ICG Commodity Update – August 2020
The ICG Commodity Update is our monthly published comment on energy, industrial metals and precious metals market.
Crude oil capped a 4th monthly gain in August but has struggled to hold >$43 as increasing coronavirus infections raise concerns about the sustainability of the demand recovery. Following a year of unprecedented shocks, uncertainties over oil fundamentals has never been higher. Even at the latest OPEC+ meeting, the group announced a very high compliance rate of 97% but the statement, while positive in tone, offered also cautious guidance for the coming months. Indeed, the oil market flipped into undersupplied territory in July. However, the fragility of the oil market was also highlighted, along with the significant uncertainties associated with oil demand, and all members were called on to be vigilant in the coming months. Only China, that had a stronger-than-expected PMI with its early recovery and robust fiscal/monetary support resulted in an oil demand level above last year’s. On the equity side, the 2nd quarter of 2020 will go down in history as one of the worst for the energy industry. A collapse in demand, a collapse in drilling activity, and a collapse in oil prices took their toll without exception. Company results were a sea of red. However, investor expectations were low, so generally speaking energy stock prices were unfazed by dismal results. Rather, investors scrutinized how management teams are planning to position their companies to ensure greater resilience to future oil price cycles. Many companies also used the opportunity to reset their stated long-term energy price expectations, resulting in big asset write-downs. Finally, a couple of companies adjusted their dividends lower and made them more flexible. Therefore, we think the exceptional situation was used by many to lower the bar and this should accelerate the earnings recovery from here. Dedicated energy investors are increasingly comfortable with the positive rate of change thesis on oil, especially the supply side. The thesis is grounded in the upstream commitment to focus on debt reduction, return of incremental dollars to shareholders, and staying disciplined on re-investment. Finally, the announcement of Exxon Mobil’s exit from the DJI Index has been widely seen as emblematic of the decline in importance of Big Oil as the wider sector’s importance dwindles (now <2.5% of the S&P). The current disparity is probably generated by a combination of the cyclical/structural and thematic/sentiment. Nevertheless, investor legend Warren Buffett increased his investments in commodity related companies (Dominion Energy, Barrick Gold, Japan’s 5 biggest trading companies) this year showing increasing interest in the commodity sector that was out-of-favour for too long and may become a big opportunity going forward, he probably thinks. ICG is looking also for the companies with the strongest moat on different variables and offer an attractive well diversified portfolio of best-in-class companies that will strongly recover with the increasing focus of general investors in commodities.
In August, copper climbed to the highest since mid-2018 after data showed China’s recovery is on track. Chinese economic activity continued to rebound in August. Signs of tight supply and a stronger-than-expected rebound in metals usage in China have driven prices higher since mid-March. Also, there are concerns about a shortfall in global copper output, with inventories on the LME dropping to their lowest since 2005 by the end of August. Treatment fees for copper concentrate extended declines this year, dropping below $50 a ton, according to data from SMM, another signal for a tight market. According to analysts, industrial metals continue to strengthen in general amid continued USD weakness, as supply disruptions dominate the narrative along with a persistent decline in LME inventories. COVID-19-related disruptions and risks to output continue to impact major mining operations globally. Bolivia’s largest mine for example has suspended operations indefinitely for the second time this year due to an uptick in infections across the country. Bolivia is a major producer of zinc and silver. Further to that, investors have also started to buy raw materials that they think will fare well if the Federal Reserve’s efforts to revive the economy stoke inflation. Market measures of inflation expectations, such as inflation breakevens, have risen during the summer. A 2015 paper for the Yale International Center for Finance found commodities were positively correlated with inflation between 1959 and 2014. In contrast, stock and bond prices tended to post small declines when inflation accelerated. On the company side, Zambia said Glencore and First Quantum Minerals are willing to sell their combined 90% stake in Mopani Copper Mines to state-owned investment group. Zambia has had an uneasy relationship with mining investors, clashing with Glencore earlier this year over the company’s plan to mothball Mopani’s operations after the pandemic hit copper prices. Also, Warren Buffett’s Berkshire Hathaway lifted the veil on stakes in five major Japanese commodity traders that dominate the nation’s energy and raw materials industries. That move will intensify a focus on the outlook for raw materials just as prices hit the highest since 2018. Berkshire’s stakes amount to a little more than 5%, but Buffett made clear that they could be increased. While the quintet operate in different areas, they derive much of their revenue from energy, metals and other commodities, supplying resource-poor Japan with essentials.
Precious metal prices pulled back recently as long-dated interest rates rebounded, hitting silver and gold in particular. By the end of the month, gold stood at close to USD 1970 per ounce, while silver closed august at USD 28.1 per ounce. However, analysts expect prices to recover to their previous highs as real US rates can go more negative, USD weakness should continue, and growth and policy uncertainties linger. On the company side, gold miners continue to find themselves in a perfect storm scenario of rising revenues and falling costs due to low oil prices and efficiency gains. Barrick and Newmont for example, two of the largest gold miners, use $65/barrel and $60/barrel respectively for budgeting and guidance purposes. This implies significant free cash flow generation and downside to future costs vs. guidance. Analysts expect the theme will persist through 2021 as low real interest rates drive investor support for the metal and mining managements continue to focus on cost discipline. Also, gold miners are widening their investment appeal as dividends are boosted. According to Gold Fields CEO, more generalist investors search for yield amid low bond-market returns. The sector, which once largely drew attention of specialist funds, is no attracting a broader base of investors who previously considered gold miners too leveraged and high-risk. A sign for that is Warren Buffett’s recent move with adding Barrick Gold to Berkshire Hathaway’s investment portfolio after shunning gold producers for years. The buy comes as a bit of a surprise, Buffett has been critical of gold, saying it isn’t as good of an investment as businesses, farms, and real estate because the metal is not productive. While the stake in Barrick Gold is small for Berkshire Hathaway, Buffett’s company is now one of the miner’s top shareholders with a stake of close to 21 million shares. In general, Berkshire’s investment in Barrick is considered good for the whole mining industry.