The thorny issue of oil majors and genuine ESG impact

Excluding all ‘old world’ players won’t cut it, so how can fund managers tap oil and gas giants as part of a meaningful energy transition? Pablo Gonzalez, our Senior Portfolio Manager, was interviewed by citywire to speak about investing in oil and gas companies and the ESG paradox.

 

“The investment industry is missing out on the chance to take a more responsible approach towards sustainable investment, such as engaging with management, rather than wholesale exclusion.”

 

Please read the full article below:

The thorny issue of oil majors and genuine ESG impact

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ICG Commodity Update – May 2022

The ICG Commodity Update is our monthly published comment on the energy, industrial metals and precious metals market.

 

Energy

Well three months into Russia’s invasion of Ukraine, global markets remain tense with oil prices holding firmly >$100/bl. The call to secure global energy supplies is getting more relevant than ever, with new actions adding to uncertainty, including a potential EU embargo on Russian oil on the horizon. Further to that, the WSJ has reported that some OPEC members are considering exempting Russia from the group’s production quotas currently in place (Russia’s target were set at 10.5mboe/d in May). No decision has been confirmed, but exemption wouldn’t be without precedents: Iran, Libya and Venezuela are already not subject to production quotas. Exemption would allow Russia to produce at maximum capacity, which is probably limited at ~11mboe/d due to export constraints through Europe. Nevertheless, an exemption of Russia would probably not impact the medium-term S/D balance according to JP Morgan. While Saudi Arabia and Iraq plan to increase production capacity, non-GCC supply continues to fall short of expectations. Some estimate that in April OPEC+ missed quotas by 1.8mboe/d. Some expect OPEC’s spare capacity (about 3.6mboe/d) to come even more into light as demand continues to recover, China reopens and the summer driving season starts in the Northern Hemisphere. It’s time to take a look at an unloved sector. Commodity prices have skyrocketed well >100% in the last 2 years. However, it’s not too late to invest. Though commodities are up, natural resource companies trade at more than a 60% discount relative to the S&P 500, a level that has almost never been seen. Indeed, also relative energy stocks are cheap discounting oil prices in the range of only $50-$70/bl. Furthermore, the current discount may be understated, as the recent spike in commodity prices has yet to flow through to the companies’ reported fundamentals. If commodity prices were to stay at current levels, many of the largest commodity producers on the planet could pay down all their debt and buy back all their shares in just a few years and keep their billions and billions of dollars of cash flow for themselves. The implication of these deeply discounted valuations is that investors don’t need commodity prices to continue to rise in order to expect strong returns. In fact, flat commodity prices would be brilliant. Energy now represents 9% and 11% of S&P net income and FCF using consensus estimates, while these would increase by 150-200bps at strip. When comparing earnings and FCF contribution with a 4.8% of S&P market cap and other sectors struggling, we think investors will find it difficult to remain underweight given greater performance slippage. If valuations remain depressed, investors will benefit from a combination of high dividend yields, special dividends, share repurchases, and M&A activity. While the exact mechanism is unknown, if you invest in profitable businesses at attractive valuations, you will be rewarded sooner or later.

 

Industrial Metals

May was a rollercoaster with most commodity prices posting a weak run and all major base metals fell on the LME as stocks and bonds slid and the U.S. dollar rose, while accelerating inflation, rising borrowing costs and lockdowns in China depressed sentiment. China’s stringent response to virus outbreaks are stoking angst over its impact on the economy. The country’s leaders warned against questioning Xi Jinping’s Covid-zero policy, reaffirming support for the lockdown-dependent approach despite pressure to relax restrictions and protect growth. Anyway, by the end of the month, commodities rebounded from a five-month low as the demand outlook was bolstered by a weaker US dollar and China’s loan-rate cut. Chinese authorities cut a key interest rate for long-term loans by a record amount. The move will help reduce mortgage costs and support the country’s beleaguered property sector, a key source of metals demand. The Stoxx 600 Basic Resources index has fallen 16% in the past month, at a time when analysts are still raising estimates. That’s left miners looking more of a bargain than they have in years, trading at about six times forward earnings, a 50% discount to the broader market. In recent history, the sector was only this cheap during the global financial crisis of 2008 and the European sovereign debt crisis in 2011, in absolute terms. Commodity prices have skyrocketed well over 100% in the last 2 years. Though commodities are up, resource companies trade at more than a 60% discount relative to the S&P 500, a level that has almost never been seen. Furthermore, the current discount may be understated, as the recent spike in commodity prices has yet to flow through to the companies’ reported fundamentals. According to GMO, the market is simply not valuing resource companies at reasonable levels given any plausible base case for how the world might play out. If commodity prices were to stay at current levels, many of the largest commodity producers on the planet could pay down all their debt and buy back all their shares in just a few years and keep their billions of dollars of cash flow for themselves. The implication of these deeply discounted valuations is that investors don’t need commodity prices to continue to rise in order to expect strong returns. In fact, flat commodity prices would be brilliant. If valuations remain depressed, investors will benefit from a combination of high dividend yields, special dividends, share repurchases, and M&A activity. While the exact mechanism is unknown, if you invest in profitable businesses at attractive valuations, you will be rewarded sooner or later.

 

Precious Metals

Gold has recovered some lost ground recently and is now hovering just below its 200-day moving average of USD 1,840/oz. This consolidation has been underpinned by an uptick in buying of exchange-traded funds following a decline in these holdings by more than 2 million ounces since the mid-April peak. The moderation in 10-year US real yields and the topping out of US dollar strength has supported some demand, with gold’s correlation with the US dollar index turning more negative of late. Despite the commencement of the much anticipated Fed tightening cycle in March and a general sell-off in equities, which likely also weighed on gold as it is typically used initially as a source of liquidity, the gold price is only down around 10% in dollar terms from its recent $2,000+ highs. Analysts believe gold’s robust performance has been driven by increasing concerns around the prospects for growth, inflation and the extent to which central bank policy can balance the mix of the two successfully. Looking at PGMs, platinum supply could contract slightly over the next two years as the industry struggles to recover from Covid-related supply chain disruptions, labor and power stoppages in South Africa and Russia’s isolation. Southern African producers have pushed the growth button potentially boosting output from 2026 should favorable market conditions hold. From 2024, platinum supply could increase by 1.5-2% a year as new projects offset reserve depletion and grade decline. The gold sector showed some M&A-activity by the end of May with Gold Fields offering 0.6 of one of its shares for each Yamana share which will make the combined company the world’s number 4 producer. The $7bn purchase implies a 34% premium to Yamana’s closing share price on May 27th. That premium offered by Gold Fields contrasts with the shift in recent years to mergers of equals in the gold industry. Those zero-premium deals, which consolidate assets to minimize costs and maximize shareholder returns, began with the $5.4 billion mega merger of Barrick Gold and Randgold announced in 2018. Yamana Gold considered other options before agreeing to be acquired by Gold Fields, suggesting there are discussions for other prospective deals in the gold industry, the Canadian firm’s executive chairman said. This is no surprise to most market participants as the so called M&A-wave is long overdue in the still segmented gold industry. Even though gold prices have risen over 40% in the last 5 years, equities of the miners are still looking cheap – companies of the precious metals champions fund producing an ounce of gold at roughly $800/oz while being almost debt-free and highly profitable (EBITDA margin >50% and a free cash flow yield 2023E >11%), this with a price-to-cashflow ratio of only 2.9x, a price-to-book ratio of 1.7x and a dividend-yield of 2.9%.

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ICG Commodity Update – April 2022

The ICG Commodity Update is our monthly published comment on the energy, industrial metals and precious metals market.

 

Energy

Oil climbed for a fifth month in April, marking the longest monthly winning streak since January 2018 before falling at the beginning of May. Oil demand keeps holding up on a global level. Most oil products have fully or almost fully recovered back to 2019 levels. Particularly China’s oil demand was very strong this year until the recent lockdown. According to JP Morgan energy demand is expected to exceed supply by 20% and would require $1.3tn of incremental capital to close the gap by 2030. Therefore energy investment needs to rise 45% to $2.7tn annually by 2030, to meet rising energy demand. US oil and gas producers are suddenly under pressure to accelerate the pace of supply additions and contribute to the security of global energy markets. Certain public producers already started revising their capital and production guidance for 2022 up. While the upside for production in 2H22 remains limited amid ongoing supply chain bottlenecks and cost escalation, the outlook for the rig counts keeps improving and nationwide growth capacity for 2023 looks much more favourable than it looked like two months ago. Nevertheless, Rystad expects the US to grow by 1mboe/d but labour and equipment shortages may reduce growth potential by half. Particularly fascinating is that total free cash flow generated by upstream for all the public E&P companies is expected to increase from $460bn in 2021 to almost $850bn this year! This will be the highest value on record. Indeed, our ECF portfolio has a weighted avg. FCF yield for 2022E of 19.3%! Energy stocks are far from pricing in strong and sustainable outlooks for fundamentals and shareholder return. For instance, Energy S&P 500 weight is only 4% (vs. 20yr average of 8% and 2008 peak of 16%). For a sector that is a direct input into every segment of the economy and a natural hedge against geopolitics and inflation. In ours view, energy’s earnings stream is worth more than the 2022E PE of 10.3x (ECF with a PE of 5.6x) which is a steep discount relative to long-term average of 16.5x since 1990. During 2013-2014 it traded at 13.5x when oil price was at a similar level though profit margins were much lower and credit risk was higher. Interestingly, all US publicly-listed energy companies have a combined market cap of only $2.2tn, which is lower than Apple’s market cap even though these companies collectively generate 5x higher revenues. Energy continues to be the cheapest sector on all valuation metrics despite the strong performance over the last 2 years. Also relative energy stocks are cheap discounting oil prices in the range of $50-$70/bl vs spot prices of $100/bl. No wonder to us that W. Buffett increased its energy exposure heavily this year making Chevron it’s 4th biggest position. However, with anti-Energy constraints likely loosening given increasing ESG performance pressure and with many reconsidering how to define ESG, we expect a positive impact to energy equity flows in the future.

 

Industrial Metals

Concerns around the Fed’s tightening and China’s widening COVID outbreaks have weighed on markets last month. Strict lockdowns are wreaking havoc on consumer spending and snarling supply chains in China, putting its growth target for GDP of about 5.5% this year under increasing pressure. Chinese authorities have already taken some steps to stem the economic damage, including accelerating government borrowing and spending to boost infrastructure investment. Still, virus concerns persist as flareups intensified, along with looming interest-rate hikes by western governments. Looking at inventories, there have been continued inventory challenges this year for base metals and upward squeezes remain possible. While Goldman says copper is “sleepwalking” toward a depletion of stockpiles, Barclays highlights that the most significant disruption is currently occurring downstream, as activity in China is disrupted. Also, copper output in Chile, the worlds largest copper producing country, is facing significant underperformance so far this year due to a combination of widespread water shortages, ore grade disappointments and technical issues that are disrupting close to half of supply in the country. On top, MMG is facing the possibility of a prolonged disruption at its Las Bambas copper mine in Peru, which represents 2% of world supply, after failing to clear the site of all protesters in an operation that has further inflamed tensions with indigenous groups. On the company side, Glencore’s trading business is headed for another year of bumper profits as the company cashes in on soaring prices and market volatility. The volatile markets have helped boost earnings for commodities traders, with merchants including Mercuria and Gunvor earning windfall profits last year. However, surging prices have also created liquidity pressures for traders, as they face massive margin calls on derivative hedging positions. Still, like several other big miners, Glencore has had problems operationally. The company cut its zinc production goal for the year and also said it would produce less copper. Anglo American and Freeport both tumbled after forecasting steep cost rises, while other miners such as BHP disappointed as COVID absenteeism and operational missteps curb output across the sector. The recent pressure on the equity side could be an attractive entry point for investors, as financial ratios remain extremely favourable. For example, the average price-to-book-ratio of the fund is currently at 2.3x, combined with an EV/EBITDA 2022E of 4x and a price-to-earnings ratio of 7x makes the portfolio look cheap compared to benchmark figures or other sectors. Also, the companies are incredibly healthy with a net-debt/equity of only 12% and profitable: free-cash-flow yield 2022E 13.2%, EBITDA margin 2022E 44%, dividend yield 3.4%.

 

Precious Metals

According to Analysts, Gold has been hamstrung by expectations the U.S. Federal Reserve will now act quite aggressively to bring inflation under control. The prospect of further U.S. interest rate hikes adds to the relative attractions of the dollar over real assets like gold that have no yield. Gold investors are balancing searing inflation against more aggressive monetary policy tightening, while digesting the added complications of a weakening economic growth backdrop and elevated geopolitical risks. Higher inflation prints, geopolitical risk and recessionary fears, in isolation, should support prices, however, central bank tightening to rein in this inflationary juggernaut will likely take some shine off gold. Looking at silver, demand is expected to climb to a record level this year thanks to increasing use of solar panels as governments boost renewable energy to meet climate goals, setting the stage for years of supply deficits, an industry report said in April. Global silver demand is expected to rise to 1.1 billion ounces this year, up 5% from 2021, consultants Metals Focus said in an annual report compiled for the Silver Institute. On the equity side, miners face shrinking margins as inflationary pressures abound. Inflation is flowing through to labor, consumables, freight, diesel, power, and royalties, while easing COVID restrictions, rising by-product credits, and an appreciating U.S. dollar offer some potential reprieve. While prices for industrial metals have risen sharper this year than inflation, gold and silver prices remain flat by end of April. Independent Capital Group attended this years European Gold Forum in April to get some insight into the industry, as gold mining companies still struggle with investors’ attention in recent years due to bad management, overspending on acquisitions and projects and in general weak communication to the public. We want to highlight that the industry is still heavily undervalued, debt free and is rewarding its shareholders for their loyalty either with dividends, share buy-backs or a combination of both, which means that shareholder returns are steadily growing. Also, the value proposition of large-caps is starting to fade. Investors will start looking for great mid-tier companies which should drive share prices and speaks for diversification instead of a single stock pick. In addition, the industry stays extremely disciplined and keeping their budgets under control – while M&A is still on everyone’s mind, an acquisition has to come at the right price. No one wants to pay high premiums anymore as many recent zero-premium acquisitions and mergers showed.

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Conference Distillate – The Denver Gold Group Gold Forum – April 2022

Independent Capital Group attended this years Denver Gold Group Gold Forum – Virtual Event from 12th to 14th of April. You can find the key takeaways in our Conference Distillate. We had the pleasure to talk to many exciting gold companies and would like to highlight 3 of our Precious Metals Champions Fund portfolio companies we met during the last 3 days.

 

– Pan American Silver – The world’s premier silver mining company

 

– Yamana Gold – On the road to 1.5 million ounces per year

 

– Alamos Gold – Leading growth profile

 

Detailed company level abstracts are available upon request. Contact us at research@independent-capital.com.

 

 

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ICG Commodity Update – March 2022

The ICG Commodity Update is our monthly published comment on the energy, industrial metals and precious metals market.

 

Energy

The storm of supply disruptions, logistic issues, sanctions, financial short squeezes and purchasing manager panic has seen some of the most dramatic commodity price moves seen in history over 1Q 2022. Especially, the oil market is potentially facing its most severe supply crisis since the 1990 Gulf War. In these most uncertain times defined by war in Ukraine, a new Covid-19 outbreak in China, and an overall wobbly economic and financial market backdrop, volatility is very high. This has been demonstrated by more than $30/bl price swings in the span of a week. Meanwhile, the impact of Western energy companies’ self-sanctioning against buying Russian crude and oil products is starting to become visible. Rystad considers the mildest case for lost Russian supply to be 1.2mboe/d, and the most extreme estimated at 4.5mboe/d. On top of these supply scenarios, analysts consider how OPEC countries with robust levels of spare capacity would respond. In the most bearish case, OPEC could boost production by 2.2mboe/d for May-22, while in the bullish case, Rystad keeps OPEC in the status quo of incremental increases and actual production continuing to lag stated targets. The analysts of Rystad said that OPEC has ample spare capacity in theory, but only KSA and UAE have “manageable” capacity by year-end. Meanwhile, the US Federal Government announced the release of up to 180mboe from its strategic petroleum reserves (SPR), during a period of up to 6 months (every day 1mboe). This is the largest release in US history and the clearest indication that the future availability of production capacity is at risk owing to limited shale and OPEC+ spare capacity coupled with prevailing strong demand. Therefore, the release may alleviate some market tightness, but it won’t resolve the structural imbalances resulting from years of underinvestment at a time of recovering global demand for oil, we think. Importantly, it should be supportive of the back-end of the forward curve and the SPR stocks will have to be replaced, lending further support to 2023-2024 prices probably. Of note this announcement is made on the day of the OPEC+ meeting, which as expected, agreed to increase quotas by the expected volume of 432 kb/d in May. On the company level, oil and gas companies continue to generate record cash flows and profits. Interestingly, some US shale companies are now facing pressure to fast track production growth and contribute to the stability of the global energy system. However, equipment lead times in the supply chain and labour bottlenecks restrict the ability of operators to bring additional rigs and frac spreads into the operation. US E&P companies have reduced hedges for 2022 to 35% of total oil output as they seek to benefit from rising oil prices.

 

Industrial Metals

In March, nickel spiked briefly above $100’000 a ton on the LME amid a short squeeze and encouraged rule changes from one of the world’s top commodity exchanges. The LME decided to allow traders to defer delivery obligations on all its main contract in an unusual shift for a 145-years-old institution that touts itself as the “market of last resort” for metals. Weeks after, the Financial Conduct Authority and Bank of England announced that they will undertake reviews into the governance, market oversight and risk management of the LME after the massive short squeeze led to weeks of turmoil that paralyzed the nickel market. Most controversially, the exchange cancelled billions of dollars of trades that had occurred, arguing that not to do so would have led to multiple defaults. The short squeeze was focused on Chinese Tsingshan Holding, which built up a giant bet on lower nickel prices and faced billions of dollars in losses when the market spiked. The exchange has been criticized by investors for its handling of the crisis. While the LME said that the price spike posed a systemic risk to its market, the decision to cancel several hours of trades at the highest prices also served as a bailout of Tsingshan and its banks to the tune of several billion dollars. In general, the storm of supply disruptions, logistical issues, sanctions, financial short squeezes and purchasing manager panic has seen some of the most dramatic metals and bulk commodity price moves seen in history over Q1 2022. Such market dislocations naturally alter commodity outlooks, both in the short and longer term. Given the biggest changes has been in energy dynamics, this also feed through into potential commodity exposures and preferences, particularly in an environment of wider commodity inflation. Meanwhile, China’s pivot to growth, while still yet to be evidenced in hard data, simply cannot be ignored. According to BMO, many of the global dynamics now expected over the coming years, whether a renewed push for energy independence or a segmentation of global trade flows, are inherently inflationary in the medium term. As a result, analysts raised the majority of their price forecasts upwards. BMO states that all-time price records in a number of metals and bulk commodities has been touched, while each and every one is trading above its respective cost curve – a very rare event. There is no doubt that physical markets that were already fundamentally tight have been further dislocated by the war and the knock-on ramifications. Although analysts expect a wave of cost inflation pressures is on its way to mining companies, they expect that there is a lag of approximately 3-6 months before higher input costs flow through to higher contract prices. Analysts expect the top end of commodity cost curves to rise at least 10% this year, though in a situation where prices are in general trading at a decent premium to cost support this has limited influence on price formation.

 

Precious Metals

Gold has pulled back from over $2,000/oz reached in March as investors balance soaring inflation against more aggressive rate hikes and quantitative tightening, while digesting the added complication of a weakening economic growth backdrop. According to BMO, higher inflation prints and recessionary fears, in isolation, should support gold; however, central bank tightening to rein in inflation will likely take some shine off gold. If central bank policy tightening does not prove effective and stagflation materializes, or if they serve to stifle economic growth, gold could likely find favor. Policymakers have the unenviable task of balancing doing too much too soon and doing too little too late, with some believing the latter already. Analysts think this uncertainty alone could be enough to keep gold prices fundamentally well supported. Also, the sizeable ETF inflows seen year to date should help propel gold to yet another annual average record in terms of nominal price. According to analysts, traditional physical buying also seems to be holding up relatively well. Looking at PGMs. The platinum market whipsawed from a significant deficit last year to a surplus owing to a 20% increase in total platinum supply. According to BMO, with average loadings per vehicle rising quickly alongside more stringent emissions legislation and more muted supply growth, the market should be back in balance by 2023. Beyond this, the culmination of increasing vehicle loadings and the growing hydrogen economy should see sustained market deficits emerge through much of the middle of this decade. That said, as more economies push toward greater energy independence and ambitious climate targets, analysts expect to see a more marked acceleration in green hydrogen production capacity, in addition to greater fuel cell adoption in the commercial vehicle segment. Both of which would provide a boost to platinum demand. Palladium on the other hand is arguably the commodity most exposed to supply disruptions arising from the conflict, with Russia accounting for 39% of global refined supply. Palladium is vital to the functioning of catalytic converters, specifically in gasoline vehicles, and fears of impending shortages initially propelled prices to an all-time record in March. On the company side, Canada’s Centerra Gold has agreed to hand control of its expropriated gold mine to Kyrgyzstan’s government. In exchange, Kyrgyzaltyn is to transfer its 26% stake in Centerra back to the company, which plans to cancel the shares. The planned deal comes nearly a year after Kyrgyzstan’s forced local managers to hand over control of Centerra’s Kumtor mine. Analysts see the deal as positive for Centerra which will be left with $1bn in cash, with production mainly in Canada and Turkey now as the deal removes a significant overhang on the stock.

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Commodities to become mainstream – again.

KEY TAKE-AWAY

 

• The war in the Ukraine has destabilized global commodity markets heavily

 

• Many commodity markets had already tightened significantly prior to the invasion

 

• The bull case for commodities rests not on the current geopolitical unrest, it only reinforces it

 

• A lower correlation between commodities and other asset classes speaks for commodities in a portfolio context

 

• Metals are in the heart of the super-cycle

 

• Natural resource equities are the cheapest they’ve been in the last 100 years on some metrics and on top in their best shape in history

 

• Investors should not view commodities as risk assets, they are an all-weather asset

 

• Our ICG Investment Solutions have done exceptionally well absolute as well as relative

 

 

 

A crisis is unfolding – A crisis of commodities

The brutal Russian invasion of the Ukraine is terrible and causes awful human suffering with unpredictable consequences. Indeed, the war in the Ukraine has destabilized global commodity markets heavily. The storm of supply disruptions, logistic issues, sanctions, and purchasing manager panic has seen some of the most dramatic rises seen in history. Anyone in the commodities world is experiencing a perfect storm as correlations suddenly shot to 1, which is never a good thing. But that’s precisely what happens when the Western sanctions the single-largest commodity producer of the world, which sells virtually everything. What we are seeing at the 50-year anniversary of the 1973 OPEC supply shock is something similar but substantially worse – the 2022 Russia supply shock, which isn’t driven by the supplier but the consumer.

 

 

Russia is an important producer and player in the world of commodities

 

 

Russia is the world’s third largest producer of oil (11.5% of global output) and second largest exporter of oil. At risk in total on the energy side is 4.3mboe/d of oil, 2.8mboe/d of oil products and 120bcm of gas. While commodities are fully carved out from the sanctions package, it is clear that Russian oil is being ostracized. About 2/ 3 of Russian oil was struggling to find buyers even at hugely discounted prices. In metals the risk amounts to 3mt aluminum, 700kt copper, 135kt nickel, 3moz palladium and 700koz platinum. So far no metals producers have explicitly been sanctioned. There has not been any significant disruptions to the flow of base and precious metals exports from Russia, particularly for long term contracts, though prices are reflecting an immense risk. (as of 15th March 2022)

 

 

 

The importance of commodity security

Nearly every single commodity is trading well above its respective cost curve, and higher than seen three months ago – a very rare event. Undeniably, the Russian invasion of Ukraine has played a key role in this. As such, some commodities are rallying for the wrong reasons – significantly higher global risk and disruptions to not only trade flows but also fears around security and stability disruptions not seen in a generation. However, some commodity markets had already tightened significantly prior to the invasion. Much of the past two years have seen a positive fundamental trend helping prices higher on the back of supply underinvestment and recovering demand. While this break from the trend has been a positive one for prices, not even producers truly believe this is a good thing. Steady, managed price rises are good for the industry value chain. Under a scenario of broad self-sanctioning, demand destruction becomes an immediate necessity. So far we have seen limited signs of demand easing. Strong economic growth is boosting consumption of energy and metals. Nevertheless, the market for commodities is not going to be what it was.

 

 

Investors need to increase commodity exposure

Commodities were one of the best-performing asset classes of 2021.

 

• The Bloomberg Commodity Index was up 25% in 2021 and as of 15th of March, up another 22% in 2022

 

Indeed, commodity markets have moved in the opposite direction of global equities so far this year. The bull case for commodities rests not on the current geopolitical unrest, it only reinforces it. With commodities also providing an effective hedge against this risk, the case for owning commodities has never been stronger. However, investor exposure to commodities is still record low (below 2% ex-gold).

 

 

Historically commodities and gold can be a good inflation hedge

A lower correlation between commodities and other asset classes speaks for commodities in a portfolio context. The commodities chaos caused by Russia’s war in Ukraine will reverberate through the global economy, sparking industry shortages and quickening inflation already at the highest in decades. While the exact path for inflation remains highly uncertain, commodities are one of the best assets to position against rising inflation given their high correlation to market-based measures of inflation expectations.

 

 

 

Metals are in the heart of the super-cycle

Government ambitions globally have grown markedly in the past few years pointing to new, increased momentum in tackling climate change. Indeed, plans to make the world fossil fuel independent increased significantly with the Russia invasion of Ukraine. Further to that, the structure of energy demand changes, with the importance of fossil fuels gradually declining, replaced by a growing share of renewable energy and increasing electrification.

 

• An energy system powered by clean energy technologies differs profoundly from one fueled by traditional hydrocarbon resources as they generally require more minerals than their fossil fuel based counterparts. These raw materials are a significant element in the cost structure of many technologies required in the energy transition

 

• Metal demand for clean energy technologies would rise at least 4x by 2040 to meet climate goals, particularly EV related metals

 

 

Metal demand for renewable energy technologies to quadruplicate

Metal demand* according to the IEA “the role of critical minerals” excludes steel and aluminium that are also very important in the green energy transition. IEA Sustainable Development Scenario (SDS) estimates that a surge in clean energy policies and investment puts the energy system on track to achieve sustainable energy objectives, including the Paris Agreement, energy access and air quality goals.

 

 

 

Producers are in their best shape in history

The exposure to natural resource equities remains very low by historical standards and in relation to the earnings contribution to the market. Balance sheets are healthier that at any point in history and natural resource equities are the cheapest they’ve been in the last 100 years on some metrics

 

• Energy makes only 4% of the S&P 500 Index weight, but the Oil & Gas producers account for 9% of the market’s earnings and 12% of free cash flow

 

• The precious metal producers have accumulated a net debt/equity ratio that is negative resp. more cash than debt, therefore debt-free

 

• While the S&P 500 price to cash flow increased over the last year, the one of the natural resource space declined. This means, that the prices of the stocks of the S&P500 increased more than their cash flow. However, the cash flow of the natural resource space increased much more than their share price. And this after a strong performance already

 

 

Big gap between the S&P 500 Index P/CF to that of the natural resource producers

 

In addition to attractive returns, natural resource equities offer investors diversification, inflation protection, a margin of safety, inefficiencies, and optionality. We remain convinced, as with commodities, natural resource equities should be part of a portfolio as the companies are in their best shape in history and valuation metrics continue to stay at attractive levels.

 

 

Investors should not view commodities as risk assets

commodities are an all-weather asset

 

 

 

Investment Solutions

 

Industrial Metals Champions Fund +207.7% over 2 years

Energy Champions Fund +207.5% over 2 years

Precious Metals Champions Fund +8.4% over 1 year

 

We invest in the top 25 producers on each sub-sector thanks to a qualitative and quantitative scorecard investment process and those companies resp. natural resource producers are currently very attractive. Therefore all investment funds managed by Independent Capital Group AG are based on proven quantitative multi-factor models that are solely based on unemotional systematic and methodological processes.

 

• For example, country risk management has always been an integral part of our ICG Alpha Scorecard. We began reducing the direct Russian exposure towards the end of 4th Q 2021 when the country risk factor signaled an increasing geopolitical risk dynamic. As a consequence we have now no Russian exposure left.

 

Feel free to contact us if you want to have more information on our funds, our investment process, a commodity update or a second opinion on any natural resource company.

 

Sources: ICG Database, Clocktower Group, Credit Suisse, Goldman Sachs, JP Morgan, BMO, IEA, Bloomberg, OpenFunds, FT, WSJ

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Fossil Fuels & Energy Transition: OpenTalk with Pablo Gonzalez

OpenTalk with our Senior Portfolio Manager Pablo Gonzalez, CFA

 

Global energy demand is increasing, while governments and private companies around the world are proclaiming goals to reach net-zero, prompting further investment in metal-intensive energy technologies. As a result of the Ukraine conflict, European leaders are now asking the bloc to speed up the transition to renewable energy. Even if the energy plan encourages a green reaction, achieving the necessary energy transformation will cost time and money. Independent Capital Group AG is a firm that specializes in asset management and financial advice. Pragmatic Sustainable Investing is incorporated into all of their investment strategies.

 

See the full interview in the video below.

 

 

 

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ICG Commodity & Russia/Ukraine Exposure Update

General

The brutal Russian invasion of the Ukraine is terrible and causes awful human suffering with unpredictable consequences. The unfolding war in Ukraine raises the risk of disruptions to commodity flows. Even though natural resources have avoided direct sanctions, traders, banks and shipowners are increasingly avoiding trade with Russia. The reasons include confusion about what is legally permitted, fears about reputational damage, or moral objections.

 

Nevertheless, the commodities chaos caused by Russia’s war in Ukraine will reverberate through the global economy, sparking industry shortages and quickening inflation already at the highest in decades. The bull case for commodities rests not on the current geopolitical unrest, it only reinforces it. With commodities also providing an effective hedge against this risk, the case for owning commodities has never been stronger. Indeed, commodity markets have moved in the opposite direction of global equities so far this year. A lower correlation between the two asset classes speaks for commodities in a portfolio context.

 

We remain convinced, as with commodities, natural resource equities should be part of a portfolio  as the companies are in their best shape in history and valuation metrics continue to stay at attractive levels.

 

Country risk management has always been an integral part of our ICG Alpha Scorecard. We began reducing direct Russian exposure towards the end of 4^th Q 2021 when the country risk factor signaled an increasing geopolitical risk dynamic.

 

Energy

The global energy market had already tightened significantly prior to the invasion. Crude oil and natural gas prices increased significantly over the last few days. The price gap between a barrel of Brent delivered now and in one year has widened to a record of more than $23.50/bl, surpassing the level after Iraq invaded Kuwait almost 32 years ago. A large chunk of Russian crude and refined products exports are not finding buyers now. Russia is the world’s third-largest producer and second-largest exporter of oil. It accounts for 11.5% of global oil output, and it exports 5mboe/d of crude and 2.85mboe/d of oil products. However, the IEA on Tuesday agreed to release 60 million barrels from its members’ strategic petroleum reserves, but that’s not close enough to cover the potential drop in Russian oil exports if self-sanctioning continues. If the release intends to cover only 30 days, it equals 2mboe/d, matching what traders believe are current losses. But the losses may be larger. IEA members hold emergency stockpiles of 1.5 billion barrels – so they can release far more oil, and quicker. OPEC+ ministers gather on Wednesday. The group is expected to stick to its existing plan and ratify another supply hike of 400kboe/d for April. Nevertheless, the situation is sensitive as Russia is the second-biggest member of the group. But OPEC has handled many conflicts in its 60-year history, including bloody wars between its own members.

 

At the start of the month our exposure was already cut to 4%. Meanwhile, we have no direct Russian exposure left and our indirect exposure in Russia is 1.5% through the partnerships of BP, Shell and Equinor with Russian companies. However, those companies have already announced to divest from Russia.

 

Industrial Metals

Industrial metal flows out of Russia have been reduced sharply over the past week. Even with trade exemptions, it is unlikely that metals export volumes will normalize quickly, with heavy logistical disruptions to metals flows through the Black Sea, both from Ukraine itself but also Kazakhstan and Uzbekistan (which are important routes for copper and zinc). With materially reduced export volume out of Russia, Kazakhstan and Uzbekistan, all the base metal markets will face accelerated tightening in the near-term against a backdrop of already multi-year low visible inventories. Elevated energy prices in Europe could also aggravate the situation. This will support a further rally in prices across physical premia, flat price and time spreads according to Goldman Sachs. Mainly, aluminium and nickel stand as the most exposed base metals given Russia’s significant supply role.

 

At the end of the year our Russia exposure was already cut to 0%. However, we have a 0.3% Ukraine exposure via ArcelorMittal. They have a steel plant and an iron mine in Ukraine with an asset value of $2.2bn according to the FY20 annual report (4% of total assets). It’s the only position with some kind of direct risk but manageable, we think. We have an indirect Russian exposure with Glencore, that has an accumulated $1.2bn stake in two Russian companies (EN+ Group and Rosneft) but they already announced to divest from Russia. Because some natural resource producers are buying raw materials from Russia like steel producers (iron ore, coking coal) and aluminium producers (bauxite, alumina) we are currently in discussion with our companies on that – the risk seems very low and manageable though.

 

Precious Metals

Gold gained last month as investors weighed mounting risks to global growth from sanctions on Russia. The metal posted its best February since 2016 as demand for the metal as a store of value climbed. The rebound underscores worries among market participants confronting high inflation at the same time war clouds the economic outlook. Gold was also supported from falling bond yields, which are further weighing on real yields with inflation continuing to soar. Investors are reducing their expectations about aggressive tightening from central banks. According to Goldman Sachs, the recent escalation with Russia create clear stagflationary risks to the broader economy, driven by higher energy prices, which reinforce the banks conviction in higher gold prices in coming months. Other investment banks followed and raised their price targets not only for gold but also for silver and palladium – Russia mines over 40% of the world’s palladium supply.

 

At the start of the month our Russia exposure was already cut to 4%. Meanwhile, we have no direct or indirect Russian or Ukraine exposure left. The Precious Metals Champions Fund is running very strong this year as the portfolio has a 17.1% PGM (Platinum Group Metals) exposure – mainly via South African producers which rallied strongly in the wake of the Russian invasion. In this case our “country risk factor” worked in the opposite direction as we also weight the commodity supply and demand with a geopolitical risk factor and this resulted in an increasing exposure to PGMs over the year.

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ICG Commodity Update – January 2022

The ICG Commodity Update is our monthly published comment on the energy, industrial metals and precious metals market.

 

Energy

Interestingly, for what once was the go-to “risk off” group in market downturns, energy has become a relative sanctuary in the midst of the broader market sell off. The oil market has entered 2022 in significant deficit, visible through OECD stock levels far below the 2015-2019 five-year average. Therefore, the market needs to build stocks in the first half of the year to ensure adequate supply for the summer driving season. However, newspaper headlines have been filled with new supply outages (Iraq, Libya, Kazakhstan, Ecuador), continued outages (Nigeria), and increasing political unrest (Kazakhstan, Russia, UAE, Saudi Arabia). At the same time, the market is questioning OPEC+ spare capacity as individual members fall short of output targets to raise output. Meanwhile oil demand is rising as European governments loosen Covid restrictions and cold temperatures hit North America. Most analysts expect oil demand to recover to pre-pandemic levels in 2022 and grow through 2030. Nevertheless, most analysts expect the oil market will gradually move from undersupplied to oversupply during 2022, depending on the actions of the OPEC+ group. Nevertheless, mid-term the oil supply is concerning. Licensing of new oil and gas exploration acreage slumped to the lowest in decades. Newfound volumes of oil and gas ended up sliding 60% from 2020 to 4.9bn boe – the lowest volume in 75 years! Energy was the top performer in the MSCI World Index over the past 12 months, with its 37% increase. Interestingly, forward-looking fossil fuel producers will play a “critical” role in decarbonizing the world economy, BlackRock CEO Larry Fink said in his annual letter to CEOs. Fink emphasized that divesting from fossil fuels, as many endowment funds such as Harvard University have done, won’t drive the world toward low carbon. Meanwhile, the 5 Big Oil producers (BP, Shell, TotalEnergies, Exxon, Chevron) will together report $36bn of free cash flow in 4Q21, bringing the full-year total to a record $116bn, acc. to Bloomberg. The 3 largest US (XOM, CVX, COP) companies will generate an average annual ROCE of 20% through 2026, acc. to Goldman Sachs. In Europe, Morgan Stanley expects that metric to reach 13% on average for the top 5 producers (BP, SHEL, TTE, ENI, EQNR). The companies will pay out >$46bn in dividends and buybacks in 2022, up from $34bn in 2021 and with “room to go higher still,” the bank predicts. Against the backdrop of improving returns on capital, shrinking debt, and higher yields, we believe that the sector offers tremendous value at about 4X EV/EBITDA and still trading at record valuations versus the overall markets. Some smaller companies trade below proven reserves NPV giving no value to probable or possible reserve. E.g. Canadian Oil & Gas could buy back their market cap in about 8 years! We are happy to say, that according to Bloomberg and CityWire we were the best Energy Fund of 2021!

 

Industrial Metals

The new year has started against a backdrop that includes record dislocations in energy, metals and agriculture, and significant amounts of money in the system – Jeff Currie, the Goldman Sachs’ global head of commodities, recently said in a Bloomberg interview. The bank is extremely bullish on commodities, amid a supercylce that has the potential to last for a decade and, given the Fed pivot, stating that commodities are the best place to be right now. Commodity prices soared strongly, underscoring the inflation concerns that prompted the FED to open the door to faster rate hikes to cool the hottest price rises in almost 40 years. The Bloomberg Commodity Spot Index climbed to the highest ever level since 2014. However, the biggest winners this year include energy products such as crude oil and natural gas as European energy crisis, supply constraints and Russia-Ukraine tensions come at a time when demand is recovering. By the end of the month, base metals edged down from near a record high as traders weighed tight supplies that have sent nickel and tin prices surging against worries over a possible seasonal slowdown in demand. For nickel, prices have recently rallied on dwindling stockpiles that fuelled a squeeze in the market. The London Metal Exchange’s LMEX index jumped more than 30% last year, and metals have burst into 2022 with synchronized tightness across markets – bolstered by Chinese stimulus and falling global inventories. All six metals in London are in backwardation, indicating a tight market. Equities of industrial mining companies were up strong in January, but have not been spared by the sell-off spurred by the FED’s planned rate hikes. Looking at new supply, it’s not getting easier for companies to build new mines – after Rio Tinto got stopped by Serbian government to build a new lithium mine, the Biden administration quashed a project of Antofagasta – both projects were stopped on environmental reasons. In terms of the Antofagasta lease, the department cited inadequate environmental analysis and consultation with the US Forest Service. The move is stoking concerns as to whether it will be possible to secure enough domestic supply of materials for batteries. Transitioning to cleaner sources of energy is a priority of the Biden administration. It isn’t the first time the administration has held up mining projects. Earlier in 2021 it put a hold on the Resolution copper mine in Arizona, which operator Rio Tinto says would be able to supply 25% of U.S. copper needs. The CEO said politics are turning against miners globally as societies and communities resist new mines. Also, Freeport-McMoRan said the task of ramping up supply to meet growing demand is getting harder as societies resist new mines and politicians seek a bigger share of profits. In short, already-positive supply-demand fundamentals look well set to improve further.

 

Precious Metals

The end of an easy-money era should normally spell bad news for gold – but now, fund managers are keeping their holdings. At a time when equities and Bitcoin, often touted as digital gold, are sinking as loose monetary policy draws to a close, gold ETF holdings are proving resilient. Despite expectations for multiple U.S. interest-rate hikes this year, bets for real rates to stay negative and demand for an inflation hedge are supporting the appeal of gold. ETF holdings are still well above where they were before the COVID-19 crisis started. Global stocks have slipped more than 6% and Bitcoin has lost about a fifth of its value on worries that an imminent Fed rate hike will sap investor sentiment. One key reason investors are sticking with gold is because they see real yields remaining negative as the Fed struggles to tighten policy enough to push interest rates above inflation. Concern about high inflation is helping gold too, with U.S. CPI rising at the fastest pace in four decades in December. The fact that gold responded well when the Federal Reserve started the last rate-hike cycle in 2015, and when it ended in 2019, may favor the metal in 2022. Not since the 2008-09 financial crisis has the one-year-out fed-fund future priced for a similar extreme disparity of higher hikes as now. This dichotomy about 14 years ago coincided with a gold foundation of around $800 an ounce, on the way to the 2011 peak just above $1,800, near the current price. Also, Goldman Sachs’ Jeff Currie is backing gold despite the Federal Reserve’s more hawkish tone, as the metal could offer a hedge against any potential policy missteps. According to the bank, there is a chance for bullion to rise if the FED mismanages its policy tightening. Looking at companies, we enter Q4/21 earnings season. According to BMO, the majority of companies delivered on expectations for back-half weighted production profiles in 2021. However, a handful of companies pushed out production increases to H1/22. Unsurprisingly, cost guidance for 2022 has been higher across the board y-o-y. Companies with cost inflation in the mid-to-high single digits were largely in line with expectations, but inflation has been steeper in some cases, with FX fluctuations playing a role, too. Looking at financial figures of the Precious Metals Champions Fund’s portfolio companies, the case looks still extremely appealing. For the first time since launch, the net debt-to-equity turned negative (-0.4%), meaning the companies have more cash than debt on their balance sheet. This leaves room for more shareholder-return through dividend hikes or share buybacks. The dividend-yield of the portfolio currently stands at over 3.2%, which is historically speaking extremely high for gold companies. The free cash flow-yield of close to 8% this year should give companies the ability to reward loyal investors for weak share performance in 2021.

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ICG Commodity Update – December 2021

The ICG Commodity Update is our monthly published comment on the energy, industrial metals and precious metals market.

 

Energy

2021 was exceptionally positive for the energy sector. WTI and Brent crude were up by more than 50%. While 2021 average oil demand was likely still below 2019 levels, end-2021 oil demand approached 2019 levels driven mainly by emerging markets. Preliminary data (implied oil demand) also suggests that US oil demand has fully recovered. Interestingly, natural gas and coal demand reached new record highs in 2021. Global natural gas prices mainly in Europe and Asia surged significantly over the last several months due to growing concerns about a potential energy shortage over the winter heating season against the backdrop of lower-than-normal global natural gas inventories. The oil market enters 2022 with OECD commercial oil inventories standing <2.7bn boe, the lowest level since 2014 and below the five-year average. Most of the oil supply growth in 2021 came from OPEC+, adding 1mboe/d of oil liquids in 2021 and higher production in Iran and Libya (exempted from cuts). However, the group’s cautious policy in reversing the production cuts implemented in 2020 was a decisive move to reduce oil inventories and support prices. Turning to 2022, OPEC+ compliance remains elevated so far and most analysts expect a balanced market in 2022 but an increasing deficit market after that driven by under-investments in the energy sector and infrastructure. Indeed, the oil and gas industry had a record low exploration success in 2021. According to Rystad the total discovered oil and gas resources in 2021 stand at 4.7bn boe, this is less than half the average of the last few years. It is worth highlighting that drilled but uncompleted wells (DUCs) have fallen to their lowest level since mid-2014, according to the EIA, indicating that US operators are completing more wells than they are drilling. Pressure from investors, who are focusing their attention on ESG issues, and not rewarding energy producers to increase their hydrocarbon output, is also a factor limiting supply growth. According to a poll released by the Fed of Dallas executives of publicly traded oil and gas companies have said they largely plan to keep production flat or expand output at low-single-digit percentage rates next year and focus on improving shareholder returns. However, they face also sharply higher costs. The index for input costs among service firms hit a record high in the survey, rising to 69.8 from 60.8 last quarter. Rising supply-chain disruption and associated inflation may have the potential to delay and impact drilling and completion activity in 2022. Nevertheless, the current average EV/EBITDA multiple of ~4x remains well below the long-term average of 6x. Considering that producers have maintained capital discipline, strengthened balance sheets and are focused on returning capital to shareholders many analysts estimate that the industry should be trading at premiums to historical averages versus the current discounts that stocks trade at.

 

Industrial Metals

Metals vital for making rechargeable batteries in electric cars are set to extend their stunning rally into 2022, potentially increasing costs for automakers and blunting a key weapon in the race to slow climate change. Metals from aluminum to zinc are in the throes of an unprecedented boom as the global push toward a greener future fire up demand for materials. At a time of constrained supply exacerbated by the pandemic. Analysts expect the supply-chain constraints that impacted the movement of materials last year to remain well into 2022. Lithium for example is expected to stay at relatively high levels for a while, bolstered by buoyant downstream consumption and constraints in brine production capacity and spodumene supply. The lithium market has tightened last year due to underinvestment and low prices. As miners scurry to expand capacity, long-term electric-car demand bodes well for the material that’s used in virtually all EV batteries. Even though the climate should be a prime time to build a lithium mine, Rio Tinto is finding out otherwise. Within months of unveiling plans for a $2.4 billion mine in western Serbia, local opponents organized a movement that’s rocked the government and brought cities to a standstill as thousands of protesters march in the streets. Authorities subsequently suspended a land-use plan for the proposed mine, though they didn’t reject the project completely. We have talked to numerous companies last year which stated the same problem. Getting the green light to build a mine is increasingly hindered by lengthy and expensive permits on sustainability concerns. Industry executives consider it their biggest challenge going forward. Historically, mining offered jobs and economic development to typically poor areas, with taxation and royalties to fill government coffers. But all too often, people living nearby paid a price for environmental degradation. That’s changing – locals are pushing back, deciding that the economic benefits don’t outweigh the costs to their quality of life. Governments also are increasingly unwilling or unable to override those concerns. Despite mining’s contribution to almost every aspect of modern life, the industry is still seen as one that takes more than it gives. It’s become more difficult to build a mine today than it ever was before, even when prices are high, and supply is needed everywhere. Antofagasta, one of the largest copper miner in the world, says that mines typically take about 15 years to go from discovery to production. Rio Tinto’s CEO states that a mine built in the 2020s, that’s going to be around for decades, is going to look very different from something built 50 years ago, or even 20 years ago and he is pushing to get this message across.

 

Precious Metals

Gold is starting the year under pressure after its biggest annual decline since 2015 as central banks started to dial back pandemic-era stimulus to fight inflation. Traders are also monitoring the risks posed by the omicron virus variant. Analysts don’t expect the price of gold to free-fall as real rates and yields are set to remain at a historically low level, very close to zero until the coast is clear from the strains of Covid-19. Ten-year Treasuries had the worst start to a year in more than a decade, according to Bloomberg data. Higher yields diminish the appeal of non-interest-bearing havens like gold. After the FED retired the word “transitory” for rising inflation, this could ignite gold’s safe-have appeal for wealth preservation after a long phase of consolidation. Since inflation expectations have been accurately measurable, historically gold has risen both nominally and in real terms every single time inflation expectations were on the rise, with one exception being the 1999 period and the bursting of the tech bubble, when inflation expectations peak and gold traded flat. According to Cantor Fitzgerald, the key takeaway being, historically, when inflation expectations have been rising, gold has never traded down. This also held true immediately following the COVID-induced sharp market crash in Q1/20, when inflation expectations initially collapsed, and then began to spike. Gold rallied to new all-time highs within six-months of the crash. The anomaly is in the nine-month period that followed from August 2020 to April 2021, when inflation expectations continued to rise, and gold did trade down, the first time on record. Through most of this mid-2020 to mid-2021 period, the general narrative was that inflation was “transitory.” This is starting to shift now to inflation that is “persistent.” When this sentiment turns in earnest, and the consensus view moves to “higher inflation is going to be with us for longer”, analysts expect the gold price to re-connect with its historical positive relationship to inflation expectations. On the company side, Newmont, sold $1 billion of bonds giving it a financial incentive to cut emissions and improve corporate governance, the first company in the energy-intensive industry to issue such securities. The 10-year bond will pay investors a higher interest rate if it fails to cut emissions, or to sufficiently boost the percentage of women in its senior leadership positions by 2030. Newmont aims to reduce direct emissions from operations and indirect emissions, or scope 1 and 2 greenhouse gas emissions, by 32% by 2030 base on a 2018 baseline. Also, the M&A-wave continued with Kinross to buy Great Bear Resources for about C$1.8bn in stock and cash.

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