ICG Commodity Update – May 2022
The ICG Commodity Update is our monthly published comment on the energy, industrial metals and precious metals market.
Well three months into Russia’s invasion of Ukraine, global markets remain tense with oil prices holding firmly >$100/bl. The call to secure global energy supplies is getting more relevant than ever, with new actions adding to uncertainty, including a potential EU embargo on Russian oil on the horizon. Further to that, the WSJ has reported that some OPEC members are considering exempting Russia from the group’s production quotas currently in place (Russia’s target were set at 10.5mboe/d in May). No decision has been confirmed, but exemption wouldn’t be without precedents: Iran, Libya and Venezuela are already not subject to production quotas. Exemption would allow Russia to produce at maximum capacity, which is probably limited at ~11mboe/d due to export constraints through Europe. Nevertheless, an exemption of Russia would probably not impact the medium-term S/D balance according to JP Morgan. While Saudi Arabia and Iraq plan to increase production capacity, non-GCC supply continues to fall short of expectations. Some estimate that in April OPEC+ missed quotas by 1.8mboe/d. Some expect OPEC’s spare capacity (about 3.6mboe/d) to come even more into light as demand continues to recover, China reopens and the summer driving season starts in the Northern Hemisphere. It’s time to take a look at an unloved sector. Commodity prices have skyrocketed well >100% in the last 2 years. However, it’s not too late to invest. Though commodities are up, natural resource companies trade at more than a 60% discount relative to the S&P 500, a level that has almost never been seen. Indeed, also relative energy stocks are cheap discounting oil prices in the range of only $50-$70/bl. Furthermore, the current discount may be understated, as the recent spike in commodity prices has yet to flow through to the companies’ reported fundamentals. If commodity prices were to stay at current levels, many of the largest commodity producers on the planet could pay down all their debt and buy back all their shares in just a few years and keep their billions and billions of dollars of cash flow for themselves. The implication of these deeply discounted valuations is that investors don’t need commodity prices to continue to rise in order to expect strong returns. In fact, flat commodity prices would be brilliant. Energy now represents 9% and 11% of S&P net income and FCF using consensus estimates, while these would increase by 150-200bps at strip. When comparing earnings and FCF contribution with a 4.8% of S&P market cap and other sectors struggling, we think investors will find it difficult to remain underweight given greater performance slippage. If valuations remain depressed, investors will benefit from a combination of high dividend yields, special dividends, share repurchases, and M&A activity. While the exact mechanism is unknown, if you invest in profitable businesses at attractive valuations, you will be rewarded sooner or later.
May was a rollercoaster with most commodity prices posting a weak run and all major base metals fell on the LME as stocks and bonds slid and the U.S. dollar rose, while accelerating inflation, rising borrowing costs and lockdowns in China depressed sentiment. China’s stringent response to virus outbreaks are stoking angst over its impact on the economy. The country’s leaders warned against questioning Xi Jinping’s Covid-zero policy, reaffirming support for the lockdown-dependent approach despite pressure to relax restrictions and protect growth. Anyway, by the end of the month, commodities rebounded from a five-month low as the demand outlook was bolstered by a weaker US dollar and China’s loan-rate cut. Chinese authorities cut a key interest rate for long-term loans by a record amount. The move will help reduce mortgage costs and support the country’s beleaguered property sector, a key source of metals demand. The Stoxx 600 Basic Resources index has fallen 16% in the past month, at a time when analysts are still raising estimates. That’s left miners looking more of a bargain than they have in years, trading at about six times forward earnings, a 50% discount to the broader market. In recent history, the sector was only this cheap during the global financial crisis of 2008 and the European sovereign debt crisis in 2011, in absolute terms. Commodity prices have skyrocketed well over 100% in the last 2 years. Though commodities are up, resource companies trade at more than a 60% discount relative to the S&P 500, a level that has almost never been seen. Furthermore, the current discount may be understated, as the recent spike in commodity prices has yet to flow through to the companies’ reported fundamentals. According to GMO, the market is simply not valuing resource companies at reasonable levels given any plausible base case for how the world might play out. If commodity prices were to stay at current levels, many of the largest commodity producers on the planet could pay down all their debt and buy back all their shares in just a few years and keep their billions of dollars of cash flow for themselves. The implication of these deeply discounted valuations is that investors don’t need commodity prices to continue to rise in order to expect strong returns. In fact, flat commodity prices would be brilliant. If valuations remain depressed, investors will benefit from a combination of high dividend yields, special dividends, share repurchases, and M&A activity. While the exact mechanism is unknown, if you invest in profitable businesses at attractive valuations, you will be rewarded sooner or later.
Gold has recovered some lost ground recently and is now hovering just below its 200-day moving average of USD 1,840/oz. This consolidation has been underpinned by an uptick in buying of exchange-traded funds following a decline in these holdings by more than 2 million ounces since the mid-April peak. The moderation in 10-year US real yields and the topping out of US dollar strength has supported some demand, with gold’s correlation with the US dollar index turning more negative of late. Despite the commencement of the much anticipated Fed tightening cycle in March and a general sell-off in equities, which likely also weighed on gold as it is typically used initially as a source of liquidity, the gold price is only down around 10% in dollar terms from its recent $2,000+ highs. Analysts believe gold’s robust performance has been driven by increasing concerns around the prospects for growth, inflation and the extent to which central bank policy can balance the mix of the two successfully. Looking at PGMs, platinum supply could contract slightly over the next two years as the industry struggles to recover from Covid-related supply chain disruptions, labor and power stoppages in South Africa and Russia’s isolation. Southern African producers have pushed the growth button potentially boosting output from 2026 should favorable market conditions hold. From 2024, platinum supply could increase by 1.5-2% a year as new projects offset reserve depletion and grade decline. The gold sector showed some M&A-activity by the end of May with Gold Fields offering 0.6 of one of its shares for each Yamana share which will make the combined company the world’s number 4 producer. The $7bn purchase implies a 34% premium to Yamana’s closing share price on May 27th. That premium offered by Gold Fields contrasts with the shift in recent years to mergers of equals in the gold industry. Those zero-premium deals, which consolidate assets to minimize costs and maximize shareholder returns, began with the $5.4 billion mega merger of Barrick Gold and Randgold announced in 2018. Yamana Gold considered other options before agreeing to be acquired by Gold Fields, suggesting there are discussions for other prospective deals in the gold industry, the Canadian firm’s executive chairman said. This is no surprise to most market participants as the so called M&A-wave is long overdue in the still segmented gold industry. Even though gold prices have risen over 40% in the last 5 years, equities of the miners are still looking cheap – companies of the precious metals champions fund producing an ounce of gold at roughly $800/oz while being almost debt-free and highly profitable (EBITDA margin >50% and a free cash flow yield 2023E >11%), this with a price-to-cashflow ratio of only 2.9x, a price-to-book ratio of 1.7x and a dividend-yield of 2.9%.