Cash & Investment Management

Sector in Focus – Global Resources Q2 2017

Monday 19th June 2017

With the recent launch of our own resource-focused fund, Capital Investment PCC – Class D – Global Diversified Fund, now seems a pertinent time to evaluate the sector. Global resources is a rather broad market that may be more easily digested when broken down into its three main components; Energy, Metals & Mining, and Agriculture.

Energy is made up largely of integrated Oil & Gas companies and is more homogeneous in that sense. It includes thermal coal too but the extraction tends to fall under the scope of mining companies. As such, the key driver of success of the energy sector is the price of oil and gas and, over the last decade, the oil price has seen the more significant fluctuations. The crude oil price tumbled along other global asset prices in the wake of the credit crunch but subsequently rebounded to pre-crisis levels of $100 per barrel in 2011, owing to the rising demand in emerging economies, most notably China.

However, the following years saw an increase in production from US shale. Substantial technological advances in the extraction technique, commonly known as fracking, opened up potential oil reserves across the US. Global reserves of shale are expected to be at least three times larger than those of conventional crude with nearly 70% to be found in the US. This extension in global supply would surely have an impact on the oil price but the cost of its extraction was anticipated to be much higher. From 2008 to 2016, US crude oil production doubled.

There were also increased concerns over the state of the Chinese economy and their bulging debt burden. In the latter part of 2014, with the oil prices beginning to slide, Saudi Arabia blocked calls from OPEC members to cut production to protect the oil price. The Saudis may had anticipated that the expensive emerging US shale industry would be the first to falter.  Over the next 6 months, the US shale oil rig count would halve but production levels were unmoved. Some of the more cost efficient producers would survive and the glut would spur further cost efficiencies in the industry. By January 2016, the oil price had slumped below $30.

OPEC have since agreed cut production to return some stability to the market, expanding their excess capacity in order to offer a buffer of control that they may assume over the oil price. Shale producers will be wary of risking capital outlay when OPEC may increase production to drive the price back down. This has brought some confidence back to the market, but the future of oil production could be littered with shocks as the battle for market share continue, and this and this supply side expansion suggests a suppression of the oil price in the near term.

Metals and mining is a diverse sector but consists primarily of the extraction, refining, and marketing of industrial metals such as aluminium, copper, lead, nickel, steel, tin, and zinc, and precious metals such as Gold, Silver, Platinum and Palladium. Precious metals are a rather speculative asset favoured for being a store of value, especially as a hedge to inflation, but also supported in when geopolitical shocks present themselves. Industrial metals tend to be most volatile in response to supply side shocks, but also perform well in times of economic expansion.

The post crisis economic world has been one of loose monetary policy, which has served to stimulate financial asset prices but surprisingly done little to support commodity prices and lay the foundation for some much-desired inflation. By the end of 2015, commodities had spent five years as the worst performing asset class. After a few years of central bank policy pushing many interest rates into negative territory, we have seen the US begin to raise rates and are now seeing the focus begin to shift from monetary policy toward fiscal stimulus, particularly following the election of Donald Trump. His promise of significant infrastructure spending has helped buoy industrial metal prices. We are, however, yet to see these policies affirmed. China also has its massive Belt and Road initiative, which is expected to inject $6 trillion of infrastructure spending into 60 countries, but the rate at which it is implemented has yet to become clear. Beyond the direct impact on industrial metal demand, the fiscal transition could provide a better policy mix to support growth and corporate earnings, which in turn could stoke some inflation, but there is still some policy divergence across developing economies.

Agriculture

The recent UN biannual report on global food markets continued to highlight adequate supplies with international grain prices remaining subdued as a result. The report also suggested that the cost of agriculture imports globally would total $1.7tn this year, driven by increasing trade volumes and relatively low transportation costs (due to an oversupply of freight vessels).

BHP Billiton

The company is currently attempting to convince shareholders that a divestiture plan proposed by an activist investor is not in their best interests. Elliot Management wants the company to split out its US oil business amongst other measures designed to unlock shareholder value. Investors are increasingly questioning the merits of a diversified asset base with resources used to prop up underperforming segments at the expense of higher margin operations. The company has underperformed its major rivals in the last few years; however, it now has a more robust balance sheet and generates significant cash flows.

Royal Dutch Shell

After an adjustment phase aimed at positioning the company for a lower oil price environment, the most recent quarterly figures showed the benefits of this turnaround plan, with a profits up 142% for the same period in 2016. The company has successfully integrated its acquisition BG Group, boosting production whilst cutting back on capital expenditure and disposing of non-core assets. Positive free cash flow, if maintained, should protect the dividend and enable the company to pay down some of its debt going forward. The share price has been resilient in the face of a weak oil price.

Syngenta

ChemChina is in the final stages of its acquisition of Syngenta, with important regulatory hurdles cleared and around 95% of the shares tendered. Doubts about ChemChina’s ability to finance the deal have been allayed, with the company securing $20bn of financing though the sale of perpetual bonds and preference shares to various backers (mostly other Chinese state-owned enterprises).  The company is also looking to pick up forced divestitures from other companies in the sector that have merged/been taken over, including assets that Bayer must sell in order to get approval for its Monsanto takeover. According to the New York Times, the Chinese state is also considering a larger tie-up between ChemChina and rival Sinochem to create an agribusiness and chemicals behemoth.