Taking Stock Of The Commodities Rally by Michelle Dunstan & Henry S. D’Auria
This year’s impressive commodity run has delivered big rewards to investors in energy and metals/mining stocks. But is this a sustainable rally, or just a dead-cat bounce?
There’s no simple answer, because all commodities were not created equal. Determining whether the rally is real requires understanding each commodity’s supply and demand intricacies.
Metals and mining stocks have advanced by 34% in the year through June 30th, outperforming energy stocks, which rose by 14%. In the coming months, we believe that a close look at industry segments—and careful choices about positioning in companies—will be crucial to investing success, as the relative performance of each sector could change course.
Energy and Metals: A Closer Look
In energy’s case, despite the recent dip in oil prices, we believe the rally is indeed sustainable. Prices will be volatile but will continue to trend higher, in our view. In the case of metals, however, the evidence supporting increasing valuation is less compelling. Take iron ore, for example. Iron is the key component in steel, which is primarily used in infrastructure. Demand for iron ore and steel, like that for most metals, has been driven by China, where growth is slowing. Even those investors most optimistic about Chinese GDP don’t believe steel demand growth will ever again reach the double-digit levels we saw earlier this century.
While demand is moderating, iron ore supply continues to grow (Display). It takes a long time to build a mine and bring it online. From the time a miner finds a mineral deposit and the process goes through permitting, design and construction, it can take an average of seven years. We are finally seeing the last wave of mines that were approved before the 2008 financial crisis come online.
It’s hard to be bullish in the short term. Supply and demand will take a long time to balance, and prices will need to rise enough to incent new production into the market. Of course, each metal has its own dynamics. We think zinc is already in a mining deficit, and copper will rebalance in the short term. Other mined resources, like iron ore, coal and uranium, will take much longer.
Energy is a different story. Demand for oil remains robust (Display), and lower fuel prices have led to more driving globally. With higher prices, global demand growth will normalize and slow—but it should still remain in line with the recent history of 1 million barrels per day per year, not materially lower as in metals.
Oil Supply and Production: What’s in the Pipeline?
The supply side is also different for oil. The lead time for the marginal producers (such as producers of shale oil) is measured in months, not in years as it is for metals. It took a bit of time for producers to react, owing to planning cycles, locked-in service contracts and oil hedges, but US production has been falling sharply and non-OPEC, non-US production growth has now turned negative.
Negative production growth combined with sustained demand growth will balance the market later in 2016, in our view. With growing demand and a 9% natural depletion rate, we believe that new projects need to materialize and a higher price is necessary for new oil production to become a reality.
Steering Toward Commodities Opportunities
Following the downward spiral that oil, metals and mining experienced the past few years, investors have benefited from a commodities comeback in 2016. But those who have passively invested in an index may have left their portfolios undefended against a number of commodities companies that are unlikely to help generate returns in the next few years.
We think energy stocks will outperform metals and mining stocks in the coming months—reversing the recent trend. An active approach focused on understanding each industry’s changing dynamics—and long-term trends—can also help steer investors toward opportunities in energy—and away from the risks of being exposed to the most vulnerable commodities companies in an index.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.