Why a large weighting in the Resources sector is not suitable for investors looking for consistent dividends and low volatility
By Anton Tagliaferro | 29 November 2018
Australia is one of the largest exporters of commodities in the world – we are the largest iron ore producer as well as being one of the largest producers of coal, LNG and gold as well as many other minerals such as manganese and lithium. This is reflected in the fact that the Resources sector is one of the largest sectors of the index representing 20% of the ASX 300. This lesson seeks to explain the risks inherent with the Resource sector and what IML believes are the most important factors when picking stocks in the sector.
While investing in the right Resource stocks can be rewarding over the long term if one picks the right companies, the sector as a whole tends to be very volatile. This is because the profits and dividends from every Resource company are highly dependent on the price of the underlying commodity that they produce – and these prices are highly unpredictable. As such it is not a sector for the faint hearted nor prudent investor to be heavily invested in.
Let’s first explore what makes the Resource sector so volatile:
- Commodity prices are often very volatile and difficult to predict
Commodity prices are determined by the supply and demand for each commodity at a certain point in time. Thus, when demand increases for any commodity, this will generally have the impact of pushing the price of that commodity higher especially if the demand increase is unexpected (e.g. an extremely cold winter in the US pushes the demand for gas higher). As the price pushes higher, new production generally comes on stream until the imbalance adjusts and prices correct back to a new equilibrium point.
The demand /supply dynamics are the same for every commodity – when demand is strong this generally pushes prices higher which in turn incentivises producers of that commodity to increase production to take advantage of the higher price. Over time this new supply will generally match or exceed demand and the price of the commodity will fall as new supply comes on stream. Conversely, when demand for a commodity is low and supply exceeds demand, the price of the commodity will fall – so that at some point higher cost producers will reduce or close production and as the supply falls the commodity price will likely move higher as a new demand-supply equilibrium is restored.
This all sounds rational and simple – in reality it is a lot more complicated than this as there are various influences that materially impact on the short to medium term direction and prices of various commodity prices:
a) Global economic cycle
Commodity prices are very dependent on the strength of the global economic cycle. A strong global economy generally means more demand for most commodities and thus higher prices – while a global recession or slowdown generally means lower demand and prices.As such it is difficult to predict where commodities will trade as it is often very difficult to forecast the future strength of global economy with any accuracy.
The reliance of the health of the global economy, and in particular its appetite for commodities, has also made China a major factor. In the last 20 years the Chinese economy has grown very rapidly so that from being almost a fringe economy 20 years ago it has now become the second largest economy in the world. The emergence of China and its huge demand for commodities as it builds new cities, airports, rail lines and bridges continues to have a significant impact on commodity markets.
Source: CLSA, CRU
Thus if one looks at the chart above, the level of Chinese growth has a huge impact on all the commodities highlighted given that Chinese consumption is anywhere from 40% to 70% of the total global production of the commodities shown in the table above.
Three of Australia’s largest Resource companies BHP, RIO and Fortescue ship out hundreds of millions of tonnes of iron ore every year with most of this going to China, which now accounts for a staggering 72% of all the iron ore consumed worldwide. This iron ore is used by the Chinese steel industry to produces over 830 million tonnes of steel per annum, with most of this used to build new infrastructure in China. Clearly any significant slowdown in China’s economy will have a huge impact on the demand and price of iron ore and subsequently the level of profitability and dividends of BHP, RIO and Fortescue.
b) Financial players’ influence
In the last twenty years, we have also seen financial players play a larger role in influencing the prices of many commodities. This has led to commodity prices being a lot more volatile on a day-to-day basis.
As with most other parts of financial markets the huge growth in hedge funds, ETFs and computerised trading over the last 20 years means their scale is now enormous and these financial players can have a huge impact on the day to day and short-term prices movements of most commodities.
Thus if one looks at the oil market, global demand is currently running at around 100 million barrels a day and this has been growing at 1% or 2% per annum over the last decade.
However, if one looks at the daily amount of oil traded on the New York Mercantile Exchange (NYMEX) futures exchange in recent times, this is often in the order of 1 billion barrels a day – with volumes spiking to 2.7 billion barrels of oil traded on the NYMEX as recently as 13 November as the oil price tumbled. Much of this oil traded is by hedge funds, ETFs and other speculators and the huge amount of volume traded – which is well above the actual usage of oil – clearly demonstrates how short-term movements in commodities can be impacted by news flow as opposed to the natural demand /supply dynamics of the underlying commodity.
It is a similar story with copper – annual Copper consumption in 2017 reached around 24 million tons, yet on the London Metals Exchange alone, close to 900 million tons of copper was traded through the futures contracts during 2017 – a staggering 38 times the physical volume as ETF users, hedge funds and speculators sought to take advantage of short term price movements or changes to the demand /supply dynamics.
c) Supply/demand shocks and geopolitical risks
Commodities are also subject to unexpected supply and demand shocks. Cyclone Debbie in Queensland in early 2017 caused a spike in coking coal prices from US$150/t to over US$300/t in a matter of weeks (see chart below). Similarly, labour strikes in Chile – a major producer of copper – have had significant impacts on the price of copper in the past. Similarly, a colder or hotter than expected winter/summer in places like the US or Europe, have often pushed up the short-term price of coal and gas.
Source: Bloomberg; 3/1/2017-3/7/2018
Commodity reserves are also sometimes located in politically unstable regions. Venezuela, Iraq and Libya are all good examples where turmoil or political instability in these countries has impacted oil production.
Government policies can also have an impact on commodity prices. In April 2018, the US Government announced sanctions against Russia and aluminium producer Rusal. The sanctions resulted in the short-term alumina price, a key raw material to make aluminium, rallying from under US$400/t to around US$650/t. This was followed by a collapse in the alumina price to US$450/t after the US Government extended deadlines to comply with sanctions.
Source: Bloomberg; 12/9/2016-12/11/2018
- Small changes in the commodity price can have a big impact on the profitability of Resource companies
Not only are commodity prices hard to predict for all the reasons given above, but it is important to understand that small changes to commodity prices can have a huge impact on the underlying profit of Resource companies as many of their costs are fixed.
The best way to show how sensitive Resource companies are to a change in the commodity price is by way of a simple example.
Company XYZ produces 1 barrel of oil or 1 tonne of iron ore per annum. The current price of the commodity is $55 a tonne or a barrel and it costs the company $50 to produce this output. As shown in scenario A of Table 1 below, the profit from producing this output is $5.
Now let’s assume that there is a surge in demand for the commodity in any one month so that the price moves up 5% in a week to now be at $57.50. The profit of producing this output now becomes $7.50 (see scenario B). Or imagine an even stronger month when the price of the commodity jumps 10% from $55 to $60.50 – the profit now on this output now becomes $10.50 (scenario C).
In other words and as can be seen from Table 1 above, a 5% movement in the commodity price leads to a 55% jump in Company XYZ’s profit, while a 10% move in the commodity price increases company XYZ’s profits by a massive 110%.
Similarly when looking at Company XYZ, imagine a poor period of demand so that the price of the commodity drops 5% to $ 52.25 in any one month as shown in scenario D below – the profit of Company XYZ now drops to $2.25 representing a 55% drop in the profits of the company while a 10% drop in the commodity price to $49.50, has totally wiped out Company XYZ’s profitability (scenario E).
As can be seen from the example above, Resource companies’ profits are extremely sensitive to movements in underlying commodity prices – which in themselves are very hard to predict for the various reasons discussed previously.
The extreme sensitivity of the earnings of Resource companies to commodity prices – as shown in the simple example above – is the reason why profits of every Resource company can vary so greatly from year to year. All Resource companies are very dependent on the price received on world markets for the commodities they produce – and these price can swing very dramatically in any given period. It is thus often said that Resource companies are price takers – in other words they have no control over the price that they receive for the goods they produce. This is a very different situation to many Industrial companies such as CSL or Brambles where the product produced or service sold is so unique that these sorts of companies have some control over the price at which they sell their products or services.
The volatility and unpredictability in the level of earnings of Resource companies because of the many factors discussed above leads to not only extremely volatile share prices and earnings, but in turn the level of dividends that Resource companies pay can also prove very inconsistent.
The charts below show the dividends of two of Australia’s largest and well-known Resource companies – Woodside Petroleum and Newcrest Mining – Woodside is the largest LNG producer in Australia while Newcrest is Australia’s largest gold producer with production of over 1 million ounces a year.
As can be seen below, since 2008 the dividend track records of both companies have been rather choppy reflecting the underlying earnings made from each company’s LNG and gold production – where the prices of both commodities have been fairly volatile over this period.
Source: Factset; 1/1/2008-30/6/2018
So are Resource companies worth holding at all in an equity portfolio?
Because of our rich abundance of mineral wealth, Australia has some of the largest and most profitable Resource companies in the world listed on the ASX.
As mentioned previously, while a large holding in Resource companies adds a significant amount of volatility to an equity portfolio, over the long term some Resource companies have in fact performed well thanks to their growth in production as China has continued to grow.
So what should an investor look when investing a portion of their portfolio in this volatile sector?
We believe that the criteria below are the important ones to focus on when selecting a Resource stock for a prudently managed equity portfolio:
- Low cost producer – Being a low quartile producer ensures the company can at most times continue to earn a profit even during periods of very low commodity prices. Low cost producers also have the advantage of achieving higher margins and returns through the cycle.
- Long life reserves / mines – Resource companies operate mines that have a finite life of reserves. Over time as a mining company extracts the commodity and sells it, the reserves of the mine will deplete over time. Companies with a short mine life face the huge challenge of having to find new reserves to be able to maintain the same level of production. If the commodity extracted is not replaced by new reserves then the mining company will cease operating! So whenever selecting any Resource company for our portfolios, IML has always selected those companies that have a long reserve life.
- Good balance sheet – Given the highly cyclical and unpredictable nature of commodity markets having a prudent balance sheet is preferable in any company selected. Resource companies with high levels of debt are often forced to raise equity during cyclical downturns to repay debt, which can potentially destroy significant value for shareholders.
- Good management (capital allocation) – this is often hard to find as many managers of Resource companies tend to often have overly optimistic views of commodity markets – and this often leads to them expanding production or making acquisitions at the very wrong time of the cycle – as we saw over the last decade with BHP’s ill-timed expansion into US shale oil and RIO’s ambitious acquisition of aluminium producer Alcan as well as its purchase of the hopeful coal producer Riversdale Mining in Mozambique. BHP and RIO subsequently wrote off many billions of dollars on all these acquisitions.
As mentioned in Lesson 12, the best way to assess the value of any Resource stock is to use the NPV methodology, where a prudent long-term commodity price is used over the life of the company’s mine lives to calculate the NPV of the Resource company. The best time to buy Resource companies is when they trade below their NPV, which is usually when the price of the commodity has fallen sharply – as happened in 2015 when the oil price collapsed from USD 100 a barrel to nearly USD 30 a barrel.
Conclusion: While holding some selective Resource company exposure in an equity portfolio may help diversify the portfolio and increase the returns as commodity prices improve, this exposure also increases the level of volatility of the portfolio. Thus a heavy weighting in the sector is not recommended for investors wanting a more consistent level of dividends and returns.
While the information contained in this article has been prepared with all reasonable care, Investors Mutual Limited (AFSL 229988) accepts no responsibility or liability for any errors, omissions or misstatements however caused. This information is not personal advice. This advice is general in nature and has been prepared without taking account of your objectives, financial situation or needs. The fact that shares in a particular company may have been mentioned should not be interpreted as a recommendation to buy, sell or hold that stock.