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    Commodities Rebound Sparks Bull Market Buzz

    Shawn Reynolds ,Portfolio Manager
    January 25, 2017

    As we look at the prospects for commodities in 2017, and even further ahead, we believe it is extremely important to keep in mind that the depths of gloom plumbed in February 2016 marked the low point in probably one of the deepest and historically longest downturns for commodity markets. However, these markets improved considerably in 2016, and we expect their emergence and rebound not to be short lived. We consider that the three pillars of the next commodity bull market – technicals, macro, and fundamentals—are all now firmly anchored in place, and we explore why in this post.

    4Q'16 Hard Assets Equities Strategy Review

    For the calendar year 2016, VanEck's hard assets strategy had a very strong year, outperforming its benchmark by returning 43.17% compared to 30.87% for the Standard & Poor's North American Natural Resources Sector Index (SPGINRTR).1 In the fourth quarter specifically, the strategy slightly lagged the SPGINRTR by posting a 3.45% return compared to the Index's 5.02%.

    For the three month period,2 the strategy's positions in the Energy sector and the Diversified Metals & Mining sub-industry were the most significant contributors to positive performance. Within the Energy sector, positive performance stemmed mainly from the Oil & Gas Drilling sub-industry; at the same time, the Oil & Gas Equipment & Services made a notable contribution. Other positive results were gained from Copper, Fertilizers & Agricultural Chemicals, and Steel. Throughout the quarter, the strategy continued to hold no positions in Integrated Oil & Gas. The strategy's Gold positions were the largest detractors in the fourth quarter, continuing the reversal which began in the third quarter following strong performance in the first half of 2016.

    Demand for Commodities Resilient

    Throughout the fourth quarter, investor sentiment remained positive and the demand for commodities stayed remarkably resilient. As was the case in the third quarter, the most significant macroeconomic factor influencing the hard assets strategy's market universe was the extraordinary monetary accommodation extended by global central banks, which continued to add support for commodities.

    In addition, two significant fourth quarter events proved to be quite supportive for commodities. First, the expectation of infrastructure and fiscal spending that followed Donald Trump's victory in the U.S. presidential election helped highlight solid positive performance in the commodities space and raised the potential of further demand strength for many basic commodities. This was particularly reflected in the performance of the broader Industrial Metals Mining sector. Similarly, the steel sector posted strong results in the fourth quarter. Steel companies, in general, were aided by solid demand and U.S.-based companies were specifically helped by tariffs on imported Chinese steel.

    Oil Prices Rise on News of OPEC Output Cuts

    Second, after having been essentially defunct, OPEC was "resurrected" by Saudi Arabia when it announced at its November meeting that member countries had agreed to the first oil output cuts since 2008. Though Iran was allowed to boost its output slightly from October levels, both Iraq (and for the first time in 15 years) non-OPEC Russia, agreed to output cuts as well in support of propping up oil prices. OPEC's November announcement to slash output by 1.2 million barrels a day from January 1, 2017 was followed by an additional announcement in mid-December that OPEC and non-OPEC producers had reached their first deal since 2001 to curtail oil output jointly. On December 10, producers from outside the organization agreed to reduce output by some 558,000 barrels a day, with Russia accounting for the lion's share. The oil market reacted accordingly with prices rising and front-month West Texas Intermediate (WTI) crude oil ending 11% higher for the quarter at $53.72.

    U.S. Oil Rig Count Rebounds by 26% in 4Q

    The U.S. rig count continued to ease its way up from the trough levels reached in May. Over the quarter, 136 oil and gas rigs were added, an increase of nearly 26%. However, we continue to believe that any such rebound should be viewed as incremental when compared with the more than 1,500 rigs that were taken out of commission across the U.S. between late September 2014 and early May this year.

    On the demand side, global demand for crude oil and gasoline remained robust during the quarter. U.S. gasoline demand remains at record highs, and the country continues to consume around 10 million barrels a day. U.S. gasoline demand also continues to exceed the unrefined crude oil demand of every country in the world except China.

    Gold Consolidates, Pressured by Fed Rate Hike and Strong U.S. Dollar

    The gold market experienced further significant consolidation during the fourth quarter. Gold equity prices were pressured by the U.S. Federal Reserve's rate hike and a significantly stronger U.S. dollar. However, we still believe that gold miners, strengthened by strategic improvements and ongoing restructurings, continue to be well positioned to withstand the current decline in the gold price, which is likely to be short term as global financial risks still appear on the horizon.

    Base Metals Benefit from Rebalancing Supply and Demand

    Among base metals, zinc and copper continued to benefit from a rebalancing of supply and demand. Zinc, in particular, had a further reduction in overall output as miners closed and/or restricted activities. Zinc three-months forward on the London Metals Exchange (LME) peaked at US$2,900 at the end of November and ended the quarter up over 8%. In response to restricted supply, at the end of December the Zhuzhou Smelter Group Co. (the strategy had no exposure during the quarter), the largest refined zinc producer in China, announced that it planned to cut output in January. (We have addressed this in several blog posts in 2016, including Deleveraging Tightens Metals Supply and Zinc's Year to Remember.)

    Agriculture Valuations Strengthened

    Abundant supplies of agricultural goods, particularly grains and commodity fertilizers continued to keep a lid on most agricultural commodity prices, despite near record demand across the complex. Nevertheless, reflecting three years of current soft prices and a broadly depressed farm economy, there has been an unprecedented wave of prospective consolidation in the industry. Seed companies have sought to merge with crop protection companies to offer a full and more robust suite of products. Input providers have also looked to consolidate and rationalize mergers across companies involved with potash, phosphate, and nitrogen. As a result, Agriculture sector valuations strengthened during the quarter and bolstered share prices for many players.

    A Half-Full Glass Indicates a More Robust GDP Outlook

    As we have always said, our hard assets strategy does not necessarily need economic and market winds at its back to deliver performance; we just need gale-force winds in its face to dissipate. As 2016 unfolded, there were increasing signs that the global economy and equity markets had become accustomed to rolling economic and geopolitical risks and, at best, by yearend, had begun to anticipate and recognize the signs of a more robust global GDP outlook. While we believe the balance of risks at the beginning of 2016 paid homage to these past fears, as the year progressed, markets began underwriting a more positive tilt, seeing the glass as half-full rather than half-empty.

    Commodity Bull Market is Now Anchored in Place

    As we discussed above, we consider that the three pillars of the next commodity bull market – technicals, macro, and fundamentals – are all now firmly anchored in place. Here's why.

    Technicals: Commodities are naturally cyclical and self-correcting, with cycles that typically last years. We are emerging from one of the worst bear markets ever and believe that the cyclical and secular adjustments we are now seeing are setting the stage for the next multi-year upswing. In the past, periods of a 20% to 50% decline in natural resources equity values have often preceded the start of a new cycle. Cycles have lasted upwards of six years with, in some cases, equity values doubling within the first three years. Also, both energy and diversified mining exposures in the major indices currently remain below their long-term values.

    Macro: What remain unprecedented are the monetary and fiscal policies currently being employed by central banks in their attempts to spur global growth. Not only have these policies led to an even greater expansion of the assets held by major central banks around the globe, we believe they have also further tightened the coiled spring of inflation.

    Fundamentals: Global commodity demand remains remarkably resilient. Global oil consumption, for example, is at record levels and the expectation is that demand could increase by another 1.4 million barrels a day in 2017. India could be poised to be the next major source of consumption stimulating the next growth cycle.

    Deep Corporate Restructuring Should Continue to Improve Overall Performance

    The supply response to the massive, multi-year decrease in capital investment is already apparent and is expected to become ever more so with lasting production implications. However, the deep corporate restructuring that we have seen over the last couple of years will likely continue to improve both operating and financial performance.

    We think that it is important to reemphasize that when it comes to the deep corporate restructuring that has occurred and continues to be undertaken in response to weak commodity prices, companies have responded in an almost unprecedented fashion.

    Of particular note has been the unanimity of the response, even if some companies have been slower than others in their responses, and the breadth and depth of the collective response. It has involved not just staff reductions and cost cuts of the low-hanging fruit variety, but companies have, also, markedly used all the restructuring tools at their disposal, including a much more nuanced approach to high-grading personnel and capital spending, the pursuit of enhanced technological solutions to operating expenses, and a "no-sacred-cows" approach to asset rationalization. Critically, since debt levels had raised existential risks, companies unabashedly pursued an all-of-the-above approach to balance sheet repair, including the elimination of dividend distributions and share repurchase programs, as well as issuing equity and using other, novel, financial engineering. In our view, this could lead to much stronger operational and financial results as companies emerge from this historical downturn. We continue to believe that Glencore,3 one of the strategy's largest holdings, provides a prime example of such a response, and of its effectiveness.

    Our investment philosophy compels us to look for long-term growth and the structural enhancement in intrinsic value in the companies in which we invest. Even in today's market conditions, this continues to be one of our guiding tenets. Since we remain convinced that positioning our portfolios for the future, and not just reacting to current circumstance, is of paramount importance, our focus across the sectors in which we invest remains on companies that can navigate commodity price volatility and help grow sustainable net asset value.

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