ICG Commodity Update – February 2024
The ICG Commodity Update is our monthly published comment on the energy, industrial metals and precious metals market.
Energy
Crude oil has seen a gradual but steady upward trend this year. The widening time spreads indicate a tightening of physical conditions influenced by various disruptions, such as attacks on ships in the Red Sea. Hedge funds have also reduced their short positions. Nevertheless, delayed expectations of a Federal Reserve rate cut, robust production from non-OPEC+ sources and an uncertain Chinese demand outlook have limited gains. OPEC+ extended its oil production cuts until the middle of the year, totalling around 2mboe/d. This extension had been widely expected by traders and analysts. Surprisingly, Russia pledged to strengthen its role by focusing more on production cuts than exports. Russia announced an additional 471 kboe/d cut for Q2/24. If these cuts are implemented in full, the oil market is likely to tighten further, according to UBS analysis. The earnings season for international oil companies (IOCs) has come to a close in Q4, with EPS results beating expectations by an average of 7% after missing by 6% in Q3. De-risked balance sheets enabled the sector to beat forecasts, with distributions now averaging 45% of operating cash flow, according to Jefferies. Consolidation in the US shale industry pushed the value of global mergers and acquisitions in the oil and gas exploration sector to its highest level in seven years in the first quarter. Deals worth over $55bn were announced in the first two months of 2024. In particular, the acquisition of Endeavor Energy Resources by Diamondback Energy, both of which focus on the Permian Basin, attracted a lot of attention. Woodmac reports that the ten largest producers in the Permian Basin will now account for 53% of production in the basin. M&A’s have the potential to lower the break-even point through cost synergies and encourage a move away from short-term thinking in terms of investment and growth, making companies less vulnerable to price volatility. It is worth noting that such acquisitions are often preceded by a slowdown in oil and natural gas production growth. Therefore, this series of follow-on deals could also support global crude oil and natural gas prices.
Industrial Metals
As reporting season kicked-off, the recent declines in profits reported by major mining companies, including Rio Tinto, BHP, and Glencore, reflect a retreat from the extraordinary gains witnessed in the aftermath of Russia’s invasion of Ukraine. It is essential to consider the context of the preceding period marked by price spikes and wild swings, which led to blockbuster earnings. Rio Tinto, despite a 12% fall in profits attributed to weaker commodity prices and rising costs, maintained resilience by paying a higher dividend, reflecting its overall financial strength. BHP, undergoing significant restructuring to enhance efficiency, faced a hit in profits primarily due to a write-down in its nickel business. However, the company’s half-year underlying profit exceeded expectations, and cautious optimism was expressed about a demand recovery in 2024. Glencore, despite a steep drop in annual profit, still achieved impressive earnings of $17.1 billion. As the mining industry anticipates a more balanced global economy in 2024, these profit declines should be viewed in the context of a return to normalized conditions following a period of exceptional highs. Looking at lithium, Albemarle, the leading lithium supplier, has voiced concerns about the sustainability of current prices, deeming them insufficient to spur the necessary supply investments for long-term demand growth. Global lithium companies scaling back expenditures and curtailing production as demand slowed precisely when new mines ramped-up. This sudden shift has resulted in a market oscillating from shortages to oversupply. Contrasting this trend, SQM, the world’s second-largest lithium producer, has adopted a distinctive strategy. Despite operating in an oversupplied market, SQM is forging ahead with expansions and stockpiling of the battery metal, positioning itself for a potential resurgence in demand. This approach carries a dual impact on the market dynamics. On one hand, the continued increase in output during a period when buyers are depleting inventories may extend the glut. On the other hand, it reflects a calculated wager on the return of buyers, aligning with the sustained growth in EV demand. According to SQM, the next decade is poised to witness a fourfold surge in lithium demand. This strategic perspective underscores SQM’s readiness to navigate the evolving market dynamics, balancing the present challenges with a forward-looking optimism anchored in the transformative trajectory of electric-vehicle adoption.
Precious Metals
While gold is breaking out, it is frustrating to see how gold equities continue to underperform. Over the past year, while the metal itself has experienced a 12% increase, the gold equity index has declined by 8%. BMO attributes this underperformance to factors such as inflation, leading to elevated total costs, diminished margins, and constrained free cash flow. Additionally, the mining industry grapples with short mine lives, requiring constant reinvestment to replace depleted ore. A looming labor shortage compounds these challenges, driving up costs and hindering productivity. Although certain issues may persist, there is optimism regarding the impact of inflation diminishing. During the annual reporting of our portfolio companies, notable improvements in costs and margins have already been observed. Analysts anticipate a reduction in inflationary pressures as the economy slows down, labor constraints ease, and energy prices normalize in the industrial supply chain. Projections point towards a 5% annual unit cost deflation in 2025 and beyond. Traditionally, the gold sector’s cost curve aligns with fluctuations in gold prices, resulting in increased marginal supply. However, the current cycle demonstrates a sustained level of discipline among companies. There is a focus on adhering to cutoff grades and reserve price assumptions, with an emphasis on generating free cash flow over prioritizing revenue. Despite rising industry costs, these do not seem to stem from self-inflicted actions. Gold equities are currently undervalued, with historically low valuations, while expected increases in free cash flow yields and dividends lie ahead. Management teams have exhibited greater discipline in capital management, avoiding overpaying for mergers and acquisitions. This prudent approach has contributed to a still fragmented industry with numerous small companies. Examining key financial metrics, the precious metals champions fund’s portfolio boasts a weighted average P/B multiple of only 1.2x, a price-to-cash flow ratio of 5.4x, and a dividend yield exceeding 2.5%. The anticipated rise in free cash flow yield from 6% in 2024 to over 15% in 2025 aligns with the continued maintenance of healthy balance sheets among our portfolio companies, characterized by minimal to no debt.
