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