Commodity Markets – Time To Buy or Run?

copper

Anyone that’s been following the commodity markets (hard commodities i.e. the mining sector) in any way, shape or form, will know that it’s been a tough sector for a while now.

The commodity markets overall have taken one heck of a pummeling since the peak of the “commodity super cycle” in around 2008. Since then, we’ve witnessed prices of both commodities themselves and the companies exposed to the sector in free fall.

As many of you will already know, commodity markets are highly cyclical and getting the timing right regarding entering the market can be a highly lucrative undertaking. On the flip side, getting it wrong can lead to some pretty significant losses for those not willing (or able) to ride out tough times.

Forecasts regarding the current “state of play” in commodity markets are a dime a dozen, and people calling for a bottom are just as voluminous as those calling for continued sector wide pain.


I personally believe attempting to forecast future price movements with anywhere near a high degree of accuracy is impossible, but there are a number of things we can look at to give us a decent idea of where the market is at and move the odds in an investors favor.

That leads me nicely to the first question we need to ask ourselves – what is the current state of play in the overall commodities market?

 

1. The Current State of Play – Times are Tough…Very Tough

There’s no hiding the current situation – times are incredibly tough for the commodities sector right now. The pain is shown perfectly in the chart below which highlights the performance of two mining focused indexes in the Australian market:

XMM vs XSR indexes

Monthly chart showing the performance of two Australian mining related indexes, the ASX 300 Metals and Mining Index (XMM) and the ASX Small Resources Index (XSR).

You’ll notice the parabolic increase in index values during the 2000’s, and the equally spectacular fall in values since about 2011, with the “chasm” in 2008 the result of the global financial crisis (GFC).

The XMM (red line), an index which averages the price movements of the larger ASX listed mining companies, is currently trading at levels not seen in over 10 years and is down over 60% from it’s pre-GFC peak.

The XSR (Blue line), which averages price movements in the more volatile, small market capitalization junior exploration companies is even worse – it’s trading at levels not seen since 2003 (over 12 years ago!) and has retraced over 80% from its 2008 peak.

Bear in mind those figures quoted above don’t even take into account inflation, which, if based on the core consumer price index (CPI), means inflation has eroded a further 38% off values since the year 2000.

Mining Industry in a State of Depression?

There are signs aplenty that the industry as a whole is in a state of depression. First of all, even the global giants, usually the least volatile players in the overall commodity market, are down significantly.

For example, the worlds largest mining company based on market capitalization, BHP Billiton is down over 50% from its 2008 peak. I’ve personally had significant experience working on BHP’s Western Australian Pilbara iron ore mines and have seen first hand what has happened during this recent downturn (think cost cutting, job losses and mine closures).

If you think the performance of BHP’s share price looks rough, the worlds largest mining company by way of revenue, Glencore, has performed even worse. It’s share price is down a staggering 78% since it was floated back in 2011 under the weight of it’s huge debt obligations and falling revenue from the ever decreasing commodity prices it produces.

Hardest hit though, is the junior exploration sector which relies heavily on regular injections of investor capital to keep the drill bit turning.

In the current commodity market climate, it’s been very, very difficult for most juniors to get funding. I’ve seen figures which show that the cash reserves held by junior explorers on the Toronto Stock Exchange (TSX) reduced from $3.5 billion in 2012 to under $1.5 billion in 2014. I’d bet that figure is even lower now.

Junior explorers simply cannot survive without investor capital, as they generate little revenue (or more often, no revenue) and rely on regular injections of cash from investors to keep the lights on, and the drill bit turning.

Drilling

A drill rig drilling at a green fields gold exploration site in West Africa.

Under the current market conditions, many junior exploration companies have either:

  1. Gone out the back door (or will in the near future),
  2. are essentially zombie “shell” companies, without the cash required to undertake exploration or,
  3. have decided to pull the pin on the commodities sector all together and “backdoor” list into other sectors such as technology, or biotechnology which are “hot” right now.

There are countless examples of explorers who have opted for option “c” over the past 12 months or so. Probably the most high profile example in Australia has been Aziana Limited (formerly AZK.AX on the ASX) which acquired BrainChip (now BRN.AX), a next generation,”artificially intelligent” computer chip in the development phase.

Aziana’s share price Fell from over $0.24 in 2012 to a low of $0.03 just prior to announcing the BrainChip acquisition – a loss of 88% in just three years.

Following the BrainChip acquisition, the company reached a peak of $0.625 (an over 2,000% increase from it’s lows) and has had people literally “throwing” cash at them since, showing why many are choosing to pack up and say goodbye to the industry in search of greener pastures.

It’s clear that both the number of exploration companies and overall money spent on exploration activity has declined dramatically since the hay days of the first decade of the 2000’s:

Chart showing the total exploration-related financings by Junior explorers, 2008-14. Source: snl.com

Chart showing the total global exploration-related financings by Junior explorers, 2008-14. Source: snl.com

This is reflected in the fact that there has been very little in the way of truly world class mineral discoveries over the past five or so years:

A graph showing a dramatic drop off in the amount of gold discovered over the past few years - the direct result of a dramatic drop off in exploration activity.

A graph showing a dramatic drop off in the amount of gold discovered over the past few years – the direct result of the significant drop off in exploration activity. Source: snl.com

Finding world class deposits is an extremely difficult process, and there simply hasn’t been the level of exploration required to unearth these kinds of deposits.

So, all in all, I’m confident in saying that commodity markets are currently in a very, very depressed state.

BUT, nothing stays down forever, and a widespread downsize of the industry is often a sign that things are nearing a low. After all, “it’s always darkest before the dawn“, right?

This leads us nicely to our next topic – where exactly are we in the commodity cycle?

 2. Where are we Currently in the Grand Scheme of the Commodity Cycle?

Firstly, this is a difficult question to answer with any certainty – anyone telling you otherwise is nothing but a charlatan (believe me, there’s many out there).

Secondly, the answer to the above question depends greatly on what kind of time frame you are talking about, and would change significantly when discussing the outlook for the next six months verses the next 10 years.

However, there are a number of “facts” that we can look at that at least give us some idea where we are in the highly cyclical commodity markets.

We’ve just had the biggest commodity “super, super cycle” in the last 200 years.

Firstly, take a look at the chart below. You’ll notice I’ve highlighted periods where the average rate of return (RoR) has a 10 year negative (red) and positive (green) average.

One thing that should stick out like dogs balls is the big green section at the very right of the chart – commodities “overall” have not had a 10 year period of average negative returns for over 70 years! 

That is quite an incredible statistic. To put things in perspective, the previous longest period without negative returns was a “paltry” 24 years between 1904 and 1928, just before the great depression.

There’s no denying it, we’ve experienced the biggest commodity “super, super cycle” in the past 200 years at least, and probably a lot longer (I don’t have data that goes back further into the past).

Commodity cycle

Annotated chart showing global commodity cycles over the past 200+ years. At no point in time during the last 200 years have we had such a long bull market as the past 50 or 60 years since World War 2. Chart modified from source: MacroBussiness.com.au

So what can we take from this? Perhaps not a lot, other than the fact that the world has experienced probably the single biggest “super long term” bull market in commodities history.

But that doesn’t mean things have been “peachy” throughout the entirety of that period – there are many shorter “sub” cycles within broader cyclical periods.

In fact, the most obvious cycles on the above chart are the those typically described as “super” (singular) cycles that tend to play out over a period of 25 to 30 years. For example, two complete “super” cycles have played out during this 70 year (and counting) “super, super” cycle, which saw peaks in about 1950 and 1983. You’ll then notice the third, incomplete cycle which brings to the present day.

So are we at, or past the peak in this wave of the cycle? Again, it’s impossible to tell with any certainty, but it’s certainly not hard to notice the “12%” 10 year average RoR achieved in 2014 is higher than at any point in the last 200 years.

That’s something that should have most investors nervous as extreme’s in the market never tend to last long (the term mean reversion almost always applies).

Going off the above chart, what is clear is that we are certainly not at the bottom of the long term (i.e. multi decade) cycles and are rather, probably closer to the top. Based on historic norms, you’d have to be the most eternal optimist to expect the parabolic upwards curve to continue in the long term.

One thing worth noting though, is that because the above chart works on a “10 year average return”, there is a significant lag between peak instantaneous values (i.e. spot commodity and stock prices) and the values shown on the chart.

For example the chart suggests we’re currently experiencing a very high (10 year average) return, even though we know commodity prices (and stock market valuations) reached their peak for most commodities as early as 2006 or 2007.

After all the industry is currently in a state of depression, right (?) – something clearly not shown on the chart above which highlights a much more long term (multi-decade) picture.

For that reason, when attempting to analyse shorter time frame commodity market movements, i.e. the next two to five years (the period that most investors care about most), it’s important to dig a little deeper and use charts that don’t apply such “long term” averaging methodology.

The Past Decade- A Look at the Near Term Picture

I’ve put together a couple of charts which highlight quite nicely where I think we are currently sitting in terms of the slightly shorter term cycles.

Firstly, lets examine a chart of  spot prices over the last 10 years for a broad range of commodities. Note that values have been normalized so that all start from the same point and plot on one Y-axis. You’ll also notice I’ve annotated the peak spot price in each commodity over the period, as shown by a colored/numbered circle.

Commodities

For some reason I couldn’t get copper to load on my charting software, so here’s the chart of the very important base metal below, with Brent Crude and Tin (same as on the chart above) overlaid as a reference:

Copper

One thing should be abundantly clear – without exception, every single one of the commodities shown above is significantly below its peak, and not just slightly, but typically 50% to 80% below.

Another snapshot is shown in the table below which provides the date each of the above commodities peaked, the percentage they are now down from their peak and their percentage change from January 2006 – almost a decade ago. I threw in bulk commodities iron ore and coal, as well as two of the Australian mining indexes for good measure.

Table of Commodity Price Changes

Table showing commodity price changes over the past decade. “Current Value” prices valid as at the end of October, 2015.

You’ll see that not only are every single one of the commodities significantly down from their peak, but most of these peaks occurred between late 2006 and mid 2008, although some (such as gold) peaked as late as late 2011. That means most of these commodities have technically been in a bear market for over 6 years and some as long as 9 years (see zinc)!

Not only that, but the majority are currently priced lower than they were 10 years ago. Some, like aluminium and coal are trading at prices more than 30% below their nominal value a decade ago.

Again, I need to reinforce the fact that the above price changes do not even take into account inflation which, based on the official CPI figures, would account for a further 22% erosion of “real” prices since the end of 2005.

Taking this all into account, it seems obvious to me that the commodities market in general is nearing an “extremely oversold” status. When markets experience this kind of sell off, there are almost always bargains to be found, if you know where to look.

Supply Side Considerations – Is The Commodity Market Deleveraging?

Value is found by finding quality companies at the low end of the production cost curve that will be the most likely to ride out and survive the period of low commodity prices. It’s those companies which can survive this deleveraging phase that will provide great real returns once the tide turns and the bulls return.

We know we’ve had a period of drastic and sustained decline in commodity prices, and this has definitely manifested in company stock prices that are exposed to the sector. But have we reached that crucial Darwinian point in the cycle where the “weak” companies are forced out the back door?

The Junior Exploration Space – The Canary in the Coal Mine

Figuring this out is actually probably one of the harder questions to answer, as the data is a little “murkier” and harder to collate. However, the best place to look will almost always be the junior exploration sector, which should be the first sub-sector to diminish in size as the investor capital with which these companies so heavily rely, dries up like the Mojave desert.

There are more than a few signs that the “downsizing” process is well and truly under way in the junior resource sector. For example, the graph below shows there has been a significant reduction in capital raised by resource companies listed on the ASX since the peak of the boom in 2009 – a drop of no less than 77%!

What I actually find more interesting than the overall decrease though, is the distinct lack of “IPO” capital raised (the blue portion of the bars) since 2011. Since the start of 2012 we have literally seen no new “metals and mining” related companies listing on the Australian market.

Total Capital Raised

Graph showing total capital raised, both through IPO’s and secondary, by ASX listed resource companies. Source: asx.com.au

Further to the above graph, I know that the total number of resource companies on the ASX has dropped from over 900 in 2010 to about 700 today – a decrease of over 20%. I’d bet the vast majority of these companies were junior explorers, a guess supported by the figure shown earlier in the post which clearly showed a significant decrease in global exploration spending over the past four to five years.

So we know that:

  1. There’s bugger all money flowing into the sector,
  2. there’s been an overall reduction in the number of resource based companies listed on the stock exchanges and
  3. there has literally been zero new companies floated on the market in that time.

To me, that’s a clear signal that the low commodity price environment is starting to move us into the “constructive destruction” phase of the cycle. However, for the forces of supply and demand to really start to equilibrate (and prices to stabilize), we really need to see supply destruction hit the majors who actually produce and supply the market with raw materials.

The Majors – A Mixed Picture

The picture is a little bit murkier when looking at the majors. Economic “theory” states that decreasing prices should result in a reduction in supply, as producers at the high end of the cost curve cut uneconomic production until equilibrium is reached.

The problem at the moment is that the production of many commodities is essentially controlled by “oligopolies” at the very low end of the cost curve.

What that has meant in practice is that these very large companies can afford to actually increase production volume (supply) to make up for the lower values of the commodities they are producing.

In other words, when margins are down, you ramp up the sheer volume you’re producing to compensate. This leads to an abundance of news headlines like this:

mining news

It’s a practice more akin to what you’d learn in “game theory” which states that “he who cooperates (i.e. reduce supply in the hope that prices rise) while others defect (i.e. increase production to compensate for lower prices) always loses”, and is actually the logical market response, when you stop and think about it.

In other words, each market player has been acting in their own best interest, and the lowest cost producers have all the power – they will happily increase their production even if that means sustained low prices and decreasing margins, if it means they can “snake” the market share off higher cost producers who are forced to cut uneconomic production (or forced out of business altogether).

Bullying

This approach is currently being seen across almost all the commodities I’ve covered so far, but is most significant in the bulk commodities (iron ore and coal) but also to a slightly lesser degree, the major base metals (primarily copper and nickel, but also zinc).

The oil space is also seeing a significant battle between low cost producers (i.e. Saudi Arabia) and the higher cost, but (previously) rapidly growing regions such as the U.S. shale producers.

I’ve seen less of this kind of activity in the precious metals market (gold and silver), but that could just be my lack of knowledge of the supply/demand metrics in that sub-sector.

Glencore – The First Major to Cut Production

Global giant Glencore was the first major producer I’ve come across to announce significant production cuts. It’s hand has largely been forced due to it’s extremely large debt load (over US$31 Billion and counting).

Glencore

It announced in early October that it would be cutting a whopping 500,000 metric tons of zinc production – over a third of it’s total zinc output and roughly 4% of the global market. As lead often exists in conjunction with zinc, it’s a move which will see the company reduce it’s lead output by 100,000 tons as well.

Glencore has also announced it will shut down production at two of its loss making copper mines in Africa for 18 months. This will result in about a 400,000 tons, equal to a quarter of it’s annual copper production and 1% of global supply, coming off the market.

As mentioned earlier, Glencore is a global behemoth – it’s the largest mining company by way of revenue and is actually the 9th largest company in the world by the same metric (revenue) – yup it has more revenue than global giants like Apple and Chevron.

So when a major player like Glencore is forced into making such drastic cuts, its definitely a sign that things are at least starting to bite.

The Rest of the Majors – Not Yet Following Suit

US based Copper giant Freeport-McMoRan, the worlds second largest copper producer, has announced moderate spending and production cuts very recently, whilst coal has been slowly seeing uneconomic supply cut from the system for years now (and still has a long way to go).

Apart from that though, I haven’t seen much evidence of significant production cuts from any other major across all the major commodities, and majors in most sub-sectors seem to be following iron ore’s lead in drastically cutting costs and, if anything, increasing output to compensate for lower prices.

Iron Ore Price vs Production

Graph showing the massive ramp up in Australia’s iron ore exports, and the effect this has had on the iron ore price. Note that production continues to grow exponentially, even in the face of drastically decreasing prices.

Companies can clearly see hurricane “Darwinism” heading their way, and everyone’s boarding up the windows and battering down the hatches, preparing for landfall.

This suggests to me that we are probably only at the beginning of the overall mid to long term deleveraging phase of the cycle. Unless we experience a positive “black swan” event which causes global demand to increase drastically in the near term, I think we’re likely to see a slow and prolonged grind towards the “survival of the fittest”.

The Demand Side of the Equation – Global Economy to “Recover”?

So far, we’ve mainly talked about the supply side of things. That’s because assessing the influences on supply are a lot simpler than trying to “figure out” how the entire global economic system operates.

After all, even the supposed “smartest economic minds” in the world (i.e. those at the US Federal Reserve) couldn’t see the global financial crisis of 2008 coming, the biggest economic shock since the great depression (for some funny examples, see the video below).

But there are a few basic statistics and theories that I think give some idea of what direction global demand is heading:

China – The Worlds Largest Commodities Addict

There’s no hiding the fact that China is now the biggest single consumer of almost all major hard commodities produced today, with the exception of oil. In fact it consumes 40% to 50% of most industrial metals and, staggeringly, over 70% of annual global metallurgical coal production.

Chinese Commodity Consumption

Graph showing China’s share of global commodity consumption. Source: BusinessInsider.com

To look at it another way, growth in Chinese demand has resulted in between 50% and 100% of global consumption increases in just about every commodity over the past decade.

Those are some staggering statistics, and anyone trying to suggest that China “doesn’t have as big of an impact on commodity prices as everyone thinks”, is burying their head in the sand, in my humble opinion.

It should come as little surprise then that commodity prices have crashed almost in lock step with a rapid and significant reduction in China’s reported rate of GDP growth:

China GDP Growth

Graph showing Chinese GDP growth rates by year. Note the rapid decline in growth since 2007. Source: TheEconomist.com

The Chinese growth machine is clearly slowing down, and in it’s heavily investment driven economy, GDP growth reduction primarily equates to one thing for commodity markets- a reduction in demand growth, and more likely a reduction in absolute demand.

At the end of the day, I feel the near to mid term outlook for commodities is largely going to depend on whether Chinese growth can plateau at this level and we see a “soft landing”. The alternative is a “hard landing” that many are expecting, where the Chinese economy experiences a serious recession or even depression – something that would very likely wreak further havoc on commodity prices.

Only time will tell, and I personally think what happens in reality will likely be somewhere in the middle of those two scenarios. But one thing I’m almost certain of, is that China’s lofty growth years of the early to mid 2000’s are a thing of the past, and we are unlikely to see the kind of extreme growth in demand for commodities that we saw during the 2000’s.

That is, unless we see someone come along to take the growth batten off China soon (most likely India, or another major emerging economy or two).

The Rest of the world

I’m not going to spend too much time talking about the rest of the world, other than to make a few basic observations which help paint a picture of how I think demand for commodities is going to play out in the near term:

The U.S. (consumer driven) economy appears to be improving and may contribute modestly to an increase in demand for commodities if we see economic activity continue to improve. However, the fact that we have been stuck with ZIRP and the most accommodative monetary policy ever seen, suggests things may not be as rosy as they seem.

Europe has been in dire straights for a long time, and has been teetering on a recession for years. Some parts (such as Greece) are clearly in a depression. Unless we see a dramatic turn around soon (possible, but unlikely, in my opinion), I don’t see much in the way of demand growth in Europe for at least the next 3 to 5 years.

Emerging markers (EM’s) have been relatively poor performers over the last year or so, and are seeing growth slow from pretty lofty levels. This is shown by GDP growth, which as a collective, reduced from 4.6% in 2014 to 4.2% in 2015, according to the IMF.

emerging markets

EM’s have been the biggest driver of global growth over the last decade and their growth is typically capital (and commodity) intensive relative to developed economy growth. Therefore, an uptick in growth in EM’s is likely important if we are to see a recovery in commodity prices.

It’s important to note that many EM’s are also big producers of raw commodities. That means many EM’s are struggling with lower commodity prices, particularly those heavily dependent on oil exports, such as those in the Middle East, Latin America and Russia – creating a sort of “negative feedback loop” (lower commodity prices = lower revenues = lower growth = lower commodity prices).

The rest of the world – Conclusions

We know China is slowing and is less likely to contribute to demand growth in commodities in the future. We know the advanced economies are struggling for growth which tends to be less “commodity intensive”, even if it does return with a vengeance.

Therefore, it’s my opinion that for a commodity bull market to return, we need to see a new growth story emerge from some of the EM players. I personally think India, with a population well over 1 billion, which has lofty development goals and has a far more “liberal” political system (compared to China), may be the next big global growth story.

Watch out for large scale government sponsored “stimulus” programs or growth initiatives that may offer short term support to the commodity demand “narrative” and offer up some shorter term trading opportunities.

Exchange Rates – The Often Forgotten Factor

It’s also important to remember that while commodity prices are currently low when priced in U.S. dollars (USD), most commodity players operate, both financially and operationally, outside the U.S. in countries like Australia, Canada and emerging economies.

Just about all of these countries have seen significant currency devaluations since the end of the boom. I remember when I first moved to Australia back in 2012, my Aussie dollar was worth more than the USD (something I remember vividly).

Fast forward 3.5 years and my Aussie dollar is buying a paltry $0.71 US – an over 35% currency devaluation from it’s peak:

Currency AUD USD

This is highlighted nicely when looking at the price of gold – down significantly when priced in USD, but actually not far off it’s 2011 peak in AUD, thanks entirely to a rapidly devaluing Australian dollar:

USD vs AUD Gold price

A chart showing the difference between gold prices in US and Australian dollars.

That means companies producing in countries like Australia where all their costs are in AUD’s, but earn their revenue in USD’s are actually sitting on surprisingly healthy margins.

Further slumps in commodity prices are likely to see even greater currency devaluations in countries heavily exposed to commodity prices, cushioning the risk of further commodity price declines.

 3. Conclusions – Time to Buy or Run?

This has been a pretty massive post thus far (yes, I got a little carried away), so lets quickly recap what we’ve covered so far.

A quick recap:

  • Commodity markets have suffered hugely over the past five to eight years and without exception, all the main hard commodities are down 50% to 80% from their peaks. As far as I see it, that means:
    • In the short to mid term, commodities appear to be reaching the extremely oversold levels, and there are some real value to be found out there, if you’re selective.
  • On the flip side, looking at a slightly longer term term (multi-decade) picture, most commodities are still well above (nominally speaking) their pre-boom levels. This could simply be the beginning of a longer term bear market in commodity markets.
  • There are signs the Darwinian “constructive destruction” phase is starting to play out – the junior exploration space in particular is showing signs of downsizing. This should have flow on effects in the long term, as a lack of new discoveries eventually leads to decreasing supply as existing resources are depleted.
  • We haven’t seen significant supply destruction from the existing major producers yet (with the exception of Glencore and a lesser extent Freeport-McMoRan).
    • If anything, we are seeing increasing supply to compensate for the lower prices (margins), a process which looks like it may be around for a while.
  • Global demand influences are a highly uncertain influence on the outlook for commodities. However, some observations show that :
    • Growth in China, by far the worlds biggest commodity consumer, is slowing and will likely provide headwinds for commodity prices in the near term.
    • Developed world growth, particularly in the U.S. appears to be improving, but there are many mixed signals. Europe is still struggling.
    • The outlook for emerging market economies is also uncertain, but likely provides the biggest potential for demand growth surprises to the upside.

Reasons to Buy:

In my opinion, there are still some real signs that now is definitely not the worst time to be looking at commodity exposed investments:

  • It’s clear that commodity markets are extremely oversold in the short term, remembering that stock prices of companies in the resources sector are typically down 70% to 80%+ on average across the entire industry. That means:
    • Companies appear “cheap” relative to what they were only a few short years ago, and there’s some real value to be found if you can sort the “diamonds from the rough”.
    • If commodity price movements surprise to the upside, there’s some real room for share price appreciation.
  • Some quality companies that earn in USD’s but have the majority of their costs in other currencies like the AUD and Canadian dollar (CAD) still have surprisingly good margins due to currency gains on the commodities they sell.
  • Investor sentiment in the commodities space is currently extremely low and the commodities sector is probably the only industry I can think of that has performed consistently poorly over the past five years or so:
    • Most investors have a very bearish outlook towards commodities, but being a highly cyclical industry, contrarian thinking is almost always the best way to make money in the commodities space.

Reasons to Run:

Depending on how you look at things, many of the “reasons to buy” cited above, could also be a reason to run (or stay on the sidelines):

  • Mid to long term price momentum is heavily negative, both in commodity prices themselves, and in the stock prices of companies exposed to them. The phrase “catching a falling knife” aptly explains the process of trying to “bottom pick” in the sector at the moment.
  • Longer term (multi-decade) data show that we are more likely to be near the peak of said long term cycles, rather than near a bottom, which means:
    • Unless we see a new driver of global economic growth (specifically commodity intensive growth), we’re more likely likely to see longer term commodity price stabilization, or even further declines, than we are to see explosive growth like that seen during the 2000’s.
  • Growth in China, by far and away the worlds biggest consumer of commodities, is slowing. This is likely to mean, at the very least, demand growth for commodities will be muted for the foreseeable future. At worst, it could mean further falls in demand, adding to the already significant downward pressure on commodity prices.

What I’m Doing:

I’m personally of the belief that commodity markets have been sold down to the point that, even though I’m not convinced we’ve hit “rock bottom”, I’m starting to at least look into and take initial positions in quality companies that I believe have been over sold and offer good value.

There are two main metrics I’m using the assess which companies are worth my time (and money); the size of the company and the sub-sector they operate in.

Company Size – Juniors, Mid Caps or Majors?

The Majors:

I’m currently not interested in any of the “big name” majors – the BHP’s, the Newmont’s, the Glencore’s.

Many have made absolutely massive capital investments during the boom times in assets that are now borderline economic, but are so far through the development phase that it’s easier to carry on than pull the plug. I believe we are only beginning to see the effects of these poor-investments, and it’s going to drag on their bottom line for years to come.

The rest (those with high quality, low cost assets) are are currently stuck in a “race to the bottom” as far as cutting costs and ramping up production goes – a process which looks set to play out for some time.

All this is likely to mean poor returns in the short to mid term, at least relative to the “mega profits” of the boom years, and investors will likely punish both decreasing profit margins and, likely, dividend payout ratio’s.

The Juniors:

At the other end of the scale, investing in juniors at this end of the cycle is extremely risky, given most are having, or will have a lot of difficulty raising capital. Not only that, but current share prices are at or near all time lows, meaning raising money by way of issuing capital is going to mean a lot of dilution for existing holders (unless you participate in the raising).

In saying that, the current climate has meant that some juniors that have made some pretty decent discoveries of late, without seeing a corresponding rapid share price appreciation that they would have, had the discovery been made during the boom times.

That means I am looking to take small positions in companies that I feel have already made a quality discovery and are likely to make it into production in the future (and have no problem raising capital to do so). 

There are also a decent number of companies trading at or even below cash backing, i.e. they have more cash in the bank than the total value of their company. If these companies also have a decent prospect, I’ve found I can often make a decent return buying when they are below cash backing, prior to news flow events (i.e. drilling campaigns).

Having cash in the bank means a) I don’t have to worry about dilution from a capital raising and b) they have next to zero (or even a negative) enterprise value (EV), meaning there is a ton of upside should they find something or the market finally wakes up to their low EV.

Juniors also will have the most upside potential when the market finally does turn, but it’s important to stress that betting on that happening in the near term is a risky play – you may have to wait years for an eventual sector wide turn around. By that point you’ve likely been either a) diluted to buggery, or b) the company has gone out the back door or has jumped ship into another sector.

So, that leads me to where I think the current investing “sweet spot” is – top quality mid cap companies.

The Mid Caps:

The main reason I’m currently the most bullish on “mid cap” companies, is because during tough times, the majors tend to consolidate focus, which means they spin off assets which may be of a high quality, but are often smaller and outside of their core focus.

For that reason, the last few years has been a great time for diligent (and cashed up) mid caps to acquire high quality assets at every attractive prices. One great examples in the gold space has been Northern Star Resources (NST.AX), which acquired quality assets from global giant Barrick Gold over the past couple of years.

NST has gone from strength to strength since, as shown when you compare the normalized share price movements of both Barrick and NST:

Northern Star Resources (NST) and Barric Gold (ABX)

Comparison of the Northern Star Resources (NST) and Barric Gold (ABX) share prices.

The great thing about the better mid caps who have acquired high quality assets is that:

  1. They are already producing, and wont need much, if any capital injections to begin or continue operating. This means little to no dilution for existing holders who are riding out the tough times.
  2. They have typically brought high quality assets which operate at the low end of the cost curve, making them the best equipped to weather periods of prolonged low prices.
  3. They have the most upside potential (relative to the majors) when we do see a market-wide change in sentiment, starting from a lower base with typically better expansion opportunities.

It’s for this reason that I am primarily looking at taking positions in the mid cap space of certain sub sectors at the moment.

Sub Sectors – Bulk Commodities (+oil), Base Metals or Precious Metals?

Bulk Commodities (Iron Ore, Coal + Oil):

In short – I’m extremely bearish on this sector and am not looking at investments in this space in any way shape or form. It’s the sector suffering the most from the “race to the bottom” and “game theory” mentality.

We’ve seen an exponential increase in supply over the past decade, and supply increases are only set to continue, particularly in the iron ore space. Meanwhile, with China slowing, demand is dwindling – a recipe for disaster, in my opinion – I see a high probability of prices reducing even further from here.

Oil is probably the best of the the bunch, being less linked to Chinese demand fluctuations, but there’s still a major battle going on for market share, with plenty of supply ready to come back online should prices rise, meaning we are likely to see a period of low oil prices for the foreseeable future.

10 year Bulk Commodities Chart

Normalized chart of bulk commodities showing the % change in prices since 1998.

Base Metals (I.e. Copper, Nickel, Zinc, Lead, Tin, Aluminium et. al.):

The outlook for individual base metals varies quite widely, something I’m not going to go into in a big way (as this post is already ginormous), but I’m currently somewhere in between bullish and bearish on the sub-sector as a whole.

I think this is probably the one space where we are starting to see lower prices leading to supply destruction (i.e. Glencore), a sign that suggests to me that it’s time to start taking initial positions in quality companies.

Zinc in particular is set to see big decreases in supply, with Glencore significantly cutting production and one of the worlds largest Zinc Mines, Century in Australia ceasing mining earlier this year.

In saying that, China is by far and away the biggest zinc producer, and details regarding actual production figures are murky at best. I’ve heard rumors of dodgy Chinese activity in the market, meaning no one is really sure about the supply side of the equation.

annual zinc production by region

Annual zinc production by region

Overall, I’m looking at quality base metal exposed companies. I’ve started to build a long term position in one particular mid cap company that I think has a very bright future, and I have small speculative holdings in one or two quality juniors in this space.

10 year base metals Chart

Normalized chart of base metals showing the % change in prices since 2000.

Precious Metals (Gold and Silver):

It’s a little harder to gauge how precious metals (PM’s) are going to perform, given that demand side influences seem to drive prices more than the supply side. Left field global geo-politcal events seem to have a big influence on demand, something that’s impossible to predict.

To compound that, gold in particular has very little in the way of industrial uses, and is “consumed” primarily in jewelry and bought by investors as “insurance”, as it’s seen as a store of value. For that reason, it’s price often acts in a completely different manner to bulk commodities and base metals, which are more strongly influenced by changes in global economic activity.

In saying that, there are a few factors which make me think the PM’s market may perform “o.k.” in the short to mid term:

1. Current All In Sustaining Costs (ASIC) for the worlds major gold miners are nearing the current spot price of gold (as shown in the graph below). This means we’re unlikely to see much in the way of new supply coming from the majors until prices recover and/or costs can be significantly reduced. This mean’s we’re likely to see high cost production shelved, while companies focus on optimizing production of their low cost reserves.

treetr

Graph showing the ASIC’s for the words largest gold miners. Source: MarketRealist.com

2. Historic ratio’s like the gold to silver ratio are looking favorable for the sector. Silver has a higher beta relative to gold, therefore it tends to under perform gold during bear markets and outperform throughout bull markets. This ratio can be used to identify “oversold” periods in the market, as historically the extremes in the ratio haven’t been maintained for long.

gold to silver ratio

Chart showing that the gold to silver ratio is nearing extreme levels.

This suggests to me we’re likely to see either:

  1. A turn around in the PM’s space, with silver outperforming relative to gold (possible),
  2. a continued decline, with silver performing “less badly” (unlikely, given it’s higher beta),
  3. a stabilization in prices, with silver slightly out performing gold (possible).

3. PM markets are typically a “counter cyclical” play. This means they tend to do well during periods of market panic and uncertainty when global growth tends to be low and industrial commodities suffer. Therefore the precious metals market is likely to do better than base metals and bulk commodities if we see another market meltdown.

Having some of your portfolio invested in PM’s thus makes sense from both a diversification and “insurance” perspective. The one quality mid cap I mentioned I’m building a position in is involved in producing both base metals and gold, giving me decent exposure to the PM markets.

In the gold space, I’m also following (but don’t yet have a position) in a number of juniors with quality prospects who are currently trading at or below cash backing.

Given that silver tends to outperform gold during a bull market, and gold to silver ratio’s are clearly suggesting a turn around may be near, I’ve also been taking a (small) position in a number of quality silver exposed juniors. This is because I see the most upside in the silver market, should we see a return to bullish conditions in the PM’s market.

Precious metals chart

Annotated chart showing the performance of gold and silver since 2000. Note both the effects of global recession and silvers higher beta relative to gold.

 4. Summary – The Take Home Message

To sum everything up – there’s no doubt that commodity markets have experienced probably single biggest bull run in history, leading up to the end of the first decade of the 2000’s. As night follows day, we’re experiencing a pretty epic bust, both in commodity prices and stock prices of companies that are leveraged to the commodity market.

After all, we’ve experienced positive 10 year average returns for over 70 years – it’s not surprising we’re now seeing a prolonged period of deleveraging and downward price pressure.

My gut feeling is that we are probably not at the absolute bottom of the cycle and are more likely to see a stabilization in prices than we are a rapid take off akin to the early 2000’s. I think there’s even a decent chance that we may even see further declines (possibly even significant declines) particularly in some sub-sectors.

Having said that, the global economic system is so complex that it’s impossible to tell with any degree of certainty what’s in store, and sentiment is so bad that it makes me wonder if a bottom really isn’t far off.

Regardless, current market conditions have meant that there is now some real value out there, if you’re willing to spend time finding quality in among the wreckage. That means I think it’s a good time to be looking at companies with quality projects at the low end of the cost curve, decent management and a solid cash position (and low debt levels).

These kinds of companies should do well in the mid to long term (and probably short term as well), regardless of what happens in the broader market. I’m starting to take initial positions in companies that fit the above criteria, and will likely add to my holdings over time.

What a massive post (probably the biggest I’ll ever write) – I hope I’ve managed to keep you engaged as I outline my thoughts about commodity markets.

I would love to hear from you about your thoughts on the subject, so please, let me know what you think about the current state of play in the commodities sector.

I look forward to hearing from you.

Happy Investing,

The Nude Investor

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