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