Natural Resources: Investment Insights, Q3 2013

BlackRock's Natural Resources Team

Gold
Evy Hambro

During the month the gold price continued to be tied to movements in the US dollar, which traded on reports from the Federal Reserve and US economic data points.  The gold price broke through $1,300/oz towards the end of the month in response to more dovish commentary around the tapering of quantitative easing.

The ETF market continued to see negative flows during the month with approximately 69 tonnes of gold redemptions.  At the same time speculative positions in the Comex gold market fell to a low of 2.8Moz (from a high of 33Moz at the end of July 2011), suggesting that investment demand for gold remains broadly negative.

The World Gold Council reported during the month that China’s gold demand could reach 1,000 tonnes in 2013.  At this level China would overtake India as the largest consumer of the yellow metal. The Reserve Bank of India has once again tightened the regulation around gold.  The latest amendment has mandated that 20% of gold imports are retained for the purpose of export.  Observers of the gold market have commented on the challenges associated with monitoring such regulation. Gold producers delivered strong leverage to a rising gold price, as these companies now have significant operational gearing to moves in the precious metal.

Fund Manager View:

It has been an extremely volatile period for gold; but the factors behind the yellow metal’s strength over recent years have not disappeared. Importantly, we are yet to see the full ramifications of quantitative easing, the most pertinent of which could be rising inflation. Over the short-term, we may see further volatility around current levels. However, jewellery demand should pick-up at lower levels, given its price-sensitive nature.

The past three years have undoubtedly been tough for the industry’s companies and investors but the significant structural change that is taking place is encouraging. New management teams, improving capital discipline and operational efficiency, and a greater willingness to return to capital to shareholders are increasingly evident and hold the key to rebuilding investor trust in our view.

Mining
Evy Hambro, Catherine Raw

After a volatile month of June, July was more muted and saw equity markets perform well, driven by European equities. At a macro level it was an encouraging period. European data surprised on the upside with PMIs coming in above 50, US indicators continued to gradually recover and Chinese data showed some improvement, interrupting its previous downward trend.

Following a torrid second quarter, gold bullion recovered in July, partly on the belief that the US Federal Reserve will maintain its current monetary policy for longer than earlier comments from Ben Bernanke initially suggested. The gold price added 7.8%, ending the month at $1,310/oz. Holdings in gold ETFs however continued to decline and the speculative net length in the gold futures market while marginally increasing over the month, remains near an 10 year low. Other precious metals also had positive returns in July with Silver returning 5.7% and platinum 8.8%.

Bulk commodities rallied in July. Iron ore in particular added approximately 14% driven by a replenishment of inventories at Chinese steel mills. Iron ore ended the month at around $134/t (source: CSLA, 63.5% Fe). Base metals overall had fairly muted month with copper, aluminium, zinc, nickel and lead all posting returns between -1% and +2%.

Fund Managers' View:

The mining sector and other cyclical areas have struggled over the last two years as the market has downgraded global growth expectations.

In the medium term, commodity prices are likely to remain range-bound as supply and demand have come closer into balance. We expect greater tightness to return for certain commodities, but for now mining companies need to be focused on capital discipline, operational efficiency and growing margins through cost control. In such an environment, well-managed mining businesses should be able to generate free cash flow, be in a strong position to return cash to shareholders and should see their share prices rewarded as a result.

Energy
Robin Bachelor, Poppy Allonby

Brent crude appreciated 5.3% to finish the month at $107.9/bbl. The modest global recovery has helped underpin crude prices this year, but supply disruption has also had a role to play. For example, OPEC crude production fell by 370kb/d in June, according to the International Energy Agency, owing to supply disruptions in Libya, Nigeria and Iraq. Libyan oil fields and export terminals have been shut-in following worker disputes and unrest. Libya’s oil production has fallen to 1.2mb/d from a post-revolution peak of 1.5mb/d in July 2012. Iraqi output has suffered from pipeline damage and inclement weather. South Sudan is also reportedly ramping down oil production a matter of months after an agreement between Sudan and South Sudan was reached for oil exports. Landlocked South Sudan possesses the oil, but is beholden to Sudan for its export terminals. Tensions between the two have resulted in oil production from the area falling well short of its ~300kb/d normal operating capacity.

WTI crude outpaced Brent, gaining 9.1%, further narrowing the spread between the two. At the end of the month, WTI (the North American crude, priced in Cushing, Oklahoma) stood at $105.1/bbl, just $2.8 below Brent. At the start of the year, WTI traded at nearly a $20 discount. The steady momentum in the US economy, a ramp up in refinery activity post a maintenance period and flooding in Canada which has reduced the oil flow from the country into America have all contributed to the narrowing.

Fund Managers' View:

We expect international oil prices to remain range bound in 2013. Global economic activity is translating into modest demand growth. The high marginal cost of production for oil, OPEC’s desire for prices to sit within a relatively high range and the on-going risk of supply disruption should all be broadly supportive of oil prices remaining in in their current trading range.

Longer term, the demand side outlook for oil looks robust. Non-OECD countries currently make up less than half of global oil demand but should provide almost all expected demand growth. Energy consumption per capita in China is, for example, far behind the levels seen in the US and with the Chinese economy slowly transitioning from an investment led to more of a consumption driven economy there is significant scope for increased use of oil and natural gas.

The energy industry is also undergoing a series of structural changes, not least with the rapid onset of shale oil and gas production in North America. These changes are creating challenges, but opportunities also abound. The energy equity proposition is arguably more nuanced than it has been in the recent past. We are focusing on companies that show value and offer differentiating, stock-specific fundamentals, both of which should be able to provide good returns in a range bound international oil price environment.