What’s the best bet: commodities or miners?
Another round of infrastructure spending in mainland China would be positive for iron ore and steel
Let’s assume that you are a somewhat contrarian investor and take the view that the recent slump to fresh lows in commodity prices, and the share prices of producers, is a sign that a turnaround is coming in 2016.
If you do take this view, is it better to buy the actual commodities or the shares of the companies that extract them?
Unfortunately there is no clear precedent from recent history to suggest that one will significantly outpace the other, but that doesn’t mean there’s no value in looking in what has happened in previous commodity routs.
BHP Billiton, the world’s largest diversified miner, reached its lowest since the 2008 financial crisis in Sydney trading on November 11, hitting an intraday low of A$19.81 (HK$107.79) a share, before closing at A$20.23.
The stock has lost almost 57 per cent in US dollar terms since the commodity rout got under way in the middle of last year, outstripping a drop in the S&P Goldman Sachs Commodity Index.
The index is a good proxy for BHP as it contains oil, which also represents about a third of BHP’s profits.
The S&P GSCI is down almost 50 per cent since its 2014 peak of 672.54 on June 23, meaning that its losses, while still numbing for investors, haven’t been as bad as those suffered by BHP shareholders.
Of course, shareholders enjoy dividends, and BHP management has remained committed to maintaining a progressive, or ever-increasing, dividend policy.
The main question is whether the company can maintain that policy, especially in the light of the likely costs of the fatal dam spill at a co-owned mine in Brazil this month and the seemingly relentless weakness in commodity prices.
BHP underperformed the index in the 2008 crisis as well, dropping 73 per cent in US dollar terms between May 2008 and November of that year, while the S&P GSCI shed 66 per cent between July 2008 and February 2009.
In the 2008 recession, BHP peaked and recovered before the index, while in the present commodity collapse, the index started sliding before the shares, even if its decline hasn’t been as steep.
While BHP has underperformed a relevant benchmark, its Anglo-Australian rival Rio Tinto has fared slightly better. Rio’s Sydney-listed shares dropped 42.2 per cent in US dollar terms from February 2013 to a late September low this year of around US$32.
Asian spot iron ore dropped 72.2 per cent in that time, from US$158.90 a tonne in February 2013 to the low of US$44.10 in July this year.
Iron ore provides about 90 per cent of Rio’s profits, making the spot price a more relevant benchmark for the company’s shares than a broader-based index.
Rio also outperformed iron ore in the previous price correction, when the spot price dropped 54 per cent from a record high reached in February 2011 to a low in September 2012.
Rio’s shares fell 46 per cent between April 2011 and August 2012 in US dollar terms, meaning, that similar to BHP, the stock started recovering slightly before the underlying commodity.
But before concluding that equities are more likely to recover before commodities, it’s worth deciding exactly what form any expected recovery in commodity demand is likely to take.
The prevailing market view is that China, the world’s top consumer of natural resources, will attempt to kickstart its flagging economy by launching another round of infrastructure spending.
If this is the case, it will be positive for iron ore, steel and the minor metals most associated with steel beneficiation, such as manganese and zinc.
However, it’s also possible that the Chinese authorities will try to stimulate the economy through consumer spending, meaning more cars, consumer electronics and residential housing construction.
While these also use steel and aluminium, such stimulus would probably provide a bigger boost to industrial metals, with copper leading the pack.
It therefore becomes key to look at how any recovery will unfold, what commodities will be needed most and which of those commodities has the most constrained supply-demand balance.
Among major commodities, copper appears to have potentially the tightest market balance for 2016, meaning that a company like Freeport McMoRan, which is more focused on copper, stands to benefit more than diversified producers such as BHP, Rio and Glencore.
For commodities in structural oversupply, such as iron ore, companies could reap relatively bigger benefits from even a small rally in prices, as any gain in the price flows directly to the bottom line of major miners such as Rio and BHP, both of whom have spent much of the past three years driving cost cuts.
It’s also possible that companies with large trading operations will be early beneficiaries of any rebound in commodity demand, as they make money by being integrated into the whole supply chain from mine mouth to factory floor.
Many of these companies are privately held, but there are some listed ones such as Noble Group and Glencore, both of which have been hammered by investors recently.
While the risks of investing in commodity equities will rise the longer the price rout goes on and the more stress is placed on corporate balance sheets, companies are more likely to respond faster to any uptick in commodity demand.