Despite the resource sector’s impressive gains booked during 2016, the Newgate Absolute Return Fund still likes the resource sector for a number of reasons, which the fund detailed in a letter to investors sent out earlier this month, a copy of which was reviewed by ValueWalk.
- Chart: How Every Commodity Performed In 2016
The letter, a copy of which has been reviewed by ValueWalk, explores the eight key reasons why Newgate likes commodity companies despite the turbulent price movements the sector has seen over the past few years.
Overall, the thesis revolves around a traditional supply/demand argument. Newgate finds clear evidence of a synchronized recovery in the global economy and the same time the fund’s analysts believe there is a genuine supply-side side restraint.
Newgate Absolute Return Fund: Why We Like Commodity Companies
The current supply/demand environment is, Newgate Absolute Return Fund believes, a result of the commodity industry’s own mistakes. The resources boom, which took place between the early 2000s and 2014 was fuelled by China’s insatiable demand for commodities. However, commodity companies squandered this opportunity for profit by making decisions to invest in new capacity at record high prices for industrial and bulk commodities pushing up input prices such as labor and materials to a point where capital costs of expansion were much greater than originally forecast. These decisions obliterated billions of dollars in shareholder equity as the simultaneous production expansion caused a major increase in commodity supply sending prices sliding. The world’s largest iron ore producer, Rio Tinto is a great example of this colossal value destruction. Newgate points out that between 2005 and 2015 Rio increased its asset base from $20 billion to $130 billion but over the same period return on equity collapsed from a high of 45% in 2005 to a low of -5% in 2012 and is currently around 0%.
“In very simple terms, one of the greatest resource booms in recorded economic history was squandered by the poor decisions made by the leadership of major global resource companies. They outlaid too much to expand supply, and when the increased production entered the market major price falls saw dreadful project economics.”
As commodity prices plunged and costs remain elevated, many small highly leveraged commodity companies were pushed into bankruptcy, and some of the world’s largest commodity trading houses such as Glencore and Noble were forced to issue new capital and deny accusations they were close to running out of cash.
After these first two stages, Newgate points out that the commodity industry has now entered a new phase of capital preservation and risk aversion particularly in those companies which experienced a near death experience. It is the view of analysts at Newgate that resource company leadership are now a highly risk-averse group, and this will not change for the foreseeable future. They believe it could be up to a generation before resource companies embarked upon another round of value destroying capital expenditure, merger, and acquisitions.
The new risk averse nature of managements is bullish for commodity prices. Over the next few years, companies such as Rio Tinto and BHP Billiton will continue to improve productivity, reduce the cost of extraction and utilize free cash flow to reduce debt. Any new large projects are unlikely to be commissioned as companies prioritize value over volume. This new mantra is already having some impact on commodity prices and supply according to Newgate’s research. According to the fund and its conversations with company executives, the copper market is close to registering supply problems as while the price of copper has hit a high of $2.60 per pound in recent months, it is still well below the $3.30 per pound level resource companies have stated they need the commodity to be trading at in order to justify new production.
“History will tell us that eventually resource companies will react to sustainably high prices by increasing supply. Nonetheless, because of the recent experience of resource company leadership we may be in a situation for many years where resource companies are content generating excessive cash flow and rewarding shareholders, rather than increasing supply.”
China is the wild card in resource markets. The country is a key producer of bulk commodities such as iron ore and coal, and many loss-making companies have been kept alive by cheap funding, allowing them to continue to produce even though traditional economic’s dictates they should collapse and take supply out the system. For the first time, China began to reform its commodity industry last year, closing excess supply to improve the overall health of the economy and reduce bad debts. Over the calendar year 2016 these reforms saw production declines of 30% in ferrous mining, 28% in oil and gas production, 13% in transportation equipment, and 35% in coal mining. Newgate expects this trend to continue over 2017 improving the supply-side picture. At the same time, the fund’s analysts believe the country’s consumption of bulk commodities will continue to grow at a steady rate for the foreseeable future.
Overall then, Newgate is highly optimistic about the outlook for commodity prices and commodity companies going forwards. Here is the concluding paragraph of Newgate’s January newsletter to sum up:
“Our conclusion is that the recent harsh lessons of the previous cycle means a supply response to high commodity prices may be very slow. This in turn may mean commodity prices remain elevated for longer than expected, allowing resource companies to enjoy heavy cashflows that can be paid out to shareholders over 2018 and 2019 and beyond.
Despite the excellent performance from resource companies over calendar year 2016, we still assess that it is a mildly contrarian investment. Many market participants are sceptical about current commodity pricing and are unwilling to invest in the sector, particularly after such strong performance over calendar year 2016.
We concede that some of our arguments may be wrong (in particularly Chinese demand and their fiscal position), and we will be tracking our thesis closely, but on the balance of probabilities, we believe it is time to be optimistic on global cyclical companies, particularly resources.”