PRODUCTION COSTS AND THEIR EFFECT ON COMMODITY VALUATIONS By: Bob Hyman and Bob Greer of CoreCommodity Management, LLC If something cannot go on forever, it will stop. --Herbert Stein Although he was speaking about balance of payments deficits when he was the Chairman of the Council of Economic Advisors, Herb Stein s words are quite relevant with respect to today s commodity markets. In this context, Stein might have said that if producers cannot sell products above their cost of production then they will not produce those products forever. That is what has been happening, to a greater or lesser extent, in many commodity markets. 150 Chart 1: Bloomberg Commodity Total Return Index 125 100 75 50 June-10 June-11 June-12 June-13 June-14 June-15 June-16 Data Range: June 30, 2010 June 30, 2016 Data Source: Bloomberg LP The return of the Bloomberg Commodity Index (BCOM) has been sharply negative over the last few years. (Chart 1) Given the severity of the price decline, many analysts have attempted to assess the fundamental valuation of commodities at these depressed levels to identify potential levels of support for prices. One possible methodology for this approach is to consider the relationship between commodity prices and their cost of production. 1 P a g e CoreCommodity Management, LLC 680 Washington Boulevard Stamford, CT 06901 Tel: 203.708.6500 www.corecommodityllc.com
Chart 2: Bloomberg Commodity Total Return Index 550 500 450 400 350 300 250 200 150 100 50 2002 2004 2006 2008 2010 2012 2014 2016 Bloomberg Commodity Spot Index Cost of Production of Bloomberg Commodity Spot Basket Cost of Production Data Range: December 31, 2001 December 31, 2015; Bloomberg Commodity Spot Index Range: December 31, 2001 June 30, 2016 Data Source: CoreCommodity Management LLC; BCOM Cost of production is estimated based on publicly available information, data from market research providers, proprietary models and government data and is as of each year end. Compiled by CoreCommodity Management LLC. CoreCommodity analysts estimated the cost of production of various commodities over an approximately 15 year period. Chart 2 shows the weighted average price of the commodities in the Bloomberg Commodity Index, and, additionally, shows the weighted average cost of production of those commodities. Over the last 15 years, there have been only three instances when commodity prices fell below their cost of production (as estimated above). In two previous instances, rapid and sustained price increases ensued as fundamental economics prevailed. We may be at another such turning point in the commodity pricing cycle. The Data Estimating the cost of production for various commodities is an imprecise exercise. Some of the issues include whether to analyze global costs or costs in a specific location and whether data pertains to mean or marginal production costs. Core- Commodity analyzed and compiled data from many sources, including the United States Department of Agriculture, market research providers, CoreCommodity Management s proprietary models and, for some markets, the public filings of commodity producing companies. Core- Commodity s historical analysis utilizes a consistent methodology to examine the long-term relationship of prices and production costs. 2 P a g e
For finite periods of time, companies may continue to produce commodities below their production costs. In cases where large up front capital expenditures have already been incurred, ongoing operating costs (so called cash costs ) may be significantly below full cycle production costs. In addition, if they have cash or borrowing reserves, some companies may actually continue to produce commodities below cash costs in order to generate cash flow necessary for debt service or to maintain ongoing operations in the hope that prices/profits will eventually recover. These so-called ghost companies are in effect swapping in-the-ground assets for cash at a net loss in order to survive. Crude Oil: A Case Study Recent developments in the crude oil market provide an example of the relationship between production costs and commodity valuations. When OPEC, led by Saudi Arabia, announced in November 2014 that OPEC would not curtail production, oil prices accelerated downward. Most observers expected that lower prices would reduce capital expenditures, curtail new production, and that the natural depletion of existing wells would reduce worldwide production. At the same time, lower energy prices were widely expected to increase demand. Despite a generally sluggish global economy, demand did indeed increase as global consumption, estimated by the International Energy Agency, increased by 1.6 million barrels / day, or 1.4% in Q1 2016, year over year. i In the U.S. for instance, not only have vehicle-miles driven increased to 17 trillion miles for the last 12 months ending April 2016 (an increase of 3.25% year-on-year), ii but for the first time since 2007 the annual average U.S. fuel economy decreased. iii Low gasoline prices contributed to increased SUV sales. From January through July 1, 2016, 3.2 million SUV/Cross-over units were sold in the U.S., which is an increase of 7.9% versus the same period in 2015. iv With respect to supply, although oil prices began accelerating downward in the fall of 2014, production continued to increase until June 2015. There are a number of factors that contributed to the increase in production while prices were collapsing. First, the cost of production of energy (and most other commodities) becomes lower as energy costs decrease, as energy is an important input into its own production. Additionally, there were a number of previously funded and approved wells prior to prices moving downward so, despite lower prices, companies continued to produce at little or no profit. Producers maintained fewer wells, but focused on their most productive assets. Finally, as described above, a number of companies continued to produce oil at prices lower than their cost of production in order to continue to service their debt until prices recovered. It is interesting to note that the rig count peaked in October 2014 while production continued to increase for another eight months before finally beginning to decrease in June 2015. v There are other factors which contributed to the decrease in global oil supply. According to Wood Mackenzie, an industry consultant, lower oil prices have forced global oil and natural gas companies to delay or cut over $1 trillion in exploration projects through 2020. vi At oil prices below $50, Wood Mackenzie estimates that as much as $1.5 trillion of prospective investment destined for projects is uneconomical. vii Additionally, the cost to fi- 3 P a g e
Million Barrels Per Day nance new operations increased dramatically over the last 18 months. Credit spreads, or the difference in yields between high yield energy bonds and U.S. Treasury notes, traded in excess of 1800 basis points as lenders modeled much higher rates of default. viii Massive losses estimated at more than $15 billion for 2015 ix forced global producers to lay-off more than 350,000 workers. x The effect of these factors can be seen in U.S. shale production, which has come to be regarded as a key global short-term swing producer. According to Department of Energy reports, since peaking in June 2015, total U.S. production has declined by over 1.1 million barrels / day, as of June 30, 2016. xi Through June 30, 2016, the number of rotary rigs drilling for oil dropped by over 80% from the high of 1,609 in 2014 to 341. xii As a result of lower prices, over 80 energy exploration and production companies with over $50 billion in aggregate debt have filed for bankruptcy since the beginning of 2015. xiii While a bankruptcy will not necessarily halt production, an insolvency proceeding impairs the ability of a company to obtain capital to maintain production. These stop-gap responses are dwindling, so much so that the EIA recently estimated that in Q4 2016, U.S. production would average 8.5 million barrels / day. xiv Lower prices are indeed leading to lower production, and non-u.s. production is currently not making up the difference. Note, for the last 10 years oil production outside United States, Canada and Mexico has risen by only 5.6%, while consumption has risen by 19.7% xv (Chart3). Chart 3: Global Oil Production and Consumption, Ex-North America 75 70 65 60 55 50 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Data Range: 2005-2015 Data Source: British Petroleum Statistical Review Global Oil Consumption ex-north America Global Oil Production ex-north America 4 P a g e
Price as a Percent of 10-Year Range Implications and Conclusions 100% Chart 4: Where Asset Prices are within their 10-year Range 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Date range: June 30, 2006 to June 30, 2016. Calculation: [(Price June 30, 2016 10 year price low) / (10 year price high 10 year price low)] Data Source: Bloomberg LP. Stocks are represented by the S&P 500 Total Return Index. Bonds are represented by the Barclays U.S. Aggregate Corporate Government Bond Total Return Unhedged Index. REITS are represented by the Dow Jones Equity REIT Total Return Index. Commodities prices used are respective front-month futures contract prices. Current prices are as of June 30, 2016. While Chart 2 highlights the intrinsic valuation metric of price to production cost, Chart 4 shows the current price of various commodities, equities and fixed income compared to their long-term ranges. While traditional financial assets remain at or near all-time high levels supported by coordinated government policy, on a relative basis commodities may represent attractive long-term value. Several years ago, when the sustainability of high commodity prices was questioned, the response came that, The cure for high prices is high prices, which implied that those high prices would incent additional production while dampening demand. Now, it may be that the cure to low prices is low prices. Fundamental economics, as succinctly stated by Herbert Stein, still apply: If something cannot go on forever, it will stop. Bob Hyman*, Portfolio Manager, CoreCommodity Management, LLC Bob Greer, Senior Advisor, at CoreCommodity Management, LLC Scholar in Residence at the JPMorgan Center for Commodities at the Denver School of Business of the University of Colorado, Copyright CoreCommodity Management, LLC 2016 5 P a g e
i International Energy Agency, Oil Market Report for July 13, 2016 ii U.S. Federal Highway Administration, Moving 12-Month Total Vehicle Miles Traveled, retrieved from FRED, Federal Reserve Bank of St. Louis; June 29, 2016. iii Data from the Transportation Research Institute at the University of Michigan, July 5, 2016 iv Wall Street Journal, Auto Sales Data as of July 1, 2016 v United States DOE Crude Oil Total Production Data, July 1, 2016 vi Wood Mackenzie, Global upstream spend slashed by US$1 trillion since the oil price drop, June 15, 2016 vii Wood Mackenzie, Upstream cost cuts must go deeper to save projects, September 21, 2015 viii Bloomberg USD High Yield Corporate Bond Index Energy, Jul 1, 2016 ix Bloomberg LP, Hess Leads Oil Explorers Showing $15 Billion in 2015 Losses January 26, 2016 x Oilprice.com Global Oil And Gas Job Losses: 350,000 And Counting, May 12, 2016 xi U.S. Energy Information Administration (EIA), Weekly U.S. Field Production of Crude Oil, July 2016 xii Baker Hughes, North America Rotary Rig Count, Jul 1, 2016 xiiihaynes and Boone, LLP, Oil Patch Bankruptcy Monitor June 30, 2016 xiv U.S. Energy Information Administration (EIA), Short-Term Energy Outlook (STEO), July 2016 xv BP Statistical Review of World Energy, June 2015 All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. The economic statistics presented herein are subject to revision by the agencies that issue them. Any indices and other financial benchmarks shown are provided for illustrative purposes only, are unmanaged, reflect reinvestment of income and do not reflect the impact of advisory fees. Investors cannot invest directly in an index. All investments are subject to risk. 6 P a g e
*Bob Hyman is a Registered Representative of ALPS Distributors, Inc. Bloomberg Commodity Total Return Index: composed of futures contracts and reflects the returns on a fully collateralized investment in the Bloomberg Commodity Index. Bloomberg Commodity Spot Index: the index measures the price movements of commodities included in the Bloomberg CI and select sub indexes. It does not account for the effects of rolling futures contracts or the costs associated with holding physical commodities and is quoted in USD. Bloomberg Commodity Index: an unmanaged index used as a measurement of change in commodity market conditions based on the performance of a basket of different commodities. An investor cannot invest directly in an index. One may not invest directly in an index. Investors should consider investment objectives, risks, charges and expenses carefully before investing, including Additional Risks as described in the prospectus. To obtain a prospectus, which contains this and other information, call 1.866.759.5679 or visit www.alpsfunds.com. Read the prospectus carefully before investing. The commodities markets and the prices of various commodities may fluctuate widely based on a variety of factors. Because the Fund s performance is linked to the performance of highly volatile commodities, investors should consider purchasing shares of the Fund only as part of an overall diversified portfolio and should be willing to assume the risks of potentially significant fluctuations in the value of the Fund. The Fund invests in commodity futures related investments, which are derivative instruments that allow access to a diversified portfolio of commodities without committing substantial amounts of capital. Additional risks of Commodity Futures Related Investments include liquidity risk and counterparty credit risk. Counterparty Risk is the risk that a party to a transaction will fail to fulfill its obligations. The term is often applied specifically to swap agreements in which no clearinghouse guarantees the performance of the contract. Liquidity Risk is the risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. Another principal risk of investing in the Fund is equity risk, which is the risk that the value of the securities held by the Fund will fall due to general market and economic conditions, perceptions regarding the industries in which the issuers of securities held by the Fund participate or factors relating to specific companies in which the Fund invests. The Fund s investments in non-u.s. issuers may be even more volatile and may present more risks than investments in U.S. issuers. Equity investments in commodity-related companies may not move in the same direction and to the same extent as the underlying commodities. 7 P a g e
ALPS Portfolio Solutions Distributor, Inc. is the distributor for the ALPS CoreCommodity Management CompleteCommodities Strategy Fund. ALPS Advisors, Inc. is the investment advisor to the Fund and CoreCommodity Management, LLC, is the investment sub-advisor. ALPS is not affiliated with CoreCommodity Management, LLC. CoreCommodity Management, LLC, serves as investment advisor to the Fund s Cayman Islands subsidiary. CompleteCommodities is a service mark of CoreCommodity Management, LLC. ALPS Distributors, Inc. is affiliated with ALPS Portfolio Solutions Distributors, Inc. JCI000394 12/31/2016 8 P a g e