Commodities on a bumpy, but profitable road

Investing in resources is not going to be for the faint of heart, over the mid- to near term. But thanks to continuing fundamental demand from emerging markets, the long-term prospects for commodities remains strong.

Canadian investors have lucked out in many ways, because the domestic stock market is heavily weighted in producers of arguably the three most sought-after commodities – energy, gold and fertilizer. Physical resource prices have reached record highs, meaning investors could get burned if they try to time the market, but investment managers still see stock prices for producers growing over the long term.

COMPARISON TO MID-1970’s Commodities manager Jamie Horvat of Sprott Asset Management, who has managed funds in a variety of resource sectors for several asset managers, sees a number of parallels between what’s going on in today’s market and the sector in the mid-1970s.

During the late ’60s and early ’70s, he says, economies like Japan and Asia were coming off a period of rapid industrialization and emerging as major consumers of commodities, not unlike what’s happening with emerging markets like China and India, today.

“Commodities went sideways and [were] volatile for an extended period of time. I think that’s the situation we are in today,” Horvat says. “Until we resolve the issues with liquidity and the housing market in the U.S., I think commodities are going to continue to trade sideways and remain volatile.”

SHORT-TERM IMPACT What this means for investors, Horvat notes, is that they can expect a flat period or even a slowdown in the near term. Because infrastructure building, which requires extensive materials and energy, remains a consistent priority in the emerging markets, he sees commodity prices remaining high over the long term.

“There are these major projects in China. They are building infrastructure, such as roads and railways, and a number of buildings are going up. These are things you cannot just shut off overnight. This is underpinning the demand for commodities right now,” he says. “The trouble in the U.S. housing market is obviously going to impact demand on the margin. The larger growth factor – the global growth – isn’t being impacted overall.”

LONG-TERM REBALANCE On top of the slowdown in the U.S., Horvat says, demand in China will likely slow in the near term but will start winding down after the Olympic Games. He thinks it will provide a good opportunity for investors to rebalance their commodities exposure.

“On a long-term basis, what I said before and what I continue to believe is if you were able to invest in the commodities move at the end of the dot-com market collapse in 2000 and you had significant returns, if you’re 55% to 75% allocated to commodities, there is nothing wrong with taking some profits and rebalancing,” he says. “If you missed that first movement of the commodities cycle, which I believe is going to continue going forward after we work through this sideways malaise, I would build some exposure to the buildings and gas and commodities.”

A similar tactic is being viewed by Sadiq S. Adatia, chief investment officer for Russell Investments Canada.

“Right now, we are underweight energy and commodities in general because it has gone up too quickly. When there are pullbacks, that’s when you’ll see us pick up some of those names at a little more of a discount,” he says. “We do think the market needs a pullback in commodities until it can take off again. A lot of people believe oil at $140 is unsustainable. Even at $110 or $120 a lot of those oil companies are still doing very well.”

FUNDAMENTALS REMAIN Adatia expects small-cap producers to be the big winners during the next phase of a commodities run.

“We’ll be looking at a lot more smaller-cap names in those sectors. A lot of larger-cap names have gone up significantly. There will be opportunities for smaller caps to catch up, and in some cases larger caps will go and buy some of those companies with the profits they have earned.”

Of course, energy is not the only story in commodities, and in some circumstances, high prices can increase the costs in other sectors – such as fertilizer and gold – which need substantial energy for transportation and extraction.

Even if other costs increase, Darren Lekkerkerker and Joe Overdevest, co-managers on the Fidelity Global Natural Resources Fund, say the fundamental supply and demand for commodities remains very high.

“There is a large amount of the global population moving into the middle class, but what they are consuming right now is actually very low. It will increase more as nations develop,” says Overdevest. “In the next six months, there could be pullbacks and volatility. We keep an eye on that, but that’s not the biggest thing we are focusing on. The biggest thing we are looking at is fundamental supply and demand.”

From a macro-level, the supply and demand indicators remain positive, says Overdevest, who only invests in resource equities. He thinks Wall Street and Bay Street expectations on resource stocks are still too low. As a result, the stock valuations remain generally attractive.

“The indicators, for potash, agriculture, oil and steel, are still looking attractive,” says Overdevest.

Lekkerkerker says this belief is further reinforced by his travels to the BRIC countries – Brazil, Russia, India and China – and has seen firsthand the underpinnings of sustained demand for commodities. For this reason, potash remains the fund’s largest holding in absolute dollars, despite record prices.

“There is a lot of primary work [that’s been done] to find out if the demand is really there, and where it is coming from. If prices fall off, we actually feel comfortable stepping in, taking a position of size and benefiting from it,” he says.

COAL & GOAL TOP THE LISTS In the case of sustained high oil prices, they say there are opportunities in alternative energy sources to satiate emerging market demand – such as thermal coal.

Lekkerkerker says 80% of China’s energy is powered by thermal coal. In addition, metallurgical coal is the primary resource used in blast furnaces to make steel, a key ingredient in urbanization projects across emerging markets.

“We expect coal prices to be higher next year; more than $300 a tonne,” he says. “When energy prices go up, on a per-BTU basis, coal starts to look really cheap and thermal coal goes up in price.”

Gold is a slightly trickier proposition in the current market. Managers tend to favour gold equities to take advantage of their leverage to the rising price of gold, but diesel and energy costs are major factors to the price of gold extraction. This squeezes the margins of equities substantially.

“When I look at the mess in the financial system, the market liquidity crisis globally, and the housing market mess in the U.S., U.K., Portugal, Spain and Australia – which I’m reading, now, might potentially impact Canada – it’s one of the clearest things that gold is a benefit,” says Horvat. “I would look at getting exposure to both equities and bullion.

“Over the long-term trend, equities tend to outperform bullion due to the leverage factor by about two to three times,” he adds. “Because of the risk in the financial system, I would be personally – and I am in my own account – having some exposure to the physical bullion.”

For the fund Horvat manages, he says he has about 10% to 20% exposure to gold and is looking to increase that slightly.

“Marginal cost of production is going up, because one of the larger costs is diesel for extraction in open pit mines. This will cause physical gold prices to go higher,” he says. “As far as the equities go, our approach is to look at the management teams. We always look first to companies with a history of success.”