ICG Commodity Update – April 2021
The ICG Commodity Update is our monthly published comment on energy, industrial metals and precious metals market.
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.
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.
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.