The commodities sector has struggled in the past few years as a result of the eurozone debt woes, a sluggish US economy and slowing growth in China.
But with an ever-increasing global population, a limited supply of resources and greater demand, returns may yet be plentiful for those investing in natural resources.
In the very short term, where more traditional economic indicators, such as GDP, are backwards looking, commodities are traded based on futures contracts.
In anticipation of a global recovery, there has been a bounce back in the market. Prices move up and down based on projected demand, so they become useful tools for peering into the near future.
Copper has become particularly useful in foreshadowing economic activity in China, which is dominated by government infrastructure spending. It is also one of the most straightforward benchmarks because generally very little affects its price other than supply and demand. It has increased in value by 6.65 per cent in the past month.
According to Index Mundi, the price of Indonesian liquefied natural gas saw the largest gain in the past 12 months, rising 65.50 per cent. Cotton, on the other hand, saw its price depreciate by more than 43 per cent.
Overall, 33 out of the 90 commodities made a gain in the past 12 months.
Accessing commodities
There are two ways of accessing commodities – through a mutual fund or an exchange traded product (ETP) that tracks the price.
Where mutual funds were once the favoured choice, with global growth continuing to recover and supply-demand fundamentals forecast to continue to tighten, an increasing number of investors are using ETPs as a convenient method of gaining exposure, according to ETF Securities.
The group says that its commodity ETPs saw the largest inflows in 10 months in March, with inflows up $256m (£163m) as strengthening fundamentals in the market drove demand from investors.
Meanwhile, natural resources mutual funds made an average loss of 15.94 per cent in the year to March 9 2012, with the Craton Capital Global Resources fund making the largest loss, of 31.16 per cent, according to Morningstar. They also saw outflows of £47m.
However, all equities had a tough time during last August’s stockmarket dip, and natural resources mutual funds invest in companies that are actively involved in economically sensitive extractive industries or their service providers, so are naturally more volatile.
“Our view is that the market is going to be hard to call in the near term – three, six and nine months – but for the next decade we’d expect to see similar conditions to what we saw in the last decade. You will continue to see emerging market growth outperform developed market growth, and more importantly you will see the supply side struggle to keep up with demand.
“The supply side issues in terms of long-permitting times, cost of capital equipment going up, lack of labour engineers, fitters, boiler makers, lack of exploration and discovery mean these supply issues aren’t going away,” says Neil Gregson, co-manager of the £2.1bn JPM Natural Resources fund.
Richard Davis, manager of the BlackRock World Resources Income fund, agrees: “There are some very good opportunities in some of the commodity equities.
“They’re good value – they look cheap on a whole range of metrics – and their businesses are doing well. Commodity prices are at good levels and importantly [commodity producers’] balance sheets are much stronger than they have been, so one of the themes we’ve been seeing is that more cash is being returned to shareholders.
“If you buy a commodity equity today it’s pretty cheap. You will probably get a dividend that will grow and you’ll have potentially long-term capital growth as the commodity markets remain at decent levels, potentially higher.”
Equity funds
In the longer term, natural resources equity funds have produced an average monthly return of 1.52 per cent in the three years to March 2 2012, according to Morningstar.
Mr Davis also argues that active management is better because you can buy a commodity today and the price could remain flat for years, so your return is zero, yet if you buy an equity you will make money and the chances of it being the same price in 10 years are unlikely.
“Active managers can pick and choose whatever are the best stocks to own and not every stock will do well – certain ones will be managed poorly and will underperform. If you pick the right manager he or she will pick the stocks that will outperform.
“The other thing with equities is that they pay dividends so you can pick the stocks that will actually pay a dividend as well, so even if the market goes sideways you’ll still be receiving a cheque every quarter/year – it’s very powerful towards the long-term return,” he adds.
Outperforming companies
Mr Gregson says that the trick is to look for companies that can add value through exploration, develop their assets as well as manage their costs of production effectively.
He explains: “Our starting point is not trying to make money because commodity prices go up, but trying to get them to grow their production. So we use the scenario of flat commodity prices, which of course won’t happen, but it’s about identifying those companies that can grow production and in order to do that they need to make exploration and development success – and to buy companies that have discovered the deposit, buy them at the right price and have the equipment to utilise that.
“Every year that you extract from an oil or mine filed you’re depleting that resource. So their business model has to be that they either find more of the stuff nearby or more of the stuff in other countries, and other geographies and continue to produce the same amount, always replacing the stuff they extract every year. Those types of companies will outperform,” he adds.
Mr Gregson says that Fortescue Metals Group, an Australian iron ore company, is a great example of this.
“It’s the first investment which we made in the fund in 2005. When we bought it the stock price was well below $1 a share, as the market did not believe that the company could bring iron ore deposits in west Africa into production. But it did and that today has added market cap of AUS$17bn-18bn (£11.5bn-21.1bn). We still think that’s got a lot of growth in terms of production,” he says.
Mr Davis says you don’t have to dip too heavily into smaller companies to find potentially attractive holdings. “Some of the bigger names out there in mining and energy are on single digit price/earnings ratios for this year, and are yielding 2.5 per cent or 3 per cent and can grow [their payouts]. These are the likes of Rio Tinto and Chevron, which in our view are very good long-term investments.”
Especially if commodity prices go into decline from their recent highs, natural resource investors will have to pay attention to more active strategies if they wish to realise returns for their investors.
Simona Stankovska is features writer at Investment Adviser
