High prices make resource rebalancing risky

(July 2008) Grabbing the resources bull by the horns will give investors a rough ride, but it can be a worthwhile one, a trio of portfolio strategists tell Advisor.ca. They warn the difficulty for individual investors, though, is not deciding whether they should be riding the bull; it’s when and where to get on.

The general consensus from money managers seems to be that fundamental demand, particularly in emerging markets, will continue to drive the commodities market. The three major drivers of resource markets in Canada have been energy, gold and fertilizers.

Investors who got in on this bull market earlier are realizing huge returns on commodity prices that have soared to almost unimaginable heights. However, these prices may be too high at the moment. This makes it difficult for investors who have little to no resources exposure to really capitalize on any further upside to resources, unless there is a short-term pullback in prices.

“There are massive infrastructure projects going on with India and China that you can’t just switch to off. When they start these massive urbanization projects, they have to finish them, and material demand for those types of projects is very high,” says Clancy Ethans, chief investment officer for Richardson Partners Financial Limited. “When you talk about bull markets in commodities, they last a long time. We’ve invested no money in finding new resources, both in materials and energy. I think energy prices at $140 are too high, although I’m not calling for a $60 oil price by any stretch.”

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Starting with energy, when should investors buy? Sadiq S. Adatia, chief investment officer for Russell Investments Canada, is currently mulling over this question. His firm wants to add to the energy holdings of its portfolio funds, but it’s not ready to pull the trigger just yet. Adatia is bullish on the long-term prospects of energy, but Russell is actually underweight on energy because the short-term run-up in prices has been so fast and furious.

“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,” he says. “When there are pullbacks, that’s when you’ll see us pick up some of those names at a little more of a discount. We’ll be looking at smaller-cap names in those sectors. A lot of larger-caps 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.”

Bob Gorman, chief portfolio strategist for TD Waterhouse, says in the portfolios his firm constructs for their private client group, they’ve used the opposite tactic and have been adding to their large-cap oil holdings because those stocks have greater downside protection in the advent of a significant pullback in oil prices. Their portfolios have been relatively even with the energy allocation of the S&P TSX Composite index, which hovers around a 30% weighting to energy.

Gorman says investors looking to add energy exposure in this current climate should be looking at what it costs companies to produce a barrel of crude. This will give investors some sense of their earnings in comparison to the price of oil. He says in general the large-cap producers have stock prices that reflect a lower barrel-per-oil cost and have the scale and production to maintain healthy profit margins if oil prices plummet.

“We generally don’t make a big bet on the price of oil in terms of how we will invest, because it’s a very hard thing to call. Perhaps one of the most important aspects of our own portfolio construction is we focus very much on the larger-cap energy stocks that in our view are not priced as if oil is north of $100. Instead, their share prices reflect expectations of oil that are a fair bit lower than that. If the price of oil moves up, as it generally has been over the last few months, they’ll participate in the upside, but they’ve got pretty fair downside protection, because their shares have not been factoring in really high oil prices,” he says. “Companies like Petro-Canada, Encana, Exxon-Mobil and ConocoPhilips — in general the integrated oils — have been quite inexpensive.”

Investors need to be wary that what’s good for energy companies may not be so great for other resource producers that use a lot of diesel and fuel to extract their goods. Much of the run-up in the Canadian materials sector has been due to the rising price of gold and fertilizers. The price of gold for instance may very well go up with energy prices and inflation, but gold producers may see their margins squeezed by higher energy costs.

Ethans, for example, is a fan of gold equities.

“We tend to play stocks. Usually you get better leverage out of the them. If gold drops in prices you want to be holding bullion, but if gold is going up in price you want to hold the stocks themselves because of the leverage,” he says. “The U.S. dollar has been in pretty rough shape. I’m not so sure that, until we see the effects of the credit crisis end, with regards with financial institutions, we will see the U.S. dollar rise substantially. Any type of bailout that the fed has to do for a financial institution or a quasi-government organization is not good for the U.S. dollar [therefore good for gold].”

Adatia, however, is underweight on gold and overweight on fertilizers.

“Anytime you start talking about raising rates, and that may not be this year but likely next year, you expect a pullback in gold. Any allocation [we have] in gold is going to be a short-term risk controlled measure,” he says. “With fertilizers, even if they fallback, I think there are going to be a lot of buyers that get back in.”

This optimism about fertilizers is due to a general bullishness about an increasing demand for food. However, specific sectors of food are extremely volatile and dependent on factors like the weather. Regardless of what’s being grown there is likely going to be continued need for fertilizer. Gorman says if an investor is bullish on agriculture, fertilizer is likely the best bet to get broad-based exposure to sector.

“The agricultural theme has been fertilizer stocks. We’ve had positions in Potash and Agrium; those have been in our view the best way to play that issue,” he says. “Just as the underlying grains have moved up sharply, you’re seeing a pullback in some of those places as of late, which is a supply response. Weather is always a big factor, and you have seen increased planting for things like wheat here in Canada and elsewhere. It’s been a great run but I would be leery about taking positions if they hadn’t done so already at this point.”

Gorman also notes that if investors have a long-term bullish view of a certain resource sector, they should be looking at a drop in prices to expand those holdings. For example, he thinks right now is a good time to look at uranium.

“In the investment field, your greatest opportunities are in weakness. If you’re investing in the long run, when sentiment turns negative, you can pick up things under-priced in the short term,” he says. “Uranium is a good example, where the commodity price has dropped for good reason. Nevertheless, the long-term prospects are very sound. That would cause me to take a good long look at stocks like Cameco.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(07/23/08)

Mark Noble