ICG Commodity Update – June 2021
The ICG Commodity Update is our monthly published comment on energy, industrial metals and precious metals market.
Oil recently rallied to above $76/bl, its highest level since October 2018. Unlike then, when the market was supported by excessive fear of a potential stop in Iran oil exports, the current rally is driven by a steadily tightening physical market, with strengthening time spreads across WTI, Brent and Dubai. The tight WTI-Brent differential implies that North America is driving the current deficit, as local demand rebounds in the face of inelastic local supply. This tightening is in fact running slightly ahead of most analyst expectations, with high-frequency mobility and flying data pointing to global demand currently near 97.5mboe/d and with shipping data pointing to a still moderate ramp-up in OPEC+ exports. Goldman Sachs estimates that the global market is in a 2.3mboe/d deficit currently, with the remaining excess inventories down to 330mboe. At the current rate of draws, this excess will be gone within 3 months. However, oil prices are down this week as the market awaits the next OPEC+ decision, scheduled for July 1. While the need for higher OPEC+ output in August is clear, there remains uncertainty on the magnitude of this next output hike. Ultimately, much more OPEC+ supply will be needed to balance the oil market by 2022. Analysts forecast demand to rise by an additional +2mboe/d by year-end, leaving for a 5mboe/d supply shortfall, well in excess of what Iran (1mboe/d max) and US shale producers can bring online (expected up 0.3mboe/d through year-end). Therefore, it’s not so surprising to see some commodity traders like Trafigura or bank analysts like Bank of America saying oil may surge to $100/bl next year.
After the hard times of 2019/20, the higher oil prices came initially as a relief and now as an opportunity for the oil and gas producers. Firstly, a wider array of organic developments should provide good returns with budgeting at $60/bl; and secondly, the large-scale continuing divestment by the major oil companies – driven by a push towards greener energy – is providing scope for inorganic growth. Oil and gas companies are generating record free cash flows currently and valuation continue to be depressed. Further to that, futures prices for crude oil and natural gas remain well ahead of sell-side consensus expectations based on data compiled by Bloomberg. This suggests material CF / EPS revisions are anticipated in the coming months. We continue to see the current environment as a very attractive investment opportunity for the natural resource sector.
The global economic recovery continues and remains metals intensive, with demand expectations still being pushed higher. With this, analysts expecting widespread supply bottlenecks in terms of both raw materials and logistics. However, China’s anti-inflation rhetoric has been stepping up, dampening both physical demand aggression and financial market positioning. Analysts remain positive on current commodity prices and especially pointing out industry free cash flow which looks extremely robust. While demand tailwinds may be easing, with extended lead times and raw material markets susceptible to disruption, a supply risk premium to the cost curve can be justified over the coming quarters. Additionally, and adding another layer of complexity to commodity markets is the unusual situation where the developed world is leading industrial growth instead of China, mainly owing to the different timing of 2020 lockdowns. As excess economic support is slowly drained from the Chinese economy, the US and Europe currently lead the way in physical end-demand indicators. As the IEA recently noted, the shift towards clean energy naturally involves burning less fuel but building more equipment. Indeed, on the IEA estimates, since 2010 the average amount of minerals needed for a new unit of power generation capacity has increased by 50%, with an onshore wind facility requiring nine times more mineral resources than a gas-fired plant of the same capacity. According to some analysts, the energy transition is much more important for future demand than for the current market, and while the thematic trend has undoubtedly driven asset allocation towards the sector, in their view it is merely a supporting act in the current demand upcycle. The metals and mining industry on the other hand isn’t immune to inflation. Oil prices are a significant input cost – analysts expecting to see cost inflation creep into earnings over the coming quarter. However, unlike previous cycles we are not seeing the same surge in capex-related costs, with lower growth spending meaning less exuberance in pushing projects. Furthermore, management is expected to remain disciplined and as a result, cost gains are unlikely to provide shocks. Most commodity prices remain trading well out of cost curves and with the relative lack of supply response, there is less need to spend time pushing supply off the market through the inevitable cycles over the coming years. This should lead to a period of sustained free cash flow and strong margins over the coming years well above longer-term cyclical norms for incumbent producers.
Although precious metals already have one eye on a potential Federal Reserve tapering cycle, analysts expect relatively sticky demand support for gold and silver from both central banks and ETFs over the next few months, particularly if wider market volatility increases. Unsurprisingly, given rising inflationary pressures and positive economic growth surprises, central banks around the world are increasingly setting the stage for less accommodative actions over the coming months and quarters. As Federal Reserve Chair Powell recently noted, it is time to start talking about tapering. As BMO Economics notes, Fed policy (and the same is true for many other central banks) appears destined to become less accommodative but remain meaningfully net accommodative overall through 2023 at least. Compared to other commodities, 2021 hasn’t been a great year for gold so far, with current prices slightly down over those at end-2020 and ETFs seeing outflows. And yet, things are well on course for yet another annual average record in terms of nominal price. For gold producers, even with cost inflation starting to show some signs of a comeback, operating margins are extremely robust, and with the industry now showing impressive capital discipline relative to past cycles, analysts anticipate strong free cash flow over the coming years. This is seen as the important story for gold equities, rather than potential for further aggressive underlying commodity price gains. Regardless of this, investors continue to be generally sceptical of the discipline of company management teams and potential for erosion of free cash flows including the increasingly heated M&A market, which has seen a recent influx of transactions at higher premiums (versus the zero-premium “mergers of equals” which were seen last year). With a relatively flat, but very robust precious metals pricing environment, analysts believe that the entire group is trading at a discounted level. This can be seen for the Precious Metals Champions Fund portfolio companies. While trading at a P/CF of 6.9x and a P/B of only 2.9x, the expected free cash flow yields for 2021E, 2022E and 2023E are at 10.8%, 14.5% and 14.2%.