Rudi's View | Nov 13 2013
By Rudi Filapek-Vandyck, Editor FNArena
This week I am applying maximum flexibility on my part by scrapping my initial idea for Weekly Insights in favour of a report published by commodity analysts at Goldman Sachs, as I believe the content of this report should attract the attention of every investor in today's share market.
On November 6-7 Goldman Sachs hosted its second Global Natural Resources Conference in London with close to 400 attendees from across the commodities and financial sectors. Judging by Goldman Sachs' research report after the event, the gathering in London touched upon some very interesting topics and themes.
Underlying all the discussions, presentations and public panel debates, runs the message that investors in commodities and in resources equities should not expect to see a resumption of the upswings witnessed between 2004 until mid-2008 or after March 2009.
The key difference with those two recent reference points, explain the analysts at Goldman Sachs, is that commodity prices are transitioning into a new phase of the cycle wherein improved supply delivery and stronger cost and capital discipline will lead to stable or even declining prices. Judging by feedback from industry participants at the Conference, management teams have already taken this new reality on board. Changes in company policies will have major ramifications for the years ahead.
Critics will say all of the above fits in neatly with the Goldman analysts' own view. After all, this is the team of analysts that has been making the exact same prediction for a while now. While this is true, and there certainly is every possibility that a certain bias has crept into the Conference debates, if not in the written report after the event, this by no means implies the broader framework that is being painted is incorrect.
I would argue the opposite. Because it is a broader framework, it is more likely to progress at a gradual pace and remain hidden for many commentators and investors who are merely focused on short-term, daily price movements.
After all, I hope I am not the only one who has observed the price of copper hasn't changed (net) since late 2011 (and down for the current calendar year), while crude oil prices, despite all the peak oil nonsense and supposed close link to Emerging Markets growth, have essentially remained in a sideways trading pattern since mid-2010.
Investors should also note, the team at Goldman Sachs revised its sector view on Monday for Resources stocks to Unattractive from Attractive. It would appear that feedback (or call it "confirmation") from the Conference has played some part in this decision.
The following paragraph summarises the key motivation behind the switch in sector rating:
"As global economic growth slows, and demand for mining commodities with it, miners have embarked on austerity and productivity drives to lower costs and improve output. In isolation at the individual company level, such measures can deliver greater sales revenue and improved profitability. However, if all companies strive for such improvement in unison, we believe the benefit is double-edged, with the greater volume and falling costs likely to meaningfully lower and extend out the industry cost curve. We expect such activity to drive significant reductions in long-term commodity price forecasts, margin compression and valuation destruction." (emphasis mine)
Even if one does not agree with this (long-term) outlook, I believe there's enough in the Conference papers to take on board for the short and medium term.
– Trend number one: owners of major assets are now focused on maximising returns, lowering costs and on sweating existing assets for extended returns (major ramifications for industry capex)
– Trend number two: the industry now has a strong focus on "capital efficiency". This includes share buybacks to enhance shareholder returns. Also, Goldman Sachs reports share buybacks appear the best way to make dividends per share more sustainable by reducing share counts. The energy sector seems to have taken the lead with ENI and BP currently pioneering this trend, report the analysts.
– Trend number three: contractors and engineering firms are becoming leaner and meaner too and as such they are able to better assist miners and energy companies in their quest to lower operational costs.
– Trend number four: there's a growing number of new supply sources opening up in the energy sector (both crude oil and gas). Leading new developments, including Kurdistan and Brazil's ultra-deep water pre-salt region, are highly profitable at current prices with estimated all-in costs (ex acquisition) at half or even less Brent's US$100/bbl-plus price level. Goldmans analysts draw from this the conclusion that crude oil prices are facing a sideways, if not lower price environment, in the years ahead.
– Trend number five: energy producers are now on the same level as their mining peers in that the sideways price outlook is forcing operators to squeeze as much as possible out of existing assets.
Within the context of that last trend, investors might want to pay extra attention to the following paragraph:
"At our oil price forecasts of US$105/bbl for 2014 and US$100/bbl for 2015, we estimate that the major integrated oil companies will be free cash flow negative after working capital, capex and dividends over the coming two years. Given this, and the importance to the companies of maintaining their dividends, we believe that the large integrated companies are re-thinking their strategies, moving away from investing in low-return and more marginal projects and refocusing on cash returns to shareholders (aided by an ongoing divestment programme of non-core assets). As a consequence, we expect capex growth through 2014 and beyond to be constrained. This lowers the revenue growth opportunities for the oil services sector."
In terms of specific sectors, here are some of the key take-away conclusions from the report:
– Iron ore remains en route to significant market surplus, with the second half of 2014 marking the turnaround. By 2015, Goldman Sachs sees a "structurally oversupplied market". It has to be noted, this view, which has remained unchanged even though the price of iron ore has remained far more resilient than most experts had expected, is probably the most bearish in Australia right now.
Goldman Sachs is forecasting a decline in the iron ore price from US$134/tonne this year, to US$108/t next year, to US$80/t in 2015, after which the price is only projected to bounce to US$85/tonne by 2017. This is going to be an interesting forecast that will be watched closely from here onwards, to say the least.
– As with iron ore, Goldman Sachs is projecting price decline for copper in the years ahead as a wall of new supply is anticipated to hit the market. A lot of this additional supply already is heavily de-risked, argue the analysts, though they admit there's still plenty of issues that can plague the copper supply side. Taking a leaf from the 1996-97 experience, the analysts predict the price of copper is going to trend towards the fourth quartile in terms of production costs. If correct, this means further downside to the price of copper. Goldman Sachs is forecasting an average price of US$6,600/t (c.US300c/lb) in 2014.
– One interesting observation with regards to copper is that a panel discussion at the Conference highlighted that greenfield projects for copper are today essentially infrastructure projects requiring much larger financial investment than your typical traditional mining development.
– With regards to gold, the coming years should see downward price pressure persist as the US economy improves and the Federal Reserve scales back its liquidity stimulus, report the analysts. They believe key for the direction of the gold price is that institutional investors will swap their gold exposure for better performing assets elsewhere, which then creates a self-fulfilling process. The report cites GFMS as predicting gold will drop below US$1000/oz in 2014. (GFMS is the old "Gold Fields Mineral Services" which was acquired by ThomsonReuters in 2011).
– Cheap gas prices are likely to stay cheap for longer in the US, predicts Goldman Sachs. This will, in a few years' time, create a burst in demand, changing the industry's dynamics. Also, shale gas has the potential to change the energy sector outside the US as much as it has changed dynamics inside the US, but this prospect is longer dated outside the US.
– The global energy sector is poised for a spike in M&A as it is now cheaper for the large integrated firms to acquire rather than to explore for new volumes. This is further reinforced by the analysts' observation that over three quarters of the global E&P sector is presently trading below sector finding costs on their discovered and development assets. Unfortunately, Goldman Sachs' report does not highlight any Australian candidates.
(This story was originally written on Monday, 11 November, 2013. It was published in the form of an email to paying subscribers on that day).
(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)
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THE AUD AND THE AUSTRALIAN SHARE MARKET
This eBooklet published in July this year forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).
My previous eBooklet (see below) is also still included.
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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS
Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January this year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.
This eBooklet was released in January this year and is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).
If you haven't received your copy as yet, send an email to info@fnarena.com
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Rudi On Tour
– I have accepted an invitation to present to ATAA members in Canberra on November 19, which shall be my final presentation for calendar 2013.
The event takes place at the Ainslie Football Club, 52 Wakefield Ave, Ainslie (6-8pm).