Thursday, 10 December 2015

Resources meltdown: Armageddon or an opportunity?

By Johann van Rooyen

With the Bloomberg commodity index (representing 22 raw materials) trading at a 16-year low and billions of dollars having being wiped off the value of mining companies, overwhelming fear and despondency have gripped resources investors worldwide.

Commodity prices are collapsing. The price of iron ore has dropped by 45% this year, that of copper by 27% and other minerals by even more. Glencore and Anglo American have lost more than 70% of their market cap this year alone - the latter just announced that it is slashing its assets and workforce by over 60%. Glencore is selling its assets as fast as it can, BHP has shifted its worst performing assets into a separate company and Rio Tinto has slashed capital expenditure by $1 billion. While the immediate outlook for these relatively financially sounder large companies is dismal, hundreds of smaller resources companies face extinction -  collectively the commodity sector issued $1.9 trillion in bonds over the past five years and there is great concern now for the ability of many of these companies to keep on servicing their debt.

How did it come to this, so fast and so severe, from a commodity supercycle to a complete bust? Basically it is a combination of three things: 
1. A massive over-supply caused by the money printing and low interest rates of the central banks of the United States, Europe and China  - this led to vast-scale borrowing to open new mines and increase supply;
2.  As the dollar becomes stronger, it makes commodities more expensive and reduces demand further;
3.  A slowing Chinese economy and the resulting lower demand for resources from the world’s biggest consumer of resources.  

With all this doom and gloom it is not surprising that virtually all analysts and fund managers are predicting prices to continue sliding and expecting even more of a commodities Armageddon. The ‘get out of commodities’ trade is virtually unanimous and blood is almost literally flowing in the streets of commodity land.

But, the question for the astute and more risk-tolerant investor is whether this then not the time to be a contrarian and go the opposite way, to buy assets of solid companies that are on a sale at a price of 10 - 30% what they cost one year ago?

There are several compelling reasons to consider such as move, least of all outstanding longer term value found in many of the former resources blue chips – most are trading at a 19% discount on net asset values at forward curve prices, according to an RBC analysis. A second reason is that, as mining companies such as Anglo are cutting back supply, supply and demand will reach an equilibrium eventually and any supply disruption could cause panic buying without much warning. Thirdly, China and the Eurozone both have their hand on the stimulus tap and would not be averse to unleash more QE, which could benefit commodities.

Fourthly, the U.S. economy is growing steadily now and it remains the second largest consumer of commodities. Lastly, the strong dollar may have already discounted the pending rise in U.S. interest rates and could eventually adjust to lower levels, which will make American exports more affordable and resource prices cheaper.

It is not often that a potential trade is so much against the overwhelming consensus and there is no doubt that it will be fraught with risk, but for the patient investor who uses cost-averaging, the benefits could be substantial.