Fund Manager
Craig Porter
Equity markets were extremely volatile in the quarter, as the credit crisis and collapsing housing markets in the U.S. started to spread around the world. Credit markets froze up to a point where lending stopped and banks refused to lend to each other, out of fears of counterparty risk. Lehman Brothers went bankrupt and other major investment banks were forced to merge or were nationalized to ensure survival. Markets were falling at a pace not seen since 1929. Dramatic action was required, and that’s what we saw from governments around the world. Fannie Mae and Freddie Mac, two agencies that issued and guaranteed mortgages, were essentially taken over by the US government. The U.S. government then announced a $700 billion bailout package to buy up bad mortgage instruments and to take direct equity stakes in banks in an attempt to get capital flowing. Massive amounts of capital have been injected into the banking system on a global basis in an attempt to get credit flowing again. These actions will have a positive effect, but some time will be needed before results are felt.
Energy prices were hard hit during the quarter, with the price of oil off 28% and the price of natural gas down 44%. After hitting an all-time high of $146 per barrel, influenced by speculative buying, we saw a sharp sell-off in the commodity on fears of dwindling demand in a recession. The U.S. still consumes about one of every four barrels produced, so any slowdown there would have a measurable effect on oil demand. As the quarter ended, oil was continuing its dramatic fall, and we anticipate that OPEC will soon intervene and cut production in an attempt to stabilize prices. On the equity side, the TSX Energy index was down 28% on the quarter. Large cap companies outperformed, as many have strong balance sheets due to years of rising commodity prices. The fear going forward is that lower commodity prices typically cause banks to limit credit, forcing companies to cut back on exploration or merger activity. We saw this scenario play out with Chesapeake, a large U.S. gas producer, who announced a $5 billion cut to their exploration budget over the next two years. Falling gas prices have dramatically cut into their profitability on drilling new wells. The outlook on natural gas looks positive though. Gas in storage, in North America, remains at normal levels as we enter winter, and exploration cutbacks will hinder future growth in production. A significant proportion of the decline in equity prices has been caused by fund liquidations to meet investor demand. Investors are looking for some semblance of stability in commodity prices before they get back into the sector.
Recession fears hit the base-metal sector hard in the third quarter. The prices of copper, nickel and aluminum were all down around 25%. Inventory levels started to build with slowdowns in the U.S. and Europe, and a temporary halt of heavy industry in China around the Olympics led to decreased demand. Although many companies have strong balance sheets, their shares remain below justified recessionary levels. Some shares are even trading at their cash levels. While the commodity prices have fallen dramatically, we feel they are approaching floor levels on how far they can drop. Production will be limited as we have started to see numerous mine closings, as it is estimated that 50% of the world’s zinc and 20% of the world’s nickel mines are currently uneconomic.
The price of gold was quite volatile during the quarter, trading as high as $930 per ounce and as low as $740, before ending at $874. It appears to have held up better than most other commodities though, confirming its status as a safe-haven investment in times of turmoil. Gold equities were not so fortunate. Starting in July, the equities began to decouple from the price of gold, underperforming by about 30%. Particularly hard hit have been the smaller companies. Those who will be impacted by a lack of lending have seen their share price fall over 80% this year. Longer term, we’re still positive on the prospects for gold for numerous reasons. With the massive amounts of capital being injected into the U.S. economy, and the resulting expansion in national debt, we expect a weaker U.S. dollar and stronger gold. As well, limited central bank sales and few new mines have limited the supplies of gold hitting the market.
Although things appear gloomy, there is still reason for optimism in the resource sector. Share valuations have been over-punished in many areas. The market is already pricing in large negative earning surprises, so share price reactions may be muted as news is released. Many of the longer-term secular themes that we have focused on during the past few years remain intact. Urbanization and modernization in countries such as China remains an on-going, yet temporarily weaker, trend. As well, even though commodity prices were exceptionally strong the past few years, the problems of the lack of new supply and infrastructure were not solved as escalating costs limited new development. It has been shown that the stock market foreshadows the economy by 6-9 months, so perhaps we have seen the lows. At present we are comfortable allocating some of our capital back into the markets, focusing on companies with strong balance sheets and low costs of production. Prices today will look like bargains one to two years out.
At the time of writing, markets continued their dramatic sell-off through the middle of October. Credit markets have started to see some opening up as coordinated global rate cuts, government debt guarantees, and massive injections of capital have led to some optimism that banks will lend again. The markets still have quite a ways to go to regain investor confidence, but a bet against the markets now is a bet against the balance sheets of governments worldwide.
Craig Porter
Portfolio Manager
Front Street Capital
CRAIG PORTER - Q3 2008 COMMENTARY
Date Published
Related Fund(s)
Fund Manager
Equity markets were extremely volatile in the quarter, as the credit crisis and collapsing housing markets in the U.S. started to spread around the world. Credit markets froze up to a point where lending stopped and banks refused to lend to each other, out of fears of counterparty risk. Lehman Brothers went bankrupt and other major investment banks were forced to merge or were nationalized to ensure survival. Markets were falling at a pace not seen since 1929. Dramatic action was required, and that’s what we saw from governments around the world. Fannie Mae and Freddie Mac, two agencies that issued and guaranteed mortgages, were essentially taken over by the US government. The U.S. government then announced a $700 billion bailout package to buy up bad mortgage instruments and to take direct equity stakes in banks in an attempt to get capital flowing. Massive amounts of capital have been injected into the banking system on a global basis in an attempt to get credit flowing again. These actions will have a positive effect, but some time will be needed before results are felt.
Energy prices were hard hit during the quarter, with the price of oil off 28% and the price of natural gas down 44%. After hitting an all-time high of $146 per barrel, influenced by speculative buying, we saw a sharp sell-off in the commodity on fears of dwindling demand in a recession. The U.S. still consumes about one of every four barrels produced, so any slowdown there would have a measurable effect on oil demand. As the quarter ended, oil was continuing its dramatic fall, and we anticipate that OPEC will soon intervene and cut production in an attempt to stabilize prices. On the equity side, the TSX Energy index was down 28% on the quarter. Large cap companies outperformed, as many have strong balance sheets due to years of rising commodity prices. The fear going forward is that lower commodity prices typically cause banks to limit credit, forcing companies to cut back on exploration or merger activity. We saw this scenario play out with Chesapeake, a large U.S. gas producer, who announced a $5 billion cut to their exploration budget over the next two years. Falling gas prices have dramatically cut into their profitability on drilling new wells. The outlook on natural gas looks positive though. Gas in storage, in North America, remains at normal levels as we enter winter, and exploration cutbacks will hinder future growth in production. A significant proportion of the decline in equity prices has been caused by fund liquidations to meet investor demand. Investors are looking for some semblance of stability in commodity prices before they get back into the sector.
Recession fears hit the base-metal sector hard in the third quarter. The prices of copper, nickel and aluminum were all down around 25%. Inventory levels started to build with slowdowns in the U.S. and Europe, and a temporary halt of heavy industry in China around the Olympics led to decreased demand. Although many companies have strong balance sheets, their shares remain below justified recessionary levels. Some shares are even trading at their cash levels. While the commodity prices have fallen dramatically, we feel they are approaching floor levels on how far they can drop. Production will be limited as we have started to see numerous mine closings, as it is estimated that 50% of the world’s zinc and 20% of the world’s nickel mines are currently uneconomic.
The price of gold was quite volatile during the quarter, trading as high as $930 per ounce and as low as $740, before ending at $874. It appears to have held up better than most other commodities though, confirming its status as a safe-haven investment in times of turmoil. Gold equities were not so fortunate. Starting in July, the equities began to decouple from the price of gold, underperforming by about 30%. Particularly hard hit have been the smaller companies. Those who will be impacted by a lack of lending have seen their share price fall over 80% this year. Longer term, we’re still positive on the prospects for gold for numerous reasons. With the massive amounts of capital being injected into the U.S. economy, and the resulting expansion in national debt, we expect a weaker U.S. dollar and stronger gold. As well, limited central bank sales and few new mines have limited the supplies of gold hitting the market.
Although things appear gloomy, there is still reason for optimism in the resource sector. Share valuations have been over-punished in many areas. The market is already pricing in large negative earning surprises, so share price reactions may be muted as news is released. Many of the longer-term secular themes that we have focused on during the past few years remain intact. Urbanization and modernization in countries such as China remains an on-going, yet temporarily weaker, trend. As well, even though commodity prices were exceptionally strong the past few years, the problems of the lack of new supply and infrastructure were not solved as escalating costs limited new development. It has been shown that the stock market foreshadows the economy by 6-9 months, so perhaps we have seen the lows. At present we are comfortable allocating some of our capital back into the markets, focusing on companies with strong balance sheets and low costs of production. Prices today will look like bargains one to two years out.
At the time of writing, markets continued their dramatic sell-off through the middle of October. Credit markets have started to see some opening up as coordinated global rate cuts, government debt guarantees, and massive injections of capital have led to some optimism that banks will lend again. The markets still have quite a ways to go to regain investor confidence, but a bet against the markets now is a bet against the balance sheets of governments worldwide.
Craig Porter
Portfolio Manager
Front Street Capital