Natural Resources Turn Choppy as Trade Winds Persist
Shawn Reynolds, Portfolio Manager
July 23, 2019
Natural Resources Turn Skittish in Q2
After an encouraging first quarter to the year, commodities and natural resource equities turned choppy and skittish. A clear, finite resolution to the problems surrounding tariffs and trade remained elusive. As concerns around slowing growth and undershot inflation targets increased, central banks around the world re-engaged, reversed their policies and started easing. In June, this led to a surge in the price of gold and renewed hope that previous fears around threats to global growth would prove unfounded.
Crude oil and natural gas prices fell during the quarter. And, though they may have had a good start to the year, North American oil and gas producers languished as the perceived outlook for global oil demand weakened while, simultaneously, production moved higher in April and May.
For base and industrial metals, the second quarter was considerably more unsettled as trade concerns remained unresolved and individual companies were faced with a host of operational and geopolitical setbacks. However, gold and gold stocks shone brightly, especially in June, when the shift in central banks’ policies towards greater accommodation lead to a meaningful, technical breakout above $1,400 per ounce.
Finally, among the grains, corn saw a significant jump during the quarter as considerable rain and flooding in the U.S. Midwest injected a fair amount of uncertainty into the outlook for this year’s corn yields and output.
Outlook: Looking for Trade Resolution
We believe resolution on trade and further accommodative central bank policy would be positive for the space. In the meantime, these macroeconomic headwinds may dampen the impact of potential tightening supply and demand fundamentals or significant corporate actions.
Energy allocations remain at historic lows with the vast majority of long-term investors in the sector demanding that North American unconventional oil and gas companies deliver on their promise of return of capital. For this reason, prioritization of capital discipline remains critical and companies must be willing to “prove it” by delivering attractive returns on capital and associated cash flow yields and, furthermore, by initiating or expanding their dividend and share repurchase programs. Mergers and acquisitions that would have otherwise sparked interest—in terms of potential cost synergies and growth opportunity—have, for the most part, fizzled with this core investor base.
Base metals and mining companies are unable to escape trade fears and so, perhaps more than any other natural resources sector, would substantially benefit from a resolution. Headline risks have also increased for many of these companies following several major incidents, including Vale’s tailings dam collapse in Brazil and a fatal landslide at a Glencore mine in the Democratic Republic of Congo. Fundamentals in the space remain as enticing as ever, particularly for copper, yet the market has reluctantly imputed these factors into the share price of many operators.
We believe gold miners are in perhaps the most favorable position of all natural resource sectors at this point. A roughly 8% move in gold can often generate double-digit increases in free cash flow for some operators (depending on their all-in mining costs) and shifts in central bank policy, declining real rates and a weaker dollar could help establish a higher trading range for the metal over the next several months. The current price to cash flow valuations of majors and mid-tiers are also hovering around their 15-year lows, presenting an attractive value opportunity with a relatively tangible short-term catalyst.
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