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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ICG Commodity Update – November 2021

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

 

Energy

A new COVID-19 variant called Omicron has put energy prices under heavy selling pressure, with oil prices falling by 20% to below $70/bl or a 4-month low. Lower market liquidity post the Thanksgiving holiday in the US has also likely exaggerated the move. So far South African health officials are not nearly as alarmed as some media out there and are reporting predominantly mild cases but data on Omicron is also sparse. Nevertheless, several countries started to reintroduce lockdowns and restrictions on movement. Against this backdrop, the OPEC+ alliance will decide on their supply policy for January later on Thursday. The emergence of the Omicron variant could provide the group with the needed excuse to defer the planned output increase, which could partially also offset the release of strategic inventories. This after a move that was long on political theatre and short on fundamental market impact, President Biden announced the strategic release of 50 million barrels of crude from the Strategic Petroleum Reserve over the coming months. Meanwhile, the rapid recovery in oil demand in 2021 proved the naysayers wrong and nothing has emerged so far that suggests the Omicron variant will prevent the recovery. Global oil demand reportedly has returned to pre-COVID-19 levels of roughly 100 million b/d led by the strong recovery in demand in the US and Asia. US gasoline demand achieved record highs this past summer while Asia demand resumed its two-decade long growth streak. Most analysts believe that oil demand will continue to grow through 2022 and beyond for a while. Therefore, structural underinvestment in oil and gas supply, combined with robust demand and rapidly shrinking OPEC+ spare capacity are likely to support higher oil and gas prices for some time according to JP Morgan. Further to that, they estimate that the ‘true’ OPEC spare capacity in 2022 will be 2mb/d (43%) below consensus estimates of 4.8mb/d. There are first voices out there, saying that if this trend continues, we may reach by 2023 a period without any excess global pumping capability, this would be a new period in the history of oil. As prescribed the oil and gas equities sold off during the last few weeks but less than the oil price. This is quite an exception and may be related to the improving sentiment towards the strong fundamentals of the industry. Rystad Energy’s annual cost of supply analysis has revealed that costs within the upstream sector have come down considerably in 2021, making new oil more competitive and significantly cheaper to produce. The average breakeven price for new oil projects has dropped to $47/bl – down around 8% over the past year and 40% since 2014. Therefore, with lower cost structures, better balance sheets and continued capital discipline there is still ample FCF for shareholder returns. Because companies hit debt targets, we are persuaded they will contine to increase allocations to shareholder returns.

 

Industrial Metals

According to analysts, copper holdings tracked by the world’s metal exchanges look set to hit the lowest level since late 2005 within the next few days. That may signal a tighter global market, buttressing prices just as omicron concerns rock risk assets. Holdings of copper in LME sank 45% in November, falling for a third month. They’re now just a whisker above the low registered in September 2020, and a small, additional draw would cut them to the lowest in 16 years. It’s significant that, at the same time, stockpiles in China are already close to the lowest since 2009. November was volatile as investors evaluated the economic threat of the omicron coronavirus variant and comments by the FED that signal a faster-than-expected end to the central bank’s asset purchases. Market participants perceive the recent rise in COVID-19 cases as downside risks to employment, economic activity, and increased uncertainty for inflation. Even with inventories historically low, key base metals including copper and aluminum remained under pressure in November as traders grappled with weaker demand in China, where an energy crisis and property slump has hurt consumption. In China, the latest manufacturing data offered some positive signs though. Chinese factory sentiment improved, growing for the first time in three months and easing fears around the country’s slowdown. Premier Liu He said recently, the country’s economic growth this year will exceed targets. The government plans more support for businesses and is fully confident of prospects for next year. On the equity side, global dividends rose by 22% year-on-year on an underlying basis with 90% of companies either raising them or keeping them steady over the third quarter. The mining sector fueled most of the rebound according to the financial times. With soaring commodity prices, many mining companies delivered record profits, in turn increasing shareholder payouts. BHP for example, is expected to be the world’s biggest dividend payer this year, distributing almost $18.9bn to shareholders. This coincides with the statements of companies we recently talked to. Most of the companies prioritize shareholder returns via dividends and share buybacks as well as internal growth over expensive mergers and acquisitions as the industry overall is basically debt-free. Especially small to midcap companies, which didn’t pay dividends in the past, thinking about installing regular dividend payments to attract mainstream investors. In our opinion, this makes sense. The industrial metals champions fund currently has a free cash flow yield of 12.1% (2022E) with a historically low net-debt-to-equity of only 7% – there is enough room for more shareholder returns.

 

Precious Metals

Gold edged higher as a new COVID-19 variant emerged, but also declined to where it started the month after hawkish hints from the FED buoyed the dollar and blunted support for the metal. After surging to a five-month high earlier in November, the precious metal lost most of its gains. Prices have come under pressure as a slate of FED policy makers said they were open to a more rapid removal of pandemic-era stimulus in response to accelerating inflation. Federal Reserve Chair Jerome Powell said the strong US economy and elevated inflation could warrant ending the central bank’s asset purchases sooner than planned next year. The dollar is being bolstered by a flurry of positive US economic data including a jump in consumer spending while Treasury yields rebounded, denting bullion’s appeal. On the other hand, traders are still assessing the uncertain outlook for growth. Economists are warning that possible new lockdowns risk derailing plans to withdraw monetary stimulus, while reinforcing the same imbalances that have fueled the current wave of surging consumer prices. On the company side, Gold Fields has budgeted to spend $1.2bn on reducing its carbon footprint by 2030 according to the CEO. The company committed to reducing its Scope 1 and 2 carbon emissions by 30% on a net basis and by 50% on an absolute basis by the end of the decade. Moreover, they are targeting a recycling or reusing rate of 80% of its water and a reduction in freshwater use of 45%. Also, Impala Platinum revived its pursuit of Royal Bafokeng Platinum, seeking control of the smaller South African miner in an escalating battle with Northam Platinum. Implats valuing the miner at $2.7 billion and has long wanted to own Royal Bafokeng’s low-cost mechanized assets, which are key to prolonging the life of its own deep-level operations in the adjacent Rustenburg mining complex. More M&A related news are coming from B2Gold, the Canadian company is interested in acquiring gold assets in Zimbabwe and has held talks with the government and other officials in the southern African nation. The company said they are looking at it as intriguing potential with some advanced projects as well as exploration potential. Further, Hochschild Mining said it has agreed to buy Amarillo Gold in Brazil for about $106mn in a move that would diversify its Peru-focused operations. The deal comes after Peru’s government backed away from a plan to withhold further permitting extensions at Hochschild’s two most important mines in the country which sent shock waves through the local mining industry and depressed the share price of the company.

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ICG Commodity Update – October 2021

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

 

Energy

The COP26 Conference has just begun in Glasgow. A critical opportunity for countries to make progress on their plans to reduce emissions. The easy work is the pledge, the hard work is following through. Nevertheless, the new energy economy will be more electrified, efficient, interconnected and clean. However, the rapid but uneven economic recovery from last year’s Covid-induced recession is putting major strains on parts of today’s energy system, sparking sharp price rises in natural gas, coal and electricity markets. For all the advances being made by renewables and electric mobility, 2021 is seeing a large rebound in coal and oil use. While the energy transition theme is likely to present enormous market and investment opportunity, it needs to be executed delicately. There is no doubt that energy transition presents a major go-forward challenge for the oil and gas industry, but it is not going to culminate overnight. First, the IEA in its most recent World Energy Outlook conceded that the world remains far off of a “net zero” trajectory, and the “Announced Pledges” of world governments to date do not translate to a meaningful decline in oil demand until after 2030. In addition, the world will require a lot more natural gas production to bridge the gap between now and a renewable future. Indeed, natural gas emits half as much carbon as coal and may smooth the switch-over to the likes of wind and solar energy. Second, we think, the energy sector has to be at the heart of the solution to climate change. Fossil fuel divestment, in our view, stands as a permanent negative call on an industry that may be more dynamic and innovative than some market observers expect. As the CEO of Shell recently said, the revenues generated by the oil and gas business is financing the investment in renewables. The energy sector as a whole was the second-highest producer of green patents! Investors who sell their shares pass up the opportunity to engage with management and use their leverage as long-term shareholders to push for ESG improvements, including energy transition plans. About 1’300 institutions across the capital markets have committed to fossil fuel divestment. The issue of fossil fuel divestment in some ways has become politicized and may pose difficult questions for fiduciary investors if the sector continues to outpace the market. We believe that energy companies are likely to continue to benefit over the short run from a favourable market environment driven by a combination of increasing global energy demand and potential crude oil and natural gas supply shortages stemming from unprecedented underinvestment. As the recent 3Q results showed, the positive trend we saw in the 2Q continues with record high revenues and profits. Allowedly, after years of poor returns, the oil and gas companies are trying to woo investors by giving most of the extra cash they’re making into share purchases and rising dividends. We like that!

 

Industrial Metals

In October, copper inventories available on the LME hit the lowest since 1974, in a dramatic escalation of a squeeze on global supplies that sent spreads spinking and helped drive prices. Copper tracked by LME warehouses that’s not already earmarked for withdrawal has plunged 89% last month after a surge in orders for metal from warehouses in Europe. Stockpiles have also been falling fast on rival bourses and in private storage, and LME spreads have entered historic levels of backwardation, with near-term contracts trading at record premiums. The slumping global stockpiles and resilient demand for copper stand in stark contrast to mounting worries over the macroeconomic outlook, and the risk that stagflation and power shortages could derail the world’s strong growth trajectory. Base metals took a breather on the race to record highs amid concerns the energy crisis could slow down a nascent global economic recovery. Soaring energy prices are raising production costs for metals producers and forcing smelters to close even as inventories are dwindle. Power shortages are also forcing manufacturers to cut production, meaning they’re using less metals, especially when it comes to energy-intensive ones like aluminum and zinc. The higher cost pressure for everything from power to raw materials are leading to fears of higher inflation and a slowdown in global growth. On the other hand, fears of inflation could also increase demand for metals as there is a perception that they are a hedge against inflation, which is especially true for gold and copper. The supply curtailments started in China as the country restricted power to energy intensive industries and have now spread to Europe as the region faces its own power problems spurred by record gas prices. For example, Glencore’s zinc cuts followed an announcement that Nyrstar, one of the biggest zinc producers, would reduce output at three European smelters by up to 50% due to rising power prices and costs associated with carbon emissions. Meanwhile, Matalco, the largest US producer of aluminum billet, warned its costumers it may curtail output and ration deliveries as soon as next year amid a magnesium shortage. Steelmakers, including ArcelorMittal, have also cut production. As most metals are in backwardation and physical demand high, the ingredients are there for materially higher prices across the board. According to Anglo American, the global energy crunch could be repeated in metals markets in future years as supply falls well short of demand during the transition to greener power. With an average lead time of about 15 years to bring a new mine online, supply is likely to undershoot demand. That could replicate the dynamic seen in global energy markets, where years of underinvestment have left producers ill-equipped to compensate for a drop in renewable power output. The looming shortages of metals are forcing miners to reconsider investing in riskier jurisdictions, with BHP considering buying into a project in the DRC. The world’s biggest miner has become more receptive toward riskier operating environments for growth projects that offer access to the best mineral deposits. Exploration budgets in general are slowly coming back with copper exploration being on the rise but the industry may need greater assurance that the market can hold at high levels before meaningfully expanding budgets. Producers have adopted a cautious approach after being squeezed by years of low prices at a time that deposits are getting trickier and costlier to find and develop. Overall mining exploration spending this year is still a little more than half the all-time high of 2012. Activity is expected to rise about 10% next year, as drilling increases for gold, copper, and battery metals, before plateauing in 2023 and declining in 2024, according to S&P.

 

Precious Metals

Gold posted a monthly gain in October even as central banks globally prepare to rein in pandemic-era stimulus. There have been some recent signs of investor interest in gold ramping up. By the end of the month, hedge funds trading the Comex boosted their net long position the highest in 12 weeks, while exchange-traded funds had modest net inflows, snapping five weeks of outflows. According to analysts, rapid tightening cycles and unbalanced recoveries could trigger demand for gold over the coming quarters. Gold’s traditional role as a hedge against inflation has faltered all year but growing risks that the global recovery could stall as price pressure rise may signal turnaround for the precious metal. Energy shortages in some parts of the world, an associated sharp rise in energy prices, slowing industrial activity, and the delta variant disrupting the services recovery have raised the specter of stagflation. Indeed, inflation expectations are rising and growth expectations softening for the short run. According to UBS, these risks could support gold prices in the next month or two, particularly if concerns about stagflation persist—historically, gold has performed well during periods of stagflation. When most economists and investors talk about stagflation, they typically refer to the early 1970’s and then from 1975 to the very end of 1979 with the “Oil Shock”. During these two periods, gold prices rose +200% and +325% in nominal terms respectively and rose considerably in real terms as well. On the company side, Impala Platinum Holdings is in talks to buy its smaller rival Royal Bafokeng Platinum, in a deal that Implats said may create South Africa’s largest platinum-group metals producer. Flush with cash after higher rhodium and palladium prices, the company is seeking to expand by buying lower cost and mechanized assets as some of its deep-level operations near their end. A deal would help the producer exploit synergies from deposits adjacent to its sprawling Rustenburg mining complex. It should also extend the life of the mines and end royalties that Implats was paying to Royal Bafokeng. Stricter car-emissions rules have kept palladium and rhodium, key metals in autocatalysts, in tight supply and at historically high prices, increasing earnings for mining companies. Implats in September reported a record profit, prompting it to boost its dividend. Also, Sibanye Stillwater’s deal in October to pay $1 billion for nickel and copper mines in Brazil shows how miners are looking to use cash to expand. After buying up PGM assets from Zimbabwe to North America, Sibanye is now looking toward battery metals needed for a green revolution. The precious metals champions metals fund holds a stake in all of the three mentioned companies.

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TXF Global Commodity Finance Conference 2021 – Panel Discussion: The role of copper in the energy transition

Pablo Gonzalez, our Senior Portfolio Manager, was invited to speak at this years TXF Global Commodity Finance Conference in Geneva about the role of copper in the energy transition. You can watch the panel discussion in the video below. You can also access the slides by clicking the respective link.

 

Independent Capital Group – Slides for the TXF Global Commodity Finance Conference

 

 

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ICG Commodity Update – September 2021

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

 

Energy

The latest gains for oil prices have come as part of a broader rally in energy markets, with depleted natural gas inventories and resurgent economic activity sparking fierce competition in Europe and Asia for natural gas to feed their power markets. A global natural-gas production deficit, depleted inventories, lower imports from Russia and a push from the Chinese government to slash emissions (switching out coal for gas) have all played a role in pushing gas prices higher. That comes as the Northern Hemisphere heads into the winter indoor heating months. Futures for US natural gas reached $5.8/MMBtu last week. They are up some 130% this year while European natural-gas prices have more than quadrupled this year. Coal and carbon-permit prices headed higher, too, adding to the strain on energy-hungry companies and industries in Europe and Asia. India’s power plants have only 4 days left of thermal coal stocks. A shortfall in global energy supplies is spilling into crude markets and could add momentum to this year’s rally in oil prices according to several analysts that increased oil price forecasts. Power plants are already starting to switch from using natural gas to using oil in Asia. China ordered its state-owned companies to secure energy supplies for winter at all costs. The order from Beijing is the latest sign that rising energy prices are becoming a political issue, after the White House recently said crude’s rally was a concern. Meanwhile, the OPEC+ alliance will meet today to review the next monthly increase. Paradoxically, high prices are partly the result of cuts to exploration budgets. Globally, producers have cut back capital spending by about half over the past decade. Therefore, not surprisingly, OPEC’s said consumers should brace for more energy shortages unless the world boosts investment in new oil-and-gas development. Despite its clear unpopularity the energy sector has been the best performing sector within the S&P 500 this year by a wide margin. Indeed, oil and gas companies are earning as much cash as never before. The positive price outlook and rising demand for oil has prompted renewed M&A activity, with ConocoPhillips agreeing to acquire Royal Dutch’s Permian Basin assets for $9.5bn in cash. This perhaps portends further consolidation among industry players as the O&G majors divest of assets for ESG reasons and smaller operators exit the market. Finally, we think, it’s becoming increasingly understood that the various ESG policies to reduce fossil fuel usage are having a counter-productive effect on energy prices, as renewable energy generation is not able to bridge the gap between continued demand and fossil fuel plants going offline as we transition to renewable energy sources. Interestingly, the OPEC secretary M. Barkindo said: the world can’t afford to underinvest in oil and the energy crisis in Europe and many parts of the world is a wake-up call. The ECF continues with an absolute and a relative strong performance.

 

Industrial Metals

The power crunch in the top base-metals consuming country has triggered production losses at smelters and fabricators in the past few months, hitting both supply and demand for everything from copper to tin. So far, the biggest impact has been felt at energy-intensive aluminum plants. According to Goldman Sachs, that has chocked off aluminum supply, just under 3 million tons of annual smelting capacity, fueling the metal’s rally to the highest level since 2008. While that’s already about 8% of China’s total capacity, the prospect of further power rationing as the country braces for higher winter demand will keep the sector under pressure. Policy makers in China are worried about higher commodity prices and are willing to intervene to drive costs down. While the nation’s position as the world’s top buyer gives some pricing power, ultimately, they’re hostage to the dynamics of supply and demand. According to analysts, Beijing announced the first of its metal sales in June, with more following in July and September. Since then, copper has remained near unchanged, while aluminum and zinc extended gains. Clearly, those sales were not enough to materially alter the market balance in the mid- to long-term. Looking at copper, prices for the bellwether commodity this year will probably average more than $4/pound – that would be a record annual average. The supply-demand equation for copper is very tight, even amid market-wide uncertainties fueled by Chinese property turmoil and global energy crunch. Copper plays a crucial role in in a global transition toward cleaner energy and transport. But not only copper, the world needs more mines to meet demand for battery metals required to shift to less polluting energy sources. The ability to build mines in a world where extractive resource industries has become more challenging as investors put greater weight on the environmental credentials of metals producers, while social issues including dealing with local communities have also been under the spotlight. That adds to industry challenges that include supply disruptions and rising cots of raw materials. The industry keeps its exploration budgets in check though. BHP, one of the world’s biggest miner, spent little more than it earned in an average 12-hour period last year exploring for new deposits. The company spent just $53 million looking for copper last year, when it posted record profit of $37.4 billion. The industry is universally bullish on copper, expecting a surge in demand while long-term supply looks constrained by the lack of new mine development. Yet part of the reason copper is so favored by miners and investors alike is because new deposits have been so hard to find. The company expects its total exploration spend to jump to $800 million this year.

 

Precious Metals

Gold prices were set for a second quarterly drop in three quarters as the prospect of the U.S. Federal Reserve tapering its pandemic-era stimulus strengthened the greenback, making bullion more expensive for holders of other currencies. Expectations that the Fed could withdraw economic support kept the dollar index near a one-year high. Spiking U.S. bond yields added to the currency’s firmness. Deepening safe-haven bullion’s woes, benchmark U.S. 10-year Treasury yields held above 1.5%, a level not seen since late-June. Reduced central bank stimulus and interest rate hikes tend to push government bond yields higher, raising the opportunity cost of holding non-yielding gold. While gold’s price action has been lacklustre, the fact that investors have already offloaded a lot of their gold holdings suggests prices shouldn’t drop much further. According to analysts, the fears of stagflation are growing ever stronger, which could once again spur interest in precious metals. Also, there are multiple crises currently threatening the global economy. In China, a slowdown in growth looks likely due to the power crunch and there’s still a risk from Evergrande Group’s financial woes. And while President Joe Biden has signed a nine-week stopgap funding bill that averts a government shutdown, it fails to resolve the threat of a US default linked to the debt limit. Even though gold ETFs suffer persistent outflows, holdings are still historically high. Looking at gold equities, Agnico Eagle Mines and Kirkland Lake Gold, the largest and second-largest gold producers in Canada, announced an all-stock merger, valued at about $13.5 billion that creates a new mining giant with its centre of gravity in Canada. The merged entity will produce about 2.5 million of its 3.4 million ounces of gold per year form Canadian gold mines. According to the companies, the deal will create regional synergies and at least $2 billion in savings during the next decade as the two companies have a large geographic overlap in their asset base, with a string of exploration properties, mines and ore processing facilities located in close proximity to each other. The low premium ties into a gold mining sector trend that dates to at least 2018 when Barrick Gold announced a no-premium all-stock merger with Randgold Resources valued at $6 billion and when Newmont announced its acquisition of Goldcorp valued at roughly $10 billion.

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ICG Commodity Update – August 2021

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

 

Energy

OPEC and its allies agreed to stick to their existing plan for gradual monthly oil-production increases after a brief video conference. Ministers ratified the 400kboe/d supply hike scheduled for October after less than an hour of talks, one of the quickest meetings in recent memory and a stark contrast to the drawn-out negotiations seen in July. In the US, a government report showed a further contraction in nationwide crude inventories to the lowest level in almost two years, while the nation’s oil infrastructure continues to grapple with Hurricane Ida’s impact. Nevertheless, most processors that were hit by Hurricane Ida escaped major damage and are expected to be back online within three weeks, according to IHS Markit. As mentioned already several times, we think the shift out of fossil fuels will take place more slowly than the consensus expects. During these transition years, the energy companies offer a very compelling investment opportunity. A recent study from BMO shows that the implied price of Brent-equivalent crude oil required to cover the costs of finding, developing, and producing a barrel of crude oil and/or natural gas worldwide slipped 17% in 2020 to average $57.0/boe vs. $68.7/boe in 2019. In perspective, global supply costs are now >50% below implied levels at the 2014 peak! With oil at +$70/bl the oil and gas industry has amazing cash margins. However, the controllable characteristic of companies with higher returns is a focus on costs. We believe the key to long-term investment success is in identifying companies that take the full-cycle cost management responsibility seriously, resulting in superior returns on capital. The same BMO study also expect the industry’s ROCE to recover to 8% in 2021 and reach 18% by 2023, on an unadjusted basis—nearly as high as 2005. Further to that, to protect shareholder value during periods of lower oil prices, many companies have reduced spending and focused on capital efficiency, harvesting of cash flow, and returning free cash to investors. This trend was obvious during the 2Q21 results and we think this will continue for years as the industry is developing in an absolute cash cow. Last but not least, the median forward EV/EBITDA multiples for the sector have hovered near historical lows since mid-2018, in sharp contrast to the broader market. To put all this in context, the ECF portfolio companies have low costs (cash costs $13/boe), low debt (net debt/equity 35%), a low valuation (P/CF 4.6x) and a very high free cash flow yield (18.5% for 2022E). We think, all this continues to sound very attractive. For us its no surprise that BMO expects a multi year upcycle on oil and gas.

 

Industrial Metals

In August, commodities slumped on speculation that economic growth will slow a rebound in demand for raw materials with metals, agriculture and oil falling. According to analysts, the Fed’s upcoming reduction of asset purchases will remove some of the liquidity, which led to profit taking of some investors. The fast-spreading coronavirus delta variant is adding to investor anxiety, with recent weaker-than-expected data in the US and China suggesting the global economic recovery is slowing. While iron ore fell from its May record, attention is now turning to an uncertain outlook for consumption, raising the prospect of more sharp, short-term moves. China’s demand is showing signs of faltering, though expectations are building that authorities may turn to infrastructure to help prop up the economy. Some analysts are still massively bullish from these levels given the anticipated steel demand recovery once China overcomes the current COVID-19 outbreak. The market is being buffeted by sometimes conflicting policies in China, the top commodity consumer. Officials had turned to stimulus to boost growth, fueling demand for commodities key to infrastructure. At the same time, they sought to cut steel output and expectations for a flurry of restrictions saw mills front-load production in the first half. On the other hand, there are also long-term supply constraints that are likely to underpin iron ore. Vale, the world’s largest producer, has been trying to recover output since a dam disaster more than two years ago, while Rio Tinto has said it’s struggling to keep up with demand. Producers say the market remains susceptible to supply disruptions and short-term spikes are likely. Aluminum, another commodity targeted by production cutting in China, reached a fresh decade high. Some investment banks forecasting even further gains as the industry braces for a potentially seismic shift into deepening deficits. Supply is increasingly challenged, particularly in top producer China. The energy-intensive aluminum industry has come into China’s crosshair during a crackdown on pollution, while a seasonal power crunch has also dented output – China is responsible for almost 60% of aluminum production worldwide. In the years to come, demand looks set to soar in EV and renewable energy, and efforts to rein in the aluminum industry’s heavy carbon footprint could spell the end of a decade-long era of oversupply. The rally is creating a huge windfall for producers who’ve been plagued by weak prices for years. But the gains over the past year are adding further fuel to concerns over inflation as manufacturers increasingly look to pass on costs to consumers. The portfolio of the industrial metals champions fund is invested in in two of the top producers, Alcoa and Norsk Hydro. The fund offers its investors an exposure of almost 10% to aluminum and alumina, one of the main ingredients for primary aluminum production.

 

Precious Metals

Gold has dropped this year as progress in battling the pandemic eroded demand for haven assets and prompted central banks including the Fed to prepare to taper stimulus programs. Chair Jerome Powell said last week the US central bank could begin reducing monthly bond purchases this year, with the labour market making clear progress. In a speech to the Jackson Hole economic conference, Powell signalled the US central bank will remain patient and repeated that he wants to avoid chasing transitory inflation and potentially discouraging job growth in the process – a defence in effect of the current approach to Fed policy. According to analysts, an underperformance in job gains may support the stance for lower-for-longer rates, potentially translating to strength for gold. On the company side, South Africa’s Impala Platinum lifts pay-out on record profit. The company announced a fourfold increase in its dividend after surging platinum-group metals prices yielded a record profit. Impala follows Anglo American Platinum and Sibanye Stillwater in boosting pay-outs to investors. The final dividend of $680 million brings the total pay-out for the year to an equivalent of about 50% of free cash flow. This completes a turnaround for Impala, which just two years ago was on the verge of cutting jobs and closing operations. Supply shortfalls for the platinum-group metals are continuing to buoy prices, even as automakers, the largest consumers of the metals, slow down on some operations due to shortages of semi-conductors. According to the company, the medium-term automotive demand outlook for PGMs remains robust, with tightening emissions standards and rising production volumes from a COVID-19-depressed base, likely to support firm demand through the middle of the decade. The CEO of Impala also said that the company is studying plans to refurbish an old base metals refinery in Zimbabwe to ease bottlenecks at its main plant in South Africa. The additional processing capacity could also help lift the company’s nickel and copper output and make it easier to participate in new projects. The precious metals champions fund offers its investors exposure to the attractive PGM-market and holds 5 top-producer in the space. The 5 positions have an average FCF-yield in 2022E of almost 20%, EBITDA Margin 2022E of 54% combined with low P/CF of only 5.2x and an average net debt to equity of 19%.

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ICG Commodity Update – July 2021

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

 

Energy

Brent averaged $74.3/bl in July, marginally higher +1.2% MoM, although this masks significant intra-month volatility. Oil prices have increased by 50% since the beginning of the year but circumstances changed in mid-July when OPEC+, after two weeks of haggling, reached a deal to boost production by 400kboe/d every month starting in August, with the baseline being increased for some countries. Indeed, some days ago, a Reuters survey reported that OPEC oil output rose in July to its highest level since April 2020 at about 26.7mboe/d, up 610kboe/d from June’s revised estimate. Therefore, output has risen every month since June 2020, apart from February. Interestingly, fundamental data continues to be robust with high frequency inventory falling 16.7mboe or 1.3% WoW and down to the lowest level this year. This suggests that despite increasing production levels, the market continues to be in deficit. It’s worth noting that 2H21 looks likely to remain in supply deficit, according to several analysts. Nevertheless, at the same time, the accelerated spread of virus mutations in recent months has stoked fears that the global economic recovery and with it the oil demand growth could be slowed. This, coupled with signs of increasing inflation risks, caused stock markets and oil prices to contract during the month (Brent falling 7% or ~$5/bl on 19. July). Oil and gas equities have seen a sharp pullback with all this (US shale XOP Index fell 20% in 2 weeks). On the other side, all 3 major gas hubs rallied further in July. This is the fourth consecutive month of price increases in natural gas. The gas market appears to be sending a clear warning signal to energy markets of the dangers of curtailed investment but recovering demand. A further focus on the micro side has been on oil and gas companies 2Q21 reporting season for signs of an increase in forward production guidance, but Exxon and Chevron reporting suggest that discipline will remain for now. The same with the listed small-to-mid-cap space where capital discipline paired with strong energy pricing is leading independents to enjoy a period of super-normal FCF generation, driving accelerated balance sheet repair and potential for increased shareholder return. All this was also visible in Europe where the Oil Majors reported strong earnings and strong increases in dividends and shares buybacks. ESG remains high on everyone’s agenda, but there is an increasing focus on tangible measurements of ESG metrics and greater emphasis on ‘direction of travel’ allowing for more rational differentiation we think. Nevertheless, global oil and gas companies have cut capital spending since mid-2020 as calls for them to cut carbon emissions and adopt sustainability policies grow while producer margins over the coming couple of years are among the highest at any point in history.

 

Industrial Metals

According to Goldman Sachs, commodities are set to rebound sharply after their recent sell-off unless there are widespread lockdowns to tackle the delta variant. If delta risk does not materialize, commodities are set for the next leg higher. The risk of material lockdowns is still relatively low, and the bank said, even if that happened, it would only delay their outlook by six to eight weeks, given past experience. Broad commodity demand has yet to be impacted and nearly every raw material market is still in deficit, while the structural drivers remain intact. The metals and mining companies have been holding back on capex, M&A and opting to return more cash to shareholders rather than push organic growth. Variable dividend policies tied to free cash flow have enabled higher payouts, subsidized by lower capital spending rather than an increase in debt. Debt across the industry remain at historically low levels. Despite ample financial capability for M&A, activity is the slowest in years. In general, the mining sector has been one of the biggest beneficiaries from the world’s efforts to emerge from the pandemic. The trillions of dollars poured into recovery packages have ignited demand for commodities, driving prices sharply higher and sending inflation pressures rippling through the global economy. While previous rallies lured the industry into ambitious investment plans to build and expand mines, many producers this time appear to content to return their profit windfalls to investors. Indeed, all the five Mining Majors reported their biggest-ever earnings for the six month through June and this resulted in announcing record returns to shareholders via strong dividend increases and more shares buybacks. Mainly iron ore has been a big driver of profit for the largest producers. The world’s biggest commodity after oil hit a record in the first half and has spent the last three months hovering around $200/t, a level not seen in a decade. Steel and copper prices both set fresh records this year, thermal coal has also soared, and even diamonds have had a resurgence. Even after a recent set-back, commodity prices across the board remain historically high for now and bless the mining industry with bumper profits. One of the largest copper producers, Freeport-McMoRan, gave a hint of what to expect – the company has wiped out $5bn of debt in the last 12 months, hitting its target months ahead of schedule, and setting the stage for an increase in shareholder returns. Of course, the mining companies are not immune to inflation themselves and are grappling with a rise in input costs such as oil or rising labor costs due to worker shortages. Also, governments in resource-rich countries, especially in Latin America, are looking at the industry as a source of extra revenue – for now though, the miners are cashing in like never before.

 

Precious Metals

Gold has just gone through a very healthy year of consolidation after hitting a high of $2’089 on Aug 7th, 2020. But don’t count gold out yet. According to analysts, it could be only a matter of time before gold prices turn back towards $1’900/oz and its all-time highs from last year. Gold prices have struggled to hold support around $1’800/oz as bullion is seeing little benefit from new lows in real interest rates. Commodity analysts at Credit Suisse noted that real yields are lower than levels observed last year when gold prices were trading at $2’000/oz. The lower real rate is being driven by increased demand for inflation-linked Treasury bonds amid concerns on the delta variant’s impact on US economic growth. It appears that gold prices have decoupled somewhat from yields in recent weeks, but Credit Suisse doesn’t expect this to last, suggesting near-term upside for gold. Peaking inflation, strong job growth, and the announcement of QE tapering could still bring some downside risk to the gold market, weighing on investment demand – including ETF outflows. Goldman Sachs expects the recent move in real rates to create a perfect setup for defensive investment demand into gold. The lack of gold performance so far this year is likely due to negative wealth shock to emerging markets from a stronger dollar and COVID-related income shocks, particularly as many emerging markets lack the social safety nets, according to the bank. Looking at equities, analysts say that price-to-earnings as well as price-to-book relatives have bounced from levels that ordinarily are associated with lows and are abnormally cheap on these measures – the companies of our PMC fund have a P/CF of only 7.1x and a P/E 2022E of 9x compared to the benchmark GDX which has a P/CF of 12.1x and a P/E 2022E of 18x. Historically speaking, gold shares trade at the same index level as 25 years ago, but with a 4-5 times higher gold price. Also, gold and gold equities can be a good diversifier against extreme global leverage. Both the commodity and the companies have lagged against other asset classes this year, indicating potential upside, especially when looking at profitability measures with ultra-low net debt – the companies of our PMC fund have an implied free-cash-flow yield of 15% in 2022E with nearly no debt (net-debt-to-equity of only 2%), while the benchmark GDX implies a 7% free-cash-flow yield in 2022E or just half as much. While the industry overall is valued cheaply, making enormous high free cash with low-to-no debt, our portfolio companies showing above average financial and operational metrics relative to its peers.

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ICG Commodity Update – June 2021

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

 

Energy

Oil recently rallied to above $76/bl, its highest level since October 2018. Unlike then, when the market was supported by excessive fear of a potential stop in Iran oil exports, the current rally is driven by a steadily tightening physical market, with strengthening time spreads across WTI, Brent and Dubai. The tight WTI-Brent differential implies that North America is driving the current deficit, as local demand rebounds in the face of inelastic local supply. This tightening is in fact running slightly ahead of most analyst expectations, with high-frequency mobility and flying data pointing to global demand currently near 97.5mboe/d and with shipping data pointing to a still moderate ramp-up in OPEC+ exports. Goldman Sachs estimates that the global market is in a 2.3mboe/d deficit currently, with the remaining excess inventories down to 330mboe. At the current rate of draws, this excess will be gone within 3 months. However, oil prices are down this week as the market awaits the next OPEC+ decision, scheduled for July 1. While the need for higher OPEC+ output in August is clear, there remains uncertainty on the magnitude of this next output hike. Ultimately, much more OPEC+ supply will be needed to balance the oil market by 2022. Analysts forecast demand to rise by an additional +2mboe/d by year-end, leaving for a 5mboe/d supply shortfall, well in excess of what Iran (1mboe/d max) and US shale producers can bring online (expected up 0.3mboe/d through year-end). Therefore, it’s not so surprising to see some commodity traders like Trafigura or bank analysts like Bank of America saying oil may surge to $100/bl next year.
After the hard times of 2019/20, the higher oil prices came initially as a relief and now as an opportunity for the oil and gas producers. Firstly, a wider array of organic developments should provide good returns with budgeting at $60/bl; and secondly, the large-scale continuing divestment by the major oil companies – driven by a push towards greener energy – is providing scope for inorganic growth. Oil and gas companies are generating record free cash flows currently and valuation continue to be depressed. Further to that, futures prices for crude oil and natural gas remain well ahead of sell-side consensus expectations based on data compiled by Bloomberg. This suggests material CF / EPS revisions are anticipated in the coming months. We continue to see the current environment as a very attractive investment opportunity for the natural resource sector.

 

Industrial Metals

The global economic recovery continues and remains metals intensive, with demand expectations still being pushed higher. With this, analysts expecting widespread supply bottlenecks in terms of both raw materials and logistics. However, China’s anti-inflation rhetoric has been stepping up, dampening both physical demand aggression and financial market positioning. Analysts remain positive on current commodity prices and especially pointing out industry free cash flow which looks extremely robust. While demand tailwinds may be easing, with extended lead times and raw material markets susceptible to disruption, a supply risk premium to the cost curve can be justified over the coming quarters. Additionally, and adding another layer of complexity to commodity markets is the unusual situation where the developed world is leading industrial growth instead of China, mainly owing to the different timing of 2020 lockdowns. As excess economic support is slowly drained from the Chinese economy, the US and Europe currently lead the way in physical end-demand indicators. As the IEA recently noted, the shift towards clean energy naturally involves burning less fuel but building more equipment. Indeed, on the IEA estimates, since 2010 the average amount of minerals needed for a new unit of power generation capacity has increased by 50%, with an onshore wind facility requiring nine times more mineral resources than a gas-fired plant of the same capacity. According to some analysts, the energy transition is much more important for future demand than for the current market, and while the thematic trend has undoubtedly driven asset allocation towards the sector, in their view it is merely a supporting act in the current demand upcycle. The metals and mining industry on the other hand isn’t immune to inflation. Oil prices are a significant input cost – analysts expecting to see cost inflation creep into earnings over the coming quarter. However, unlike previous cycles we are not seeing the same surge in capex-related costs, with lower growth spending meaning less exuberance in pushing projects. Furthermore, management is expected to remain disciplined and as a result, cost gains are unlikely to provide shocks. Most commodity prices remain trading well out of cost curves and with the relative lack of supply response, there is less need to spend time pushing supply off the market through the inevitable cycles over the coming years. This should lead to a period of sustained free cash flow and strong margins over the coming years well above longer-term cyclical norms for incumbent producers.

 

Precious Metals

Although precious metals already have one eye on a potential Federal Reserve tapering cycle, analysts expect relatively sticky demand support for gold and silver from both central banks and ETFs over the next few months, particularly if wider market volatility increases. Unsurprisingly, given rising inflationary pressures and positive economic growth surprises, central banks around the world are increasingly setting the stage for less accommodative actions over the coming months and quarters. As Federal Reserve Chair Powell recently noted, it is time to start talking about tapering. As BMO Economics notes, Fed policy (and the same is true for many other central banks) appears destined to become less accommodative but remain meaningfully net accommodative overall through 2023 at least. Compared to other commodities, 2021 hasn’t been a great year for gold so far, with current prices slightly down over those at end-2020 and ETFs seeing outflows. And yet, things are well on course for yet another annual average record in terms of nominal price. For gold producers, even with cost inflation starting to show some signs of a comeback, operating margins are extremely robust, and with the industry now showing impressive capital discipline relative to past cycles, analysts anticipate strong free cash flow over the coming years. This is seen as the important story for gold equities, rather than potential for further aggressive underlying commodity price gains. Regardless of this, investors continue to be generally sceptical of the discipline of company management teams and potential for erosion of free cash flows including the increasingly heated M&A market, which has seen a recent influx of transactions at higher premiums (versus the zero-premium “mergers of equals” which were seen last year). With a relatively flat, but very robust precious metals pricing environment, analysts believe that the entire group is trading at a discounted level. This can be seen for the Precious Metals Champions Fund portfolio companies. While trading at a P/CF of 6.9x and a P/B of only 2.9x, the expected free cash flow yields for 2021E, 2022E and 2023E are at 10.8%, 14.5% and 14.2%.

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ICG Commodity Update – May 2021

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

 

Energy

The Brent crude oil price closed >$70/bl for the first time in two years on investors’ optimism that improving demand and a dwindling supply glut may mean the market can absorb additional production from OPEC+. Indeed, OPEC+ agreed to continue relaxing curbs on oil production. Vaccination programs are enabling governments across North America and Europe to reduce coronavirus restrictions and resume more normal economic activity. In the US, oil and oil-product inventories have fallen more than expected in recent weeks, thanks in part to a pickup in demand for transportation fuels. However, this month the supermajors’ transition strategies were in the spotlight. Indeed, demands on big oil to adopt policies supporting the energy transition are escalating. The Hague court in the Netherlands ordered Shell to cut its emissions by 45% by 2030, an order that includes scope 3 emissions. Shell is appealing this ruling. In the US, the activist fund Engine No.1 won two board seats on Exxon’s board. This follows a debate with the company’s management over its energy transition strategy, which the hedge fund claims to be ‘value destructive’, as it keeps focusing on fossil fuels. On Chevron’s side, shareholders backed a proposal calling for the company to ‘substantially’ reduce scope 3 emissions in the medium to long term with 61% approval. These events will likely have long-term reverberations for the energy industry regarding capital allocation, oil supply/demand balances and legal and governmental issues. Further to that, the IEA created waves across the industry through the launch of its report “net zero missions’ by 2050”. One of the recommendations is that there is no new investment in oil and gas beyond 2021. Underlying this recommendation is its assumption that global oil demand declines steadily as consumers change behaviours and new technologies are rapidly (and aggressively) adopted. While we recognize the IEA is merely providing a scenario and highlighting policy options to achieve a net zero world by 2050, we believe that some recommendations are still illusory. In our view, the effect of a sudden complet stop of investments in the fossil energy industry could harm the world more than it helps, at least in the short-term. We think it’s nearly impossible to change the whole supply chain and infrastructure in such a short period of time. The renewable “alternatives” are definitely not ready to absorb this increasing energy demand yet. We need a change but unfortunately its not as fast as some people (govt) would like to have it. Some analysts even think that all these efforts create a very real possibility of crude oil prices spiking to unprecedented levels within the next few years. Ironically, such a spike may be just what environmental-leaning governments would like to see. Nevertheless, ECF companies are in their best shape in history and have a FCF yield of 12% this year, EBITDA margins of >60% and with a valuation of 5x EV/EBITDA continue to be in a sweet spot.

 

Industrial Metals

In May, many metals hit new cyclical highs as buyers fear further inflation scramble for supply, particularly as freight bottlenecks inhibit prompt deliveries. As supply risk remains prevalent, analysts expect prices at elevated levels over the coming months and thus, mining industry margins to remain extremely strong across both base and precious metals. Especially in the steel space, analysts expect industry margins to remain well above through-cycle norms for the next quarters. Steel is the cornerstone of global industrial growth, but it is also an industry where, over much of the past decade, low effective capacity utilization has kept margins subdued. And one key element driving that has been ongoing Chinese capacity additions and resultant deflation shipped to global markets via elevated exports. However, China’s decarbonization push has the potential to alter this trend dramatically, at least in the near term. With export rebates removed and China’s government reportedly gearing up for further capacity curbs to lower emissions into H2 this year, analysts are confident that Chinese net steel exports will be significantly lower for the rest of the year. Meanwhile, the situation is most acute in North America. US spot HRC prices reached another all-time high last month on extended supply tightness and strong demand. Most of the supportive drivers remain intact, with exceptionally low inventories, continued demand resilience, extended lead times and rising scrap prices. Also, copper is still standing at prices close to record levels with available on-exchange inventory cover thin, particularly in the robust ex-China market. The raw material end of the market remains extremely tight and fraught with near-term supply risk. Especially elections in both Chile and Peru due over the coming months, potential for enhanced supply disruption via industrial action is rising, while the shipping issues afflicting many markets are also hindering copper concentrate trade, most notably from Africa. Underpinning higher metals prices is a decision made by the world’s big miners half a decade ago to stop pumping ever-expanding supply onto the global market and focus on profitability. Now opening new mines will take time, even as Trafigura estimates an additional 10 million tons of annual copper production will be needed by 2030. IMC portfolio companies are reaping in the benefits of cost savings and capex cuts made years ago und generating record margins – FCF yield for 2020E is standing at a record of 10.2%, while the EBITDA margin is forecasted to grow to almost 50% in 2021E. Also, with a dividend yield of close to 3.5%, the industry is starting to payback to its investors.

 

Precious Metals

Analysts see an opportunity for precious metals outperformance over the coming quarter, with gold back in favour with asset allocators and traditional bar, coin, and jewellery demand seeing a continued recovery. BMO states that investors should keep a close eye later in the year for signs that the FED and other central banks are giving greater clarity on timelines for paring asset purchases. Gold headed for the biggest monthly advance since July, with inflation risks in focus ahead of key US jobs data due later that will offer clues on the economic recovery. Some Federal Reserve officials have said that recent price pressures are to be expected as the economy reopens amid pent-up demand and should prove temporary as supply glitches abate. The PCE price index, which the FED uses for its inflation target, rose 3.6% from a year earlier, the biggest jump since 2008. Many market participants see the question about inflation quite different than the FED. Gold erased its 2021 losses in May amid signs of accelerating inflation and a potentially uneven economic recovery due to the resurgence of COVID in some countries. Investor interest has also returned, with hedge funds and other large speculators boosting their net-long position in gold to the highest since early January. Looking at PGMs, UBS expects platinum markets to remain undersupplied in the near term. The market was slightly undersupplied in 1Q21, which marked the fourth quarter in a row. Although total supply will be higher this year compared to 2020, the bank expects demand to rebound due to rising vehicle production, where platinum is used in catalytic converters for diesel cars and trucks, stronger jewellery demand, and healthy investment demand. Also, investment demand will benefit from expectations of palladium-to-platinum substitution in catalytic converters for gasoline cars. Johnson Matthey, a producer of catalysts, is expecting platinum demand in gasoline cars to climb steeply this year, albeit from a low base as car producers aim to reduce costs. This assumption was also underlined by the management of Sibanye-Stillwater, one of the largest PGM producers of the world and a PMC portfolio company. The company said that they already see substitution of palladium and rhodium by OEMs due to high prices and expects platinum to outperform. The company, with an estimated 35% FCF yield this year and a valuation of around 3x EV/EBITDA announced just yesterday a 5% buyback starting from June 2nd. With a weighted average dividend yield of 3.2%, the PMC portfolio companies offer a yield which is more than double the industry average. Also, free cash flow yields are expected to grow from 7.2% in 2020E to more than 11.4% in 2022E with extremely low net debt to equity of 4%.

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ICG Commodity Update – April 2021

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

 

Energy

After collapsing a year-ago, crude oil has roared back amid a recovery in Asia, positive vaccine news and the lifting of lockdowns in some countries. Brent crude has gained 30% in 2021 as investors bet the re-openings will stoke consumption and keep draining inventories. Indeed, activity levels as measured by mobility have resumed their upward trajectory, particularly in countries of advanced vaccination (US, Israel, UK), e.g. US gasoline demand is near 2019 levels and domestic jet demand is +20% since March. Alongside this is the seasonal upswing in transportation, manufacturing and construction activity that begins now and accelerates into June. During this phase Goldman Sachs expects the biggest jump in oil demand ever – a 5.2mboe/d rise over the next 6m, 50% larger than the next largest increase over that time frame since 2000. Further to that, falling global oil inventories support the general view that the oil market has been significantly undersupplied this year. Also the head of Vitol Group, the world’s biggest independent oil trader, expects crude oil demand to increase by 7 to 8mboe/d by the end of 2022 and points out that producers will be stretched to meet that surge. All this is happening during a phase where, the push for clean energy also has some unintended consequences. Chief among these is that capital is fleeing the oil and gas sector and investment is plunging. The industry has slashed capital spending over the last 5 years due to lower oil prices and growing pressure from shareholders to focus on returning capital. In addition, some companies have begun to pivot investment away from oil in response to societal concerns about climate change. Some analysts expect the lack of capital spending could have serious repercussions as new supply fails to offset natural decline and keep pace with rising demand. JP Morgan showed that corporate crude oil reserves are depleting at record rates with the largest public oils globally had a negative 45% replacement ratio in 2020! It’s not surprising to us, that some people expect this could lead to a significant increase in crude oil prices in order to encourage companies to re-invest. Nevertheless, shareholders of oil and gas companies increasingly demand that companies harvest cash flow and increase shareholder returns through dividends and share buybacks. The underlying narrative that oil demand will eventually decline serves to reinforce this view. That’s not something bad per se. In our opinion, and despite all the known risks, we think that some oil and gas companies are uniquely positioned to provide investors with a relatively steady income stream over the next several years. We do not believe that this feature is adequately reflected in current market valuations given that some companies could essentially take themselves private in as little as 5 years, in theory. In fact, our ECF equities are generating > 12% FCF yield pa over the next 3 years and the valuation is still at EV/EBITDA 2022E of 4x.

 

Industrial Metals

In April, Goldman Sachs released an updated study stating, “Copper is the new oil”. According to the bank, copper as the most cost-effective conductive material, sits at the heart of capturing, storing, and transporting the new sources of energy to decarbonize the world. At the core of copper’s “carbonomics” is the need for the world to shift away from a production system based on hydrocarbons, to one based on a range of sustainable sources such as solar, wind and geothermal. Copper has the necessary physical properties to transform and transmit these sources of energy to their useful final state, such as moving a vehicle or heating a home. Goldman estimates that by 2030, copper demand from the transition will grow nearly 600% to 5.4Mt in its base case and 900% to 8.7Mt in the case of hyper adoption of green technologies. They estimate that by mid-decade, this growth in green demand alone will match, and quickly surpass, the incremental demand China generated during the 2000s. Ripple effects into non-green channels mean the 2020s are expected to be the strongest phase of volume growth in global copper demand in history – Goldman also updated its price forecast for the metal and expects the price to reach $15’000/t in 2025. The copper market as it currently stands is not prepared for this demand environment. On the company side, the mining windfall is the latest sign of a boom in iron ore, copper and other metals that’s sending an inflationary wave through the global economy, increasing the cost of everything from electrical wires to construction beams. The top five iron ore mining companies are on track to deliver bottom-line profits of $65bn combined this year, according to estimates compiled by Bloomberg. That’s about 13% more than the five biggest international oil producers, flipping a decades-old hierarchy. This fiscal year will be just the second time this century that the big 5 out-earn their oil peers. During previous commodity boom, which peaked between 2008 and 2011, big oil easily made larger profits than big mining. Underpinning the tightness in metals is a strategic decision made by the miners half a decade ago. After spending years pumping ever-expanding supply on the global market, they ripped up growth plans and focused instead on shareholder returns. The result was that supply largely stopped rising and prices start to pick up. This means for investors, that during this wave of high prices, they’re likely to see more of the profits. Unlike in the last commodity “supercycle”, the miners are reluctant to pour their extra earnings into acquisitions or new mines and instead choosing to distribute record dividends. The portfolio companies of the Industrial Metals Champions Fund have on average a dividend yield of 3.3% and a expected free cash flow yield of 9.7% in 2021.

 

Precious Metals

Historically speaking, when gold prices go up, costs follow in lockstep. Now, however, Analysts see a disconnect. As prices rose last year, costs stayed relatively stagnant. Moreover, with limited growth capex being spent, balance sheets are naturally in much better position. Certainly, costs are set to rise this year owing to higher input prices, but margins are set to remain strong. According to BMO, the net effect of this phenomena, will give the industry a lot more optionality than seen in the past. High margins for miners have led to strong free cash flows. The challenge and the opportunity for gold miners is how to allocate these record free cash flows which are being generated. Balance sheet repair is largely complete across the sector, and return of capital through dividends, which was a key topic through most of 2020 and, while still important, should not be the only component of a capital allocation framework. Analysts often state that the global gold industry is still behind peer commodities in terms of consolidation and are expecting a new M&A wave. Currently, the world has double the number of producers over 500koz in size than at the low point, and while consolidation and partnerships have been to the fore among major producers, the spill over to the next level has been lacking. Gold is still lagging peers in consolidation. Speaking of M&A, Independent Capital Group recently participated at the Denver Gold Group Gold Forum and asked many companies about this topic. Although often cited in analyst papers, most participants favouring organic growth through asset development and/or exploration over acquisitions as valuations of development stage companies with attractive assets are currently high – preserving cash for shareholder returns and create value internally. Some participants are still looking for acquisitions though, while the focus will be more asset based than on a company level. Companies must balance among the priorities of maintaining a strong balance sheet, providing capital returns, and completing thoughtful growth as grade decline is an ongoing issue for quite some time now. Following some relative stability in recent years, grades are forecast to resume their inexorable decline, meaning ore processed by the end of this decade could be 3x that seen in the late 1990s. Gold has been out of favour as questions around a commodity “supercycle” have come up recently and the industrial side has outperformed. And yet, gold is in a pricing cycle with annual average prices above long-run inflation-adjusted norms for more than eight years. The Precious Metals Champions Fund portfolio companies are generating a free cash flow yield of over 10% in 2021 at current gold prices and are delivering record dividend yields of 3.4% and this at an EV/EBITDA of just 5.6x.

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