falling ore grades and other challenges and new projects and technologies will need to materialise to fill this gap.

For example, the world will need 25.1 million tonnes (mt) of refined copper annually a decade from now, Wood Mackenzie estimates. Existing mines are expected to produce 18.7mt in 2022, suggesting a supply gap of 6.4mt. New mines could close this gap, but we could be disappointed too. The industry's capex tripled in the five years ended 2008, but is likely to stay flat the next three years, according to consultancy McKinsey and investment bank Macquarie. Projects are starting to be mothballed and capex budgets are being scrutinised. This trend, if it persists, will bring down supply and boost prices in the long term.

So, if investors have to rake through miners with a fine-tooth comb looking for the performers what about the commodities themselves? Are there any overall trends to follow? Not really. Prices for bulk commodities such as coal and iron ore used to be agreed upon quarterly or even annually, thereby making them more predictable. These days, much is priced daily on the spot market and this can create a disconnect between long term supply planning and demand. BlackRock says iron ore can be prone to volume wars because deposits are plentiful, so it is all about the cost of production for this metal. Copper, zinc and thermal coal are depleting resources, deposits are not ubiquitous and the cost of getting a foothold in these mining areas can be steep. Nevertheless, lead, zinc and thermal coal, on average, give the best return on investment and risk, according to Wood Mackenzie.

Citi notes energy commodities, with the exception of US natural gas (up 24%) and West Texas Intermediate crude (down 14%), have returned to the levels of the beginning of the year. Base metals have also been essentially flat, although nickel has declined around 15%. Precious metals have risen significantly, with gold up 9% and silver up 17%. The biggest movers have been softs on the downside and grains on the upside. Wheat has risen around 30% while coffee and cotton are down 20%. Citi estimates that for the energy commodities most investment flows occurred early in 2012 and since then both investment in energy and agricultural commodities have faded. Only base and precious metals net investments are relatively stable.

So, what to take from all of this? Citi suggests commodities are still an attractive investment for a wide array of portfolio managers, as no other asset class provides such an opportunity to profit from wild cards. Citi says big miners look favourable in an environment where commodity prices are likely to be flat and volatile. The best bet in both mining and oil is to look at the players at the low end of the cost curve.

BlackRock suggests equities with natural resources emphasis are good value because of looming supply gaps for most metals. Low cost iron ore miners and copper producers are attractive but zinc, aluminium and nickel are less so. BlackRock also suggests focusing on those miners that are already producing. Globally diversified miners tend to have the best assets and management, in BlackRock's opinion. 
 

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