Fund Manager
Craig Porter
The second quarter was a humbling time for global stock exchanges with dramatic pullbacks including China, which was down over 40% in the first half. The U.S. economy has struggled as the impact of high energy prices, the burden of financing the war in Iraq, and a collapsing housing market have weighed on the economy. We are also experiencing a global financial crisis as bank after bank announces write-downs of bad loans brought upon them by their own risky lending practices. Many western world banks have had to raise significant equity just to stay afloat, with the saviors often being Middle Eastern sovereign funds that are ballooning because of oil revenues. What we are witnessing is a massive transfer of wealth on a global scale.
Inflation has started to rear its ugly head with soaring energy and commodity prices working their way into the cost of all goods, including food prices. Central banks have few tools to combat this, as they fear that raising interest rates to combat inflation will suffocate their economies. Many are concerned about the emergence of stagflation, where you have rising prices with no or negative growth. Typically very few sectors of the economy perform well in a period of stagflation.
Historically, severe inflation has exerted a destabilizing effect on governments. Unfortunately it is usually the poorest countries with shaky governments that feel the effects through civil unrest. The natural reaction to higher prices is a demand for higher wages. Many countries have been subsidizing their citizen’s fuel prices. China recently drew the anger of its citizens when it lifted fuel subsidies, thereby increasing the cost of gasoline by 18%. Many countries currently facing double digit food increases are quite concerned, as usually the hungry masses upset at higher prices and shortages turn their anger towards governments first.
These larger picture trends have led to many resource companies having share performances acting counter to the strong commodities that they produce. Many companies that operate in emerging countries are struggling, as many governments are asking for higher royalties, taxes and direct interest in projects. As well, additional infrastructure costs are being heaped on companies with demands for schools, fresh water, and hospitals, costs not directly associated with a project. The banking crisis has also hurt small cap companies, many of which are having trouble raising capital to develop projects in these tight credit markets. On the positive side, we should see continued consolidation as cash rich, but asset poor seniors, scoop up vulnerable smaller companies.
The price of oil rose over 37% during the quarter, closing near an all time record at $140 per barrel. A weakening U.S. dollar, limited spare capacity to meet global demand, and political tensions between Iran, India and the United States, has sent prices higher. We feel that oil prices at these levels are too high for most economies to manage. If prices were to remain at these levels we would expect to see demand destruction at levels not seen since the energy crisis of the early 1980’s. Although oil sands companies were some of the best performers in the quarter, an interesting trend has developed where we have a backlash against these projects on fears of the environmental ramifications of their development. Coupled with rising costs we expect that many of these projects will either be delayed, or won’t meet their projected production levels.
The price of natural gas was also quite robust, closing the quarter at $13.57 per million BTU, up 34%. Although production of natural gas in the U.S. is up about 10% this year, inventories have been dwindling in North America to levels well below the five-year average. This leads us to believe that industrial demand for gas has been much higher than expected. When you consider the dramatic increase in the price of oil, natural gas for heating and electrical generation has become a much cheaper alternative.
Early in the second quarter, the price of gold set an all time record trading at $1032 U.S. per ounce, before settling to end the quarter at $928. Continued weakness in the U.S. dollar, fears of inflation and political turmoil in the Middle East are fueling the rise in gold. Most companies however haven’t fully benefited from the increasing price as rising cost structures, such as fuel, electricity, steel and labour, ate into corporate margins. At the start of this decade most companies were producing an ounce of gold at around $200 per ounce, whereas today the average cost is between $400 and $500 per ounce. The fundamentals for gold still look quite strong. Although jewelry demand has softened, investment demand remains quite robust in a period of limited growth in new mine supply.
Soaring food prices helped agriculture stocks to become some of the top performers on the TSX this year. In fact, Potash Corp. is now the largest company in the TSX index on the back of surging fertilizer prices. Corn prices have tripled in the last two years while soybeans have doubled in the same period. Changing diets on a global basis, increasing fuel prices and significantly increased use of corn for ethanol production has fueled this growth. We are starting to see shortages of some food staples on a global basis, and this is troubling as we have had almost two decades of bumper crops. A few years of bad crops could have significant ramifications in many countries.
Towards the end of the quarter, base metal stocks were extremely weak. Although demand for metals remained strong, fears of a future global slowdown sent investors for the exit. Companies that mined nickel and zinc were extremely weak as those metal traded near three-year lows. Winners were those that mined bulk commodities, which saw large increases in their prices, in particular iron ore and coal.
Craig Porter
Portfolio Manager
Front Street Capital
CRAIG PORTER - Q2 2008 COMMENTARY
Date Published
Related Fund(s)
Fund Manager
The second quarter was a humbling time for global stock exchanges with dramatic pullbacks including China, which was down over 40% in the first half. The U.S. economy has struggled as the impact of high energy prices, the burden of financing the war in Iraq, and a collapsing housing market have weighed on the economy. We are also experiencing a global financial crisis as bank after bank announces write-downs of bad loans brought upon them by their own risky lending practices. Many western world banks have had to raise significant equity just to stay afloat, with the saviors often being Middle Eastern sovereign funds that are ballooning because of oil revenues. What we are witnessing is a massive transfer of wealth on a global scale.
Inflation has started to rear its ugly head with soaring energy and commodity prices working their way into the cost of all goods, including food prices. Central banks have few tools to combat this, as they fear that raising interest rates to combat inflation will suffocate their economies. Many are concerned about the emergence of stagflation, where you have rising prices with no or negative growth. Typically very few sectors of the economy perform well in a period of stagflation.
Historically, severe inflation has exerted a destabilizing effect on governments. Unfortunately it is usually the poorest countries with shaky governments that feel the effects through civil unrest. The natural reaction to higher prices is a demand for higher wages. Many countries have been subsidizing their citizen’s fuel prices. China recently drew the anger of its citizens when it lifted fuel subsidies, thereby increasing the cost of gasoline by 18%. Many countries currently facing double digit food increases are quite concerned, as usually the hungry masses upset at higher prices and shortages turn their anger towards governments first.
These larger picture trends have led to many resource companies having share performances acting counter to the strong commodities that they produce. Many companies that operate in emerging countries are struggling, as many governments are asking for higher royalties, taxes and direct interest in projects. As well, additional infrastructure costs are being heaped on companies with demands for schools, fresh water, and hospitals, costs not directly associated with a project. The banking crisis has also hurt small cap companies, many of which are having trouble raising capital to develop projects in these tight credit markets. On the positive side, we should see continued consolidation as cash rich, but asset poor seniors, scoop up vulnerable smaller companies.
The price of oil rose over 37% during the quarter, closing near an all time record at $140 per barrel. A weakening U.S. dollar, limited spare capacity to meet global demand, and political tensions between Iran, India and the United States, has sent prices higher. We feel that oil prices at these levels are too high for most economies to manage. If prices were to remain at these levels we would expect to see demand destruction at levels not seen since the energy crisis of the early 1980’s. Although oil sands companies were some of the best performers in the quarter, an interesting trend has developed where we have a backlash against these projects on fears of the environmental ramifications of their development. Coupled with rising costs we expect that many of these projects will either be delayed, or won’t meet their projected production levels.
The price of natural gas was also quite robust, closing the quarter at $13.57 per million BTU, up 34%. Although production of natural gas in the U.S. is up about 10% this year, inventories have been dwindling in North America to levels well below the five-year average. This leads us to believe that industrial demand for gas has been much higher than expected. When you consider the dramatic increase in the price of oil, natural gas for heating and electrical generation has become a much cheaper alternative.
Early in the second quarter, the price of gold set an all time record trading at $1032 U.S. per ounce, before settling to end the quarter at $928. Continued weakness in the U.S. dollar, fears of inflation and political turmoil in the Middle East are fueling the rise in gold. Most companies however haven’t fully benefited from the increasing price as rising cost structures, such as fuel, electricity, steel and labour, ate into corporate margins. At the start of this decade most companies were producing an ounce of gold at around $200 per ounce, whereas today the average cost is between $400 and $500 per ounce. The fundamentals for gold still look quite strong. Although jewelry demand has softened, investment demand remains quite robust in a period of limited growth in new mine supply.
Soaring food prices helped agriculture stocks to become some of the top performers on the TSX this year. In fact, Potash Corp. is now the largest company in the TSX index on the back of surging fertilizer prices. Corn prices have tripled in the last two years while soybeans have doubled in the same period. Changing diets on a global basis, increasing fuel prices and significantly increased use of corn for ethanol production has fueled this growth. We are starting to see shortages of some food staples on a global basis, and this is troubling as we have had almost two decades of bumper crops. A few years of bad crops could have significant ramifications in many countries.
Towards the end of the quarter, base metal stocks were extremely weak. Although demand for metals remained strong, fears of a future global slowdown sent investors for the exit. Companies that mined nickel and zinc were extremely weak as those metal traded near three-year lows. Winners were those that mined bulk commodities, which saw large increases in their prices, in particular iron ore and coal.
Craig Porter
Portfolio Manager
Front Street Capital