TAKE YOUR PICK
The choice in commodities
The well-worn adage “all good things must come to an end” is especially true for commodities price cycles, and for a while now investors have been on a thrill-ride onward and upwards as prices kept rising.
But two key questions emerge. For those on the outskirts, the question is whether it’s too late to get in on the action. For people already invested in resources, the question is how to know when the party is well and truly over.
Your money would almost have doubled if you had invested in the JSE’s resources index in the six months from early December 2015 to early June in 2016, when the oil price languished below $50 a barrel and other commodities experienced marked lows.
That’s significantly more than the 17% return you would have realised if you had chosen instead to put the cash in the JSE all share at that time.
The general mining index has had a similarly spectacular performance, and for the first time in a decade has outperformed the Alsi.
Domestically, bulk commodity prices like iron ore and coal have driven performance in the mining sector in spite of continued hardship for SA’s precious metal sectors.
Normally a resource cycle is relatively simple, says Wayne McCurrie of FNB Wealth & Investments. The economy goes into a recession, resource prices drop, the economy falters and stock markets and interest rates fall. Not long after the decrease in the interest rate demand picks up and commodity prices follow.
The previous cycle — the so-called supercycle that ended in 2008 — was different, however, because commodity companies spent enormous amounts to increase production in expectation of ever increasing demand.
Commodities companies are strange beasts. They can afford to expand only at the top of the cycle — that’s the only time shareholders allow them to do it
About $60bn of capex was spent in each year of this supercycle, McCurrie says.
“Normally commodity prices collapse because of demand [dropping off].
“This time demand was still there, though it wasn’t fantastic. The problem was that there was too much in supply,” McCurrie says.
As a result, mines had to cut back drastically on both supply and capex to stay afloat.
That was true for all the major commodities: coal, copper and iron ore, and even oil, though the latter has different driving factors because production is largely controlled by the Opec cartel.
Today there’s a fairly good balance between demand and supply, and prices have recovered to the point where mining companies are extremely profitable. “Many almost went bankrupt in 2008, but [they] are now the leanest and meanest they have been in more than 50 years,” McCurrie says.
Commodities prices are nowhere near the highs seen during the supercycle, yet these companies are virtually printing cash. “Because they’ve cut on capex, the money is flowing into their bank accounts and paid out through dividends,” says McCurrie, who has a good earnings outlook for these companies.
But there are a few signs to look out for that would indicate it could be time to sell, he says.
One is rising global interest rates. “That’s the first warning sign that future economic conditions will not be as good as they are at the time.”
Certainly, that is happening now. The US Federal Reserve has pursued a rate-hiking cycle for the past two years. It recently increased rates for the third time this year, and
Mines had to cut back drastically on both supply and capex to stay afloat. That was true for all the major commodities
warned of another before the year is out. “I don’t think this will end in disaster, but you never know,” McCurrie says.
The second warning sign is when mining companies start ramping up capital expenditure. But this is not as yet a pervasive trend.
According to PWC’s “Mine 2018” report, released in July, the level of capital expenditure among the top 40 mining companies has remained at its lowest over the past 10 years, and the firms continue to practise capital discipline. In a normal cycle, the companies would eventually give in to temptation and pursue new projects and acquisitions.
“Commodities companies are strange beasts,” says McCurrie. “They can afford to expand only at the top of the cycle — that’s the only time shareholders allow them to do it. In terms of cash flows, they are countercyclical.”
The final warning sign is incredibly high commodity prices. In McCurrie’s view the absolute level of these prices is not at its highest just yet. “We are probably 80% of the way through the cycle,” he says.
Oil, for example, had recovered to $80 a barrel at the time of writing, but it’s nowhere near the $110 realised in mid-
2015. Iron ore is $70/t — much better than $40 in late 2015 — but far from the $160 that was reached in mid-2013.
“So we’ve got one and a half [warning] signs out of three. I don’t think we are there yet. But investors should start being cautious.”
Stephen Meintjes, head of research at Momentum Securities, says it could be that the cycle has peaked. Prices have, in fact, held up longer than many expected. “A lot of people thought we would have been in a phase of falling commodity prices now,” he says.
There are a few reasons why they haven’t, he says. For one, China has gone on a huge antipollution drive and so is seeking out higher grades of coal and iron ore.
The resources stocks are not wildly overvalued, though they have reacted to the rise in prices, Meintjes says.
Though broadly the same factors drive various commodity price cycles, it’s important to note that no commodity price cycle is the same, says Arnold van Graan, mining analyst at Nedbank Corporate & Investment Banking. In the supercycle it was driven by the China growth story, he says. “The world was running out of metal. But then it fell in a heap on the back of the global financial crisis.”
This time around there’s a move towards new technologies and artificial intelligence to be considered. There are also a potential slowdown in China, the threat of trade wars and other geopolitical risk — “all of these are factors that didn’t exist in the previous cycle”, Van Graan notes.
Meintjes says producers of platinum group metals are quietly optimistic about the outlook for metal prices.
However, precious metals such as platinum and gold are driven by different factors.
Platinum is considered a “late cycle” commodity — its price rise lags behind that of key commodities such as iron ore, coal and copper.
Certainly, platinum is yet to experience a lift.
In fact, in August it hit lows that were last seen a decade ago, when the price slid below $800/oz — well below its historical mean of about $925/oz.
For gold, Van Graan says the investment advice is simple — “You really want to buy these stocks when no-one else wants to touch them,” he says.
“Historically one has not been able to persuade investors to look at these stocks, despite companies being in good shape. But once they start to run, everyone is asking about it. It’s almost a cliché.” SA’s gold stocks, in particular, is ever a long-term investment, and Van Graan warns: “There’s a big question mark over their longterm viability as assets.”
McCurrie says commodities are not long-term investments. “They are all highly cyclical and incredibly volatile.
“If you were a true longterm investor — and I’m yet to meet one — you would not own a commodity share; it’s too risky.”
Producers of platinum group metals are quietly optimistic about the outlook for metal prices. But metals such as platinum and gold are driven by different factors