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Dark Days for Commodity Investors
New York: April 23, 2012
By John Stephenson

For commodity investors, it’s been a dreary season. Despite a slate of strong corporate earnings from Alcoa and others, commodity prices have slumped, dragging down the fortunes of commodity producers. Markets have been in a tizzy lately as worries about the health of the U.S. recovery, a slowdown in China and the euro-zone’s continuing debt woes have sent stocks lower. After months of defying gravity and a first quarter that ranked among the best since the heyday of the Internet bubble years, global stocks are showing signs of fatigue. For the shares of commodity producers, the bloom is decidedly off the rose despite a gusher of profits for resource companies.

It was bound to happen. After more than three decades of staggering growth, China is slowing, causing the market bears to come out of their lairs and sending resource stocks tumbling. Fears of a possible hard landing for the Chinese economy have rattled markets for months, driving down commodity prices and shaking investor confidence.

Despite pledges from Beijing to loosen credit, the first quarter GDP growth of just 8.1 per cent managed to disappoint investors causing them to hit the sell button sending markets spiralling down around the globe. The first quarter Chinese GDP data was down sharply from the 8.9 per cent growth the economy posted in the fourth quarter and well below analyst consensus forecasts of 8.4 per cent. The first quarter growth rate marks China’s slowest pace of expansion since the third quarter of 2009 when exports and manufacturing activity plunged during the global recession.

China has become a cornerstone of the global economy, driving commodity markets and serving as a backstop for tepid growth in Europe and the United States. But China’s once-booming real estate and construction market have slowed sharply in recent months and demand from Europe and the U.S. for Chinese manufactured goods has been weak.

Concern that infrastructure spending in China has slowed, coupled with worries over the country’s overheated property markets, have also weighed on markets. Already, there is some evidence that China’s attempts at cooling the property market may be working as home sales dropped 18 per cent in the first quarter.

Behind the worrying headline GDP number are more solid fundamentals that should prevent a Chinese hard landing. Year-over-year retail sales growth of 15.2 per cent in March was higher than in both January and February. Industrial production grew at 11.9 per cent year-over-year in March, beating consensus estimates and also besting growth in the first two months of the year. Other measures, such as steel and cement production and electricity output were all higher in March than in January or February.

But the worst may be over for commodity investors as Chinese equities traded in the U.S. have just extended their longest winning streak since February. Behind the surging share price is speculation that Chinese policy makers will make further cuts to banks’ reserve requirements to spur growth and bolster lending.

Despite stubbornly high crude prices and a gusher of profits, oil company shares have been languishing for some time with Canadian oil sands stocks taking it on the chin and in the process becoming deep value plays. The reasons for the underperformance are varied but include a lack of export infrastructure; spending on new energy projects is far exceeding budgeted levels and because of soaring labor costs and sinking natural gas prices.

The shares of many oil companies are trading as if oil prices were in the mid seventy dollar range despite being solidly above $100 per barrel in North America for some time. And it looks increasingly likely that oil prices will remain elevated for the foreseeable future, suggesting that now might be an opportune time to start picking away at your favourite oil and gas names. The reason for oil’s future strength include the long term trends of meagre supply and soaring demand from China and other emerging economies And shorter term, the market is tight, supplies have been disrupted and Iran is making everyone nervous.

To balance the oil market, the world relies on Saudi Arabia, the only OPEC member with enough spare capacity to make up supply shortfalls and the best hope of keeping the market stable. Optimists are quick to point out that Iraq and Iran have vast oilfields that could eventually provide markets with millions more barrels a day. Yet this view does not take into account the Middle East’s growing thirst for its own oil.

Between 2000 and 2010, the Middle East, home to six OPEC members, saw consumption grow by 56% in the first decade of the century, four times the global growth rate and nearly double the rate in Asia. During the same time period, Saudi Arabia upped its oil-guzzling by 1.2 million barrels per day, making it the world’s sixth-largest consumer.

Demographics can explain some of this growing taste for oil. Saudi Arabia’s population surged by 37% (between 2000 to 2010) from around 20 million to 27.4 million, while Qatar’s population trebled. Another reason for the region’s surging consumption is the fact that it takes energy to produce energy: pumps must be powered and vast quantities of seawater desalinated. Aramco, the Saudi state oil company, sucks up nearly 10 per cent of the country’s energy output.

The other reason for the rising Gulf consumption is the inefficiency of domestic energy markets. According to BP, oil makes up 74 per cent of the region’s electricity production. Some 65 per cent of Saudi electricity is generated from oil, even as prices have been moving sharply higher and oil generation has proven inefficient and has all but been phased out in rich countries.

This reliance on oil-fired electricity generation will further stress Saudi Arabia’s ability to pump spare capacity to a thirsty world market during the summer months. According to research by Barclays Capital, Saudi oil demand jumped by more than 750,000 barrels per day between March and July last year as Saudis cranked up their air conditioners to battle the heat.

According to the International Energy Agency, global oil subsidies totalled $192 billion in 2010, with OPEC countries accounting for $121 billion of the total. This has created an American-style driving culture in much of the Middle East and limited the development of public transport. Many countries in the region have pledged to cut back on the subsidies, but this is extremely difficult to do when regimes are terrified of unrest. Violent protests greeted Nigeria’s attempts in January to raise the price of imported gasoline.

Deeply discounted valuations, possible future supply shocks and improving macro economic backdrop make an investment in resource stocks an attractive proposition. For my money, the oil & gas names, particularly the beaten up oil sands names seem like a very savvy bet.

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