Is the bubble set to burst?

This is the worst of times to be a consumer of oil and other commodities. This is demonstrated by the protests against fuel prices in France and the UK and food riots across the world. But while consumers have suffered, investors in commodities have been enjoying the best of times. The BGF World Mining fund, for example, returned 214.77 per cent over three years to 12 May 2008 and 456.44 per cent over five years. But can these returns continue? The four-fold increase in the oil price to reach a peak of just over $135 a barrel in May has led Lehman Brothers to talk about “oil.com.” George Soros and others have talked about potential bubbles in commodity markets. Lehman Brothers says summer market tightness could continue to propel oil prices “upwards to untested levels. But when peak prices hit, we believe they are also likely to fall precipitously. In the midst of a market trend, turning points can be sudden, unexpected and severe. If history is a guide, the turning point will come. Getting the timing right is the difficult part.” George Soros likens the investment rush into commodities to the demand that prompted the stock market crash in 1987. In testimony to the US Senate’s panel on energy manipulation, Mr Soros said: “In both cases, the institutions are piling in on one side of the market and they have sufficient weight to unbalance it. If the trend were reversed and the institutions as a group headed for the exit as they did in 1987, there would be a crash.” After all, it has been estimated that $260bn (E170bn) is invested in commodity funds, which is 20 times the level invested in 2003. Despite these concerns, commodity fund managers continue to be generally optimistic about the sector, based on their view of supply and demand trends. “It is not too late for investors to buy into the commodity sector because valuations are still at relatively low multiples,” says Evy Hambro, manager of the BGF World Mining fund. “General investors are not convinced that the current commodity cycle will continue. “Analysts have been predicting lower prices over the past three or four years than has been the case. They have caught up with oil where there are long-term estimates of $100 a barrel. The same process will have to happen for other commodities. “Stocks are at a discount to general markets in the US and the UK. There is also plenty of potential for mergers and acquisition activity as shown by BHP Billiton trying to take over Rio Tinto.” Jonathan Blake, manager of the Baring Global Resources fund, argues that the cycle of price rises for natural resources and commodities will last longer than the general market expects. Commodity fund managers play down the extent to which “speculators” have been driving up prices. Managers argue that investors have amplified the upward trend in prices rather than being the main cause. The fundamental support for prices is coming from both supply and demand, say commodity fund managers. The key driver on the demand side for this cycle, which is generally agreed to have begun in 2001, is the economic growth in emerging markets, particularly China, India, Russia and Brazil, and therefore the rise in demand for natural resources and commodities. “The Chinese economy has been growing at 10 per cent a year and it expanded at 10.4 per cent in the first quarter of 2008,” says Mr Hambro. “China is now the largest importer of commodities excluding oil. “Demand for steel is very strong as it is needed for the industrialisation of Asia. India is to spend $500bn on infrastructure over the next five years. This is for power stations, roads, railways and other infrastructure.” As the prices of commodities have increased, it has become more economical to access sources of commodities that were previously prohibitively expensive to extract. An example is Canadian sands oil, says Mr Blake. Karin Schoeman, manager of the Fortis L Commodity World fund, says there is a price floor for most commodities, which is generally getting higher because the cost of extracting commodities is rising. For example, the cost of extracting non-Opec deep sea oil may go up 15 to 20 per cent this year and 10 to 15 per cent in 2009, she says. The increasing costs include for energy, steel and specialist employees, including engineers. Therefore, the minimum price of oil will have to go up as well. “If the price of any commodity falls too far, then it becomes uneconomic to produce it,” says Ms Schoeman. “The supply will fall and then the price of the commodity will rise again.” There are other supply constraints that encourage the positive outlook for commodity fund managers. Until recently, there has been a lack of investment to increase supply because of the low price of commodities in the 1980s and 1990s. Even with greater investment, it can be a slow process to increase supply. Mr Hambro says the time it takes to get a new mine up and running varies. The best-case scenario is for a new mine in a developed country with good access to power and transport. In this situation, it may take two years for the mine to become operational. But in a less favourable scenario, it may take more than a decade. Mr Hambro says the most easily accessible resources in developed countries have generally already been excavated. “The new sites with the greatest potential tend to be in less accessible locations in developing countries. They may not have good access to power and transport.” Another challenge is trying to keep mines at full capacity. This year, for example, coal mines in Australia were hit by flooding, there was a power crisis in South Africa and a water shortage in Chile, says Mr Hambro. Another constraint is the need for producers to gain government licences to extract commodities, which has become harder in some countries because of environmental concerns. Ms Schoeman says the degree to which supply is increasing varies between commodities. She says there have been new supplies of copper but there have also been disruptions, such as in Zambia and Chile. “The earthquake in China disrupted power that took 300,000 tonnes of aluminium off the market. The supply of corn has been reduced because farmers are devoting land to wheat and soya.” Identifying returns Not everyone is as optimistic as these fund managers, however. Some economists place a greater emphasis on speculative pressures in driving up the price of oil and other commodities. Economists point out that supply worries and speculative pressures can quickly go into reverse. Nevertheless, commodity fund managers have identified areas where they believe investors can enjoy attractive returns. Mr Hambro says even when commodity prices are not rising, companies can still enjoy significant profits. He points to nickel as an example. Over the past year and a half, the price of nickel has halved to around $10 or $11. Even at this price, says Mr Hambro, mining companies are making large profits compared to when it was priced $3 to $4. Mr Blake says any commodities needed by China, such as iron ore and copper, offer a potentially attractive investment. He adds that platinum also looks attractive, partly because of its use in diesel car engines. He is bullish about soft commodities as well. Mr Blake says the fundamental factors comprise the three Fs. “These are food, feed and fuel. The United Nations estimates that the world population will reach 7.5bn in 2020. That is eight new mouths to feed every few seconds. “The feed represents the increased demand for meat as populations become wealthier. One gram of beef requires eight grams of feed. The fuel is the spread in biofuels as governments try to become less reliant on oil imports and for environmental issues. Fertiliser producers, seed companies and equipment manufacturers can be attractive investments as farms try to increase activities.” Ian Henderson, manager of the JPM Global Natural Resources fund, says there are opportunities from unheralded earnings. “This is earnings growth not fully appreciated by the market. The price rises in commodities have been so quick that analysts have lagged in terms of raising the earnings expectations for resource and commodity stocks.” Mr Henderson adds that energy price rises are not reflected in share prices in the energy sector. In pricing these stocks, the market is discounting the oil price at closer to $75 a barrel than $130. “Given the energy shortage, companies producing coal and uranium should do well,” says Mr Henderson. “There are companies on less than eight times earnings, for example, which is not particularly challenging. There are companies with price to cash flow well below five times. It is the area with my most overweight exposure.” There are two main ways in which commodity funds manage money. This is by investing in listed commodity stocks or commodity futures. Mr Blake invests in listed companies in managing the Barings Global Resources fund, which has strongly out-performed the Dow Jones-AIG Commodity and GSCI Commodity indices over three and five years. Mr Blake decides which sub-sectors offer the most attractive investment opportunities. “Then we decide which stocks we like in these sub-sectors. We also identify stocks that do not fall within these sub-sectors or themes, such as turnaround situations. This produces a portfolio of between 30 and 45 stocks.” Commodity futures Ms Schoeman says the Fortis L Commodity World fund invests in commodity futures. It has a two-part investment process. “Around 60 per cent of the risk budget is used for a quantitative systematic approach in deciding which commodities to invest in, including price momentum. The other 40 per cent is devoted to an active strategy. Through this approach we decide which sub-sectors we will be over and underweight in. We take top down and bottom up views. The top down involves macro economic analysis such as inflation and demand.” One risk is that the futures price can move against the spot price. If the futures price is lower than the spot price, this can be beneficial because when the three-month contract expires or matures it rolls into the spot price, which is higher. But if the futures price is higher than the spot price, it will roll over into the lower spot price. With equities, there is management risk and the fact profitability may not rise in line with the commodity price. This is because the price of commodities is not the only determinant of company profits and share price movements. Mr Henderson says these other factors include disruptions to supply, costs like wage rises and movements in currencies. “When the gold price went from $250 to $400, the South African rand was strong so it was difficult for South African mining companies to fully enjoy the benefits of the price rise.” The advantage of equities is that a company like BHP Billiton is diversified across commodities, including coal, for which there are not futures contracts. “The advantage of investing in commodity stocks rather than futures is that they can make significant returns when prices stabilise, pay dividends, make acquisitions, increase capacity of existing mines and open new mines,” says Mr Hambro. The Fortis L Commodity fund under-performed the index over one year to 12 May 2008 by returning 38.36 per cent against 44.88 per cent by the GSCI Commodity index. Ms Schoeman says: “We actively manage the collateral (cash). We had some problems in AA securities in the portfolio when the sub-prime sell off happened in 2007, causing liquidation from money market funds, not due to the quality of securities but because market contagion dragged down everything.” Mr Henderson says, as a neutral position, the JPM Global Natural Resources fund allocates 30 per cent to each of metals, energy and mining. The allocation can range between 20 and 50 per cent. Ten per cent of the fund is invested in others. “We then look at how our company selection fits in with our overall asset allocation views. We look for diversification to reduce the risk of the portfolio. “Around half our fund is invested in small cap stocks, which we define as having a capitalisation of below $2bn. We feel we can add particular value through investing in small cap stocks. When there is risk appetite in the market, these stocks can be rewarding. You do have to take a long-term view with smaller companies. Share price movements can be volatile. Projects can be in gestation for several years. If you are a forced seller then you can lose money in small caps,” he adds. Over one year to 12 May 2008, the JPM Global Natural Resources fund returned 4.41 per cent, which means it under-performed the Dow Jones-AIG Commodity and GSCI Commodity indices. The fund, however, strongly out-performed the indices over three years. The performance of the fund over the past year has been impacted by the “move away from smaller companies as risk appetite has been reduced since the onset of the credit crunch”, says Mr Henderson.