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    Commodities Positioned for More Strength in 2017

    Shawn Reynolds ,Portfolio Manager
    February 10, 2017

    The Stage is Set for a Multi-Year Improvement

    TOM BUTCHER: Where do you see commodities going in 2017?

    SHAWN REYNOLDS: It is important to put commodities markets in context. We need to remember that we are still in the early stages of rebounding from one of the most severe downturns in history. Whether you look at gold, metals and mining, or the energy sector, we have seen a very severe downturn — as bad as anybody still in the industry has ever seen. Gold and mining have been suffering since early 2011, and energy since 2015. You put the negative performance of these sectors together and it makes for a very rough and deep downturn.

    Huge Restructurings at the Industry and Company Levels

    We started to come out of the downturn in 2016, but we have yet to see the benefits — which were huge restructurings at both the industry and company levels — in terms of operating or financial results. The rebound in 2016 was really just on the back of the upswing in commodity prices.

    As we start 2017, we see strong efficiency on the operating side which should generate robust financial results. For the first time in many years, we are likely to see positive momentum in earnings and cash flow, and improving balance sheets. This is setting the stage for a multi-year improvement in the operational and financial performance of commodities industries.

    Commodities Companies Benefit in an Inflationary Environment

    BUTCHER: Since the financial crisis, the narrative has focused on deflation. Do you think that has changed?

    REYNOLDS: It has changed remarkably. Even as late as last year's third quarter, the narrative was still about deflation. And then, as the likelihood of the Fed raising rates in December became more of a reality, driven by high employment and rising wages, we saw an inkling of inflation picking up in some of the emerging markets. Maybe deflation was no longer the biggest risk, maybe inflation was less of a risk than people feared. The point is that the picture was becoming more balanced.

    Soon after the U.S. presidential election, the outlook changed dramatically, because if the Trump administration's pro-growth policies result in the types of outcomes that people are hoping for, we may very well see an inflationary period. While it is a risk, to be sure, we don't see it as a major risk. The conversation has flipped to something that investors are starting to contemplate, and certainly the companies that we invest in benefit in an inflationary environment.

    Admirable OPEC Compliance with Oil Production Cuts

    BUTCHER: Moving to oil, to the surprise of many, both OPEC and non-OPEC producers cut deals to reduce production in December. How do you see the supply situation shaping up?

    REYNOLDS: The best way to assess the OPEC agreements is that there has been admirable compliance, which says much about OPEC, because compliance in the past has been defined by those who cheated the least. While it is still the early days, we find it very encouraging to hear the Saudi Arabian oil minister say that he thinks that compliance is quite strong and that his country is cutting production more than required. The supply side from OPEC right now, and certainly in the near future, should be supportive for the supply-demand dynamic.

    Non-OPEC Players are Important

    Longer term, we must continue to look at some of the non-OPEC players — countries like China or even the major oil-producing companies — as we expect them to continue to have a hard time and to struggle with delivering production growth. For example, if you think about China, which few people talk about in terms of production even though it is probably the world's fifth largest producer, its production last year fell by 300,000 to 400,000 barrels a day, and is projected to fall even farther in 2017, by 400,000 to 500,000 barrels a day. This is significant in the context of a 1.2 million barrels a day cut by OPEC.

    Chart A. shows how OPEC oil production is likely to decline in the next year-and-half, and by contrast North America is likely to provide the most oil production growth.

    Chart A: World Crude Oil and Liquid Fuels Production Growth  

    Chart A: World Crude Oil and Liquid Fuels Production Growth

    Source: EIA; January 2017. Not intended to be a forecast of future events, a guarantee of future results or investment advice. Current market conditions may not continue.

    Chart B. shows that the Non-OPEC U.S., Russia, and Canada are likely to be the biggest contributors to oil production growth, while China is experiencing the biggest decline in oil production.

    Chart B: Non-OPEC Crude Oil and Liquid Fuels Production Growth  

    Chart B: Non-OPEC Crude Oil and Liquid Fuels Production Growth

    Source: EIA; January 2017. Not intended to be a forecast of future events, a guarantee of future results or investment advice. Current market conditions may not continue.

    U.S. Shale Production Increasingly Efficient

    REYNOLDS: Many people are asking about the U.S., where shale production has become increasingly efficient. Is U.S. production going to get back to growth mode? With the rig count rebounding the way it has, we would not be surprised to see some uplift off of the low point after production fell dramatically in 2014 and 2015. Could it be 200,000 or 300,000 barrels a day? Maybe.

    But when you start netting all of that out, supply is still coming down on a global basis. This bodes well for stronger, firmer commodities prices that, in conjunction with the operating and restructuring that companies have done, are making the outlook for the commodities sector quite favorable.

    Demand Remains Remarkably Resilient

    BUTCHER: On the opposite side of the coin, will oil demand hold up?

    REYNOLDS: Yes. Our position for many years has consistently been that oil demand is remarkably resilient unless you have gigantic risk or reality of global recession, which we do not expect in 2017. We also see pro-growth policies, fiscal stimulus in the U.S., and support for growth in China as positive drivers. We expect global growth in demand to continue at a fairly robust rate.