Fund Manager
Craig Porter
The resource markets have seen a dramatic correction in July and into early August. Oil has dropped $30 per barrel in the last month while gold has fallen over $100 per ounce in the last 10 sessions alone. Liquidity issues in the credit markets have spilled over into equities with small caps being sold rather aggressively. Many less liquid names have seen their share prices drop more than 10% on repeated days. The market is treating the resources sector as though the world is heading into a global recession, which we do not believe to be the case. In fact, if you look back through this decade and the resource boom, you’ll see that the market has had a 15-20% correction almost each year. Fear of SARS and the bird flu, as well as a Chinese slowdown have sent markets down sharply, only to see them rebound strongly when the underlying supply/demand fundamentals play out.
The recent trade in the market has been to sell out of natural resources and to buy the banks. We still feel that many of the excesses of bad real estate lending and easy capital will take a long time to be cleaned out of the global banking system. The U.S. dollar has had a significant bounce in the short term, but this has had more to do with relatively weaker performance in European economies than any positive fundamentals in the U.S. economy or its housing sector. We feel that the dollar will remain weak. This is positive for commodity demand as being priced in dollars, they become relatively cheaper for consumers in other countries.
Although there has been extreme volatility in commodity prices not a lot has changed fundamentally since we began the year, only sentiment. Strong global demand from emerging economies and tight supplies remains intact. On the demand side, energy of all forms continues to experience tightness. Global demand for oil has increased to over 87 million barrels a day, without a corresponding increase in production. Thermal coal, the primary source of electrical generation in India and China, remains very tight. India this week announced that 44 of their 77 thermal power stations were at critically low levels of inventory. On the supply side, continued impediments to bringing new projects on-stream have hindered supply. Higher capital and production cost, government interference, political unrest and labour issues have all halted development of new projects. We have also seen that the time frame to bring new projects on-stream has been extended, further lengthening this resource cycle. Supply has also been hurt by the decline in commodity prices. With the current zinc price it is estimated that between 15 to 20% of global mines are uneconomic, this has led to mines being shut by Lundin Mining and Teck/Xtrata.
M&A activity is starting to pick up as the relative valuations between large and small companies have widened. Larger, producing resource companies are cash rich and have access to additional capital. Meanwhile, their smaller brethren have been hard hit as a result of the broad market sell off, sector rotation, and the increasing difficulty in obtaining debt and equity financing for their projects. The winner in this cycle will be the companies making acquisitions at compelling valuations. Although takeover premiums have been relatively small (15 - 20% in many cases) targets with cash are attractive. Exclude the cash and these companies are trading at 2-3 times next years’ projected CF at lower than current commodity prices. Mid-tier producing companies like FNX and HBM are likely candidates to be taken over.
In light of the above we have taken steps to position the fund going forward. Cash has been raised to around 13% of the fund, principally through the sale of smaller cap, less liquid issuers. Although we maintain a diversified portfolio, we feel that this larger cap bias will allow us to be more flexible should we need to respond to market conditions and over/under weight a sector. At this time we have become more comfortable allocating capital into the companies with stronger fundamentals in the oil, gold, coal and fertilizer sectors. Many of the senior oil producers in Canada are trading around 4 times next years’ cash flow, offering compelling value. We’ve also been putting money into the oil service sector, in companies such as Trican, which we feel offer services that will be in high demand and short supply this winter.
With all the volatility in commodities and stock prices during the year, we believe investors are looking for stability. The price of oil has swung between $95 and $145 per barrel this year before settling currently at $115. If commodities traded in a narrower range it would provide a better foundation to determine long-term value in many projects and stocks. What we as managers have to do is look at the longer-term supply/demand fundamentals and ignore the shorter-term noise in the market. We are still believers in an extended bull market in commodities, but we must be aware of the external factors that are affecting capital flows, such as the flight to liquidity and the increasingly tight access to capital.
Craig Porter
Portfolio Manager
Front Street Capital
Front Street Resource Peformance Fund - Manager Commentary
Date Published
Related Fund(s)
Fund Manager
The resource markets have seen a dramatic correction in July and into early August. Oil has dropped $30 per barrel in the last month while gold has fallen over $100 per ounce in the last 10 sessions alone. Liquidity issues in the credit markets have spilled over into equities with small caps being sold rather aggressively. Many less liquid names have seen their share prices drop more than 10% on repeated days. The market is treating the resources sector as though the world is heading into a global recession, which we do not believe to be the case. In fact, if you look back through this decade and the resource boom, you’ll see that the market has had a 15-20% correction almost each year. Fear of SARS and the bird flu, as well as a Chinese slowdown have sent markets down sharply, only to see them rebound strongly when the underlying supply/demand fundamentals play out.
The recent trade in the market has been to sell out of natural resources and to buy the banks. We still feel that many of the excesses of bad real estate lending and easy capital will take a long time to be cleaned out of the global banking system. The U.S. dollar has had a significant bounce in the short term, but this has had more to do with relatively weaker performance in European economies than any positive fundamentals in the U.S. economy or its housing sector. We feel that the dollar will remain weak. This is positive for commodity demand as being priced in dollars, they become relatively cheaper for consumers in other countries.
Although there has been extreme volatility in commodity prices not a lot has changed fundamentally since we began the year, only sentiment. Strong global demand from emerging economies and tight supplies remains intact. On the demand side, energy of all forms continues to experience tightness. Global demand for oil has increased to over 87 million barrels a day, without a corresponding increase in production. Thermal coal, the primary source of electrical generation in India and China, remains very tight. India this week announced that 44 of their 77 thermal power stations were at critically low levels of inventory. On the supply side, continued impediments to bringing new projects on-stream have hindered supply. Higher capital and production cost, government interference, political unrest and labour issues have all halted development of new projects. We have also seen that the time frame to bring new projects on-stream has been extended, further lengthening this resource cycle. Supply has also been hurt by the decline in commodity prices. With the current zinc price it is estimated that between 15 to 20% of global mines are uneconomic, this has led to mines being shut by Lundin Mining and Teck/Xtrata.
M&A activity is starting to pick up as the relative valuations between large and small companies have widened. Larger, producing resource companies are cash rich and have access to additional capital. Meanwhile, their smaller brethren have been hard hit as a result of the broad market sell off, sector rotation, and the increasing difficulty in obtaining debt and equity financing for their projects. The winner in this cycle will be the companies making acquisitions at compelling valuations. Although takeover premiums have been relatively small (15 - 20% in many cases) targets with cash are attractive. Exclude the cash and these companies are trading at 2-3 times next years’ projected CF at lower than current commodity prices. Mid-tier producing companies like FNX and HBM are likely candidates to be taken over.
In light of the above we have taken steps to position the fund going forward. Cash has been raised to around 13% of the fund, principally through the sale of smaller cap, less liquid issuers. Although we maintain a diversified portfolio, we feel that this larger cap bias will allow us to be more flexible should we need to respond to market conditions and over/under weight a sector. At this time we have become more comfortable allocating capital into the companies with stronger fundamentals in the oil, gold, coal and fertilizer sectors. Many of the senior oil producers in Canada are trading around 4 times next years’ cash flow, offering compelling value. We’ve also been putting money into the oil service sector, in companies such as Trican, which we feel offer services that will be in high demand and short supply this winter.
With all the volatility in commodities and stock prices during the year, we believe investors are looking for stability. The price of oil has swung between $95 and $145 per barrel this year before settling currently at $115. If commodities traded in a narrower range it would provide a better foundation to determine long-term value in many projects and stocks. What we as managers have to do is look at the longer-term supply/demand fundamentals and ignore the shorter-term noise in the market. We are still believers in an extended bull market in commodities, but we must be aware of the external factors that are affecting capital flows, such as the flight to liquidity and the increasingly tight access to capital.
Craig Porter
Portfolio Manager
Front Street Capital