FUNDS ON FRIDAY b y G l a c i e r R e s e a r c h 24 J u n e 2 0 1 6 V o l u m e 8 6 7 Commodities Observing the fundamentals Written by: Dwayne Dippenaar, Research Analyst at Laurium Capital The South African market s performance year-to-date has been predominantly driven by the commodity sector. Through the end of May, the All-Share Index is up 7.5%, while resources are up 23.5% and other sectors are relatively flat. After multiple years of sombre performance from the mining index (2015: -36%; 2014: -18%) the momentum and quantum of the rebound in commodity stocks year-to-date, albeit small in the larger context versus history, has taken many market participants by surprise. Mining Index (Rebased to 100) 250 200 150 Current commodity rebound 100 50 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11 Dec-13 Dec-15 To form a constructive view on what is currently going on in the resource sector it is important to first understand the drivers of the commodity bull market from 2000 to 2007. It was during this period that world demand for commodities skyrocketed. The reason? China. Page 1
During this time the pace of the Chinese economy s industrialization accelerated, with fixed asset investment increasing from below 9% of GDP in 2000, to over 40% of GDP by 2010. To put the scale of the development into perspective, in 2000 China produced 125 million tons of steel, which had increased to 810 million tons by 2015, accounting for 50% of the world s supply. China currently consumes about a quarter of the total global output of gold, and for other precious metals such as nickel, copper, zinc and tin it s around half of the world s consumption. For aluminium, it s greater than 50%. The table below highlights the huge increase of raw material imports into China over this period. China's imports of selected raw materials, 2000-2013 Millions of tons 2000 2004 2008 2013 Bauxite 0.4 0.9 26 72 Alumina 1.9 5.9 4.6 3.8 Copper concentrate 1.8 2.9 6.1 10.1 Refined Copper 0.7 1.2 1.5 3.2 Copper scrap 2.5 4 5.6 4.4 Iron ore 70 208 444 820 Nickel ore - - 12 71 Thermal coal - - - 196 Coking coal - - 3 76 Source: Investec China s investment led growth has resulted in its economy being a key driver for global commodity prices, especially for bulk commodities and industrial metals, thereby accounting for a large share of the world trade in multiple commodities. Page 2
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 USD Billions This high growth in demand for commodities led to soaring commodity prices, resulting in resource companies investing in new capacity to meet the demand out of China, as well as to take advantage of the high commodity prices. This unprecedented ramp up in capital expenditure, as seen below, resulted in large amounts of new supply coming into the market leading to a situation where multiple commodities are oversupplied. Global Mining Capex 900 800 700 600 500 400 300 200 100 0 Source: Investec Adding to the problem is that emerging market currencies have weakened, and global freight and energy rates have dropped. This has resulted in declining US dollar costs of mining commodities (multiple commodities mined in emerging markets), allowing many high cost producers to keep on mining despite the lower commodity prices. Supply cuts due to low commodity prices have thus not materialised to the extent expected, with commodity supply being stubbornly sticky. At the same time, China has begun to shift from an investment led economy to a consumption led economy, resulting in slower GDP growth as investment led growth tapers. For instance, Chinese consumption of steel per capita is now well above the United States, and we now see the boom in steel demand slowing. This trend is likely to continue resulting in lower demand from China going forward for commodities. Page 3
China & US s consumption of steel (kt) Source: Investec The combination of surplus supply across a range of commodities and slowing demand growth out of China, leads us to believe that the underlying fundamental drivers for commodity prices are still weak. Parallels can be drawn between the current oversupplied market and the peaking of Japanese growth in 1979, where a persistent oversupply of a large number of metals led to a 20-year bear market in commodities. This puts the current 5-year bear market into perspective and highlights the time it could take for the current market to rebalance. We are of the opinion that the current commodity price and subsequently stock rally is based on short term phenomena and thus not sustainable. A few of these short term phenomena include: Weakening of the US dollar due to the Federal Reserve funds rate increases being pushed out (results in higher spot commodity prices in USD, which we think will reverse as the Federal Reserve hikes interest rates) Short term restocking in China of select commodities in the first quarter of 2016 (e.g. iron ore stocks have again hit all-time highs and restocking has slowed) Huge increase in the speculative trade of Chinese commodity futures contracts as Chinese retail investors speculate on rising commodity prices (Chinese government has stepped in to curb speculation) Short covering at various stages during the quarter, given the large net short position in the sector at the start of 2016 This being said there is growing evidence that multiple commodities have reached close to a price bottom, and are searching for a return to a lower new normal level. To see a sustainable recovery in commodity prices to this level, two things need to happen: 1) a stabilisation of demand from China and 2) discipline from the supply side of the market. Page 4
Upside/Downside to Consensus using Spot Mining Index To date there have been supply cuts announced, but not material enough to make a difference to a largely oversupplied market. When meaningful cuts occur we will become more constructive on the commodity complex. Of course the current tough environment could already be priced into the underlying resource stock prices. As per Renaissance Capital forecasts, if you use spot commodity prices in calculating the mining sectors earnings for the next 12 months, you currently get earnings that are in line with Bloomberg consensus. This, in conjunction with the fact that the mining index is currently trading at a 22.3x price/earnings multiple, which implies that post the rally we saw in the first quarter of the year, the sector currently offers limited value without a sustainable increase in commodity prices occurring. Mining index (RHS) to average downside to consensus earnings if spot commodity prices prevail (LHS) 12 000 10 0% 11 000 50 % 10 000 9 0 00 0% 8 0 00-50% 7 0 00 6 0 00-100% 5 0 00 4 0 00-150% Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 3 0 00 We continue to closely monitor supply that exits the market, along with other fundamental drivers that could result in sustainable increases in the price of commodities. This disciplined approach could allow asset managers to take advantage of any fundamental change in the market to create value for their clients in the future. Page 5
Glacier Research would like to thank Dwayne Dippenaar for his contribution to this week s Funds on Friday. Dwayne Dippenaar, CA (SA), CFA Dwayne joined Laurium in May 2015. He has eight years of asset management, corporate finance and auditing experience. Prior to joining Laurium, Dwayne worked at Electus, Berman Capital and PricewaterhouseCoopers. Page 6